PORTFOLIO MANAGEMENT:
IMPLEMENTATION AND REVIEW
Selection of Securities
Selection of Bonds
• YTM
• Default risk
• Tax shield
• Liquidity
• Duration
Selection of stocks
• Technical analysis
• Fundamental analysis
Performance Evaluation
• The key dimensions of portfolio performance evaluation are
rate of return and risk.
• To calculate the average rate of return, over a period of
several years, the following measures may be employed.
• Arithmetic average of annual rates of return: AM
• internal rate of return (IRR) also called the money-
weighted rate of return.
• geometric average (or mean), also called the time-
weighted rate of return: GM
Performance Evaluation
Rate Of Return
1. Arithmetic Mean 2. IRR 3. Geometric Mean
Rate of Return Data
Year Market value of Dividend and Rate of return
the portfolio interest income
(Rs) (Rs)
0 100,000
1 105,000 10,000 10,000 + (105,000 – 100,000)
= 15%
100,000
2 95,000 10,000 10,000 + (95,000 – 105,000)
= 0.0%
105,000
3 120,000 10,000 10,000 + (120,000 – 95,000)
= 36.8%
95,000
4 140,000 12,000 12,000 + (140,000 – 120,000)
= 26.7%
120,000
5 150,000 12,000 12,000 + (150,000 – 140,000)
= 15.7%
140,000
A.M : (15.0 + 0.0 + 36.8 + 26.7 + 15.7) / 5 = 18.8%
10,000 10,000 10,000 12,000 12,000 + 150,000
IRR :100000 = + + + +
(1+r) (1+r)2 (1+r)3 (1+r)4 (1+r)5
r ≃ 17.65%
GM : [ (1.15) (1.00) (1.368) (1.267) (1.157)] 1/5 - 1 ≃ 18.2%
Risk
• Mean Absolute Deviation
d n
• Standard Deviation
• Beta
Performance Measure
Rp - Rf
Treynor Measure :
p
Rp - Rf
Sharpe Measure :
p
Jensen Measure : Rp - [Rf + p (RM - Rf)]
Annual Returns For Three Mutual Funds
And A Market Index
PERIOD FUND A FUND B FUND C RETURN ON RISK-FREE
MARKET RETURN
1 - 38.7 -16 -33 -26 7.9
2 39.6 39.4 30 36.9 5.8
3 11.1 34.3 18.2 23.6 5.0
4 12.7 -6.9 -7.3 -7.2 5.3
5 20.9 3.2 4.9 6.4 7.2
6 35.5 28.9 30.9 18.2 10
7 57.6 24.1 34.7 31.5 11.5
8 -7.8 0.0 6.0 -4.8 14.1
9 22.8 23.4 33.0 20.4 10.7
Mean: Rp 17.1 14.5 13.0 11 8.6
Standard
Deviation: σp 28.1 19.7 22.8 20.5 _
Beta: βp 1.20 0.92 1.04 1.00 _
Performance Evaluation Of The Three
Funds
Rp - Rf
Treynor measure :
p
17.1 - 8.6
Fund A : = 7.1
1.20
14.5 - 8.6
Fund B : = 4.9
0.92
13.0 - 8.6
Fund C : = 4.8
1.04
11.0 - 8.6
Market index : = 2.4
1.0
Rp - Rf
Sharpe Measure :
p
17.1 - 8.6
Fund A : = 0.302
28.1
14.5 - 8.6
Fund B : = 0.299
19.7
13.0 - 8.6
Fund C : = 0.193
22.8
11.0 - 8.6
Market index : = 0.117
20.5
Jensen Measure : Rp - [Rf + p (RM - Rf )]
Fund A : 17.1 - [8.6 + 1.20 (2.4)] = 5.62
Fund B : 14.5 - [8.6 + 0.92 (2.4)] = 3.69
Fund C : 13.0 - [8.6 + 1.04 (2.4)] = 1.90
Portfolio Management Approaches
• Fundamental analysis
• Technical analysis
Fundamental Analysis
• Evaluating the intrinsic value of a security
or investment by analyzing various
financial and economic factors.
