C1.1.Fundamental risk arises from the inherent risk in the business –
from sales revenue falling or expenses rising unexpectedly, for example.
Price risk is the risk of prices deviating from fundamental value. Prices
are subject to fundamental risk, but can move away from fundamental
value, i...
SOLUTIONS TO EXERCISES AND CASES
For
FINANCIAL STATEMENT ANALYSIS AND SECURITY
VALUATION
Stephen H. Penman
Fifth Edition
CHAPTER ONE
Introduction to Investing and Valuation
Concept Questions
1. C1.1.Fundamental risk arises from the inherent risk in the business – from sales revenue falling or expenses rising unexpectedly, for example. Price risk is the risk of prices deviating from fundamental value. Prices are subject to fundamental risk, but can move away from fundamental value, irrespective of outcomes in the fundamentals. When an investor buys a stock, she takes on fundamental risk – the stock price could drop because the firm’s operations don’t meet expectations – but she also runs
the (price) risk of buying a stock that is overpriced or selling a stock that
is underpriced. Chapter 19 elaborates and Figure 19.5 (in Chapter 19) gives a display. C1.2.A beta technology measures the risk of an investment and the required return that the risk requires. The capital asset pricing model (CAPM) is a beta technology; is measures risk (beta) and the required return for the beta. An alpha technology involves techniques that identify
mispriced stocks tha t can earn a return in excess of the required return (an alpha return). See Box 1.1. The appendix to Chapter 3 elaborates on beta technologies. 2 C1.3.This statement is based on a statistical average from the historical data: The return on stocks in the U.S. and many other countries during the twentieth century was higher than that for bonds, even though there were periods when bonds performed better than stocks. So, the argument
goes, if one holds stocks long enough, one earns the higher return. However, it is dangerous making predictions from historical averages when risky investment is involved. Averages from the past are not guaranteed in the future. After all, the equity premium is a reward for risk, and risk means that the investor can get hit (with no guarantee of always getting a higher return). The investor who holds stocks (for retirement, for example) may well find that her stocks have fallen when she comes to liquidate them. Indeed, for the past 5-year period, the past 10-year period, and the past 25-year period up to 2010, bonds outperformed stocks—not very pleasant for the post war baby-boomer at
retirement age at that point who had held “stocks for the long run.” Waiting for the “long-run” may take a lot of time (and “in the long run we are all dead”).
3 The historical average return for equities is based on buying stocks
at different times, and averages out “buying high” and “buying low” (and selling high and selling low). An investor who buys when prices are
high (or is forced to sell when prices are low) may not receive the typical average return. Consider investors who purchased shares during the stock market bubble in the 1990s: They lost considerable amount of their retirement “nest egg” over the next few years. See Box 1.1. C1.4.A passive investor does not investigate the price at which he buys an investment. He assumes that the investment is fairly (efficiently) priced and that he will earn the normal return for the risk he takes on. The active investor investigates whether the investment is efficiently priced. He looks for mispriced investments that can earn a return in excess of the normal return. See Box 1.1. 4
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