Steps Involved:
Step 1: Economic and Market Analysis
Step 2: Analysis of Financial Statements
Step 3: Forecasting relevant payoffs
Step 4: Formulating a security value and
finding intrinsic value
Step 5: Making a recommendation
Fundamental Analysis
• Macroeconomics Analysis
• Industry Analysis
• Financial Statement Analysis
• Equity Valuation Model
Equity Valuation
Major categories of equity valuation models:
• Present value models or discounted cash flow models:
Estimate the intrinsic value of a security as the present
value of the future benefits expected to be received
• Multiplier Models or market multiple models: Based
mainly on share price multiples or enterprise value
multiples
• Asset based valuation models: Estimates the intrinsic value
of a common share from the estimated value of the assets
of a firm minus the estimated value of its liabilities and
preferred shares
Equity Valuation- Present Value Models
• Discounted Cash Flow Models
V0 =
•
V0 = Value of the share today, at t=0
Dt = Expected Cash flow in year t
r = required rate of return
Equity Valuation- Present Value Models
• Dividend Discount Model
• If the issuing firm is assumed to be a going
concern, the intrinsic value of a share is the
present value of expected future dividends
V0 =
V0 = Value of the share today, at t=0
Dt = Expected dividend in year t
r = required rate of return
Equity Valuation- Present Value Models
• Gordon Growth Model
• For companies in the mature stage of their life cycle, assumes dividends grow
indefinitely at a constant rate perpetually
• V0 = =
g=b*ROE
b = earnings retention rate
ROE = return on equity
• Multistage Dividend Discount Models
• Assumes that at some point company will start paying dividends that grow at a
constant rate
V0 = +
Ques: If the dividends paid by a firm in the
current year is Rs 10/share, and the growth
rate of dividends is 8 %. Calculate the
price/share is the required rate of return is
16%
Ques: If the dividends paid by a firm is
Years 0-3 4-8 9 yr onwards
Dividend (Rs) 6 10 12
require rate of return is 16 %.
Price/intrinsic value of the share today =?
Ques: If the dividends paid by a firm is
Years 0-3 4-8 9th year
Dividend (Rs) 6 10 12
After 9 years the growth rate of dividends is
10 %, and require rate of return is 16 %.
Price/intrinsic value of the share today =?
Ques : The dividends on a stock are
expected to be Rs.18, Rs.25, and Rs.30 for
the next three years. The share price is
expected to be Rs.350 at the end of three
years. If the required rate of return is 15%,
estimate the intrinsic value of the share.
A firm has 1 crore outstanding shares. In the
current year, out of 100 crores of its
earnings (net income), it paid 70 crores as
dividends. Its current return on equity is
14% and required rate of return by the
investors is 16 %.
Calculate the estimated intrinsic value.
Equity Valuation- Multiplier Models
• Price multiples that are generally used are:
• Price to earnings ratio (P/E): Ratio of the stock price to
earnings per share, and is used most frequently
• Price to book ratio (P/B): Ratio of the stock price to book
value per share
• Price to sales ratio (P/S): Ratio of stock price to sales per share
• Price to cash flow ratio (P/CF): Ratio of stock price to per
share measure of cash flow (free cash flow or operating cash
flow)
• Method of comparables is the most widely used approach.
Economic rationale underlying this method is the law of one
price, identical assets should sell for the same price
Multiplier Models - Example
Following data provides the P/E for the followings firms:
Firm Price Earnings P/E
A 554 38.7 14.3
B 688 43.2 15.9
C 670 34.2 19.6
D 521 37.7 13.8
Ques: Which stock appears to be undervalued?
Ques: If these firms have 95% of the total market (in terms of
sales), What will be the estimated share price of a firm E if its
earnings are 100 crores?
Equity Valuation- Asset Based Valuation
• Uses estimates of the market or fair value of the
company’s assets and liabilities.
• Works well for companies that do not have high
proportion of intangible assets.
• Asset based valuations models estimate value of equity
as the value of assets less the value of liabilities
Asset Based Valuation - Example
• An analyst has determined that the appropriate
EV/EBIDTA for company XYZ is 10.2. Using the
following information estimate the value of equity
• EBIDTA = 22,000,000
• MV of debt = 56,000,000
• Cash = 1,500,000
