Reilly-Brown- Investment Analysis and Portfolio Management-1

I use this book for the course I teach.

This book has good discussion of forecasting the variables required for analysis. Still, I feel a lot more detail needs to be added to the topic to make it useful to the reader. Also the treatment has to refer to books with more detail.

My complaint about the books of security analysis is that they are not written to provide a methodology which can be used by an aspiring investor or aspiring analyst subsequent to the study of the book.

As I identified some of these gaps, I did put in some efforts from my side to supplement the texts in my classes.

I teach Graham-Rao Method and Piotroski Methods as two methods which are totally based on past data. That gives an idea of analysis without any ambiguity. Analysis of an equity share that results in the decision to buy or not to buy.

This understanding then will be extended to DCF methods especially dividend discount model. This requires forecasting future performance of the company and here the descriptions in various books of security analysis is very limited. The methods are not clearly described and the empirical proof that the methods works with an accuracy, sufficient for investment decisions is not given. If well known and accomplished professors and scientists are not able to give an adequate treatment, there must be strong reasons. The reason could the random walk nature of corporate profits. But still it would be better, if the books contain the detailed descriptions of methods being used in practice (they must have been proposed by somebody at some point of time) along with the position of the empirical tests, that are not able to support them. But still we have to invest using some method, because we have to invest to produce things for tomorrow for ourselves. This is the risk in risky securities.

Target prices are now being given by many analysts. But as yet target price is not discussed in security analysis textbooks. I try to discuss target price methods in the class.

Technical analysis methods are more clear because they use past data and make a future prediction of trend. Once again, the empirical support may be lacking. But still the methods are more clear and there are many persons around who claim to be using them and making money in short term trading in the market. Security analysis textbooks still contain only one chapter on technical analysis. May be this allocation needs to change.

In this blog, in the posts related to the book, I plan to provide important points to remember and refresh frequently in various chapters of the book. I shall also post my comments on various issues in the chapters. I found from my experience that I do some improvements over the period, on various shortcomings that I identify at a point in time. Of course, we have to be ready to change our opinion also. Every can make a mistake in reasoning. Whenever it is pointed out, accepting the error should be a very normal response. Learning is change in behaviour. So only by accepting that the current method is inefficient or faulty, that we decide to change our behaviour and learn new behaviour.

R-B-Ch.1 Points to Refresh

Why Do Individuals Invest ?

By saving money (instead of spending it), individuals tradeoff present consumption for a larger future consumption.

Defining Investment

A current commitment of $ for a period of time in order to derive future payments that will compensate for:
the time the funds are committed
the expected rate of inflation
uncertainty of future flow of funds.

Measures of Historical Rates of Return

Holding Period Return (HPR)

= Ending value of investment/Beginning value of investment

Holding Period Yield 9HPY)

HPY = HPR - 1

*This difference between return and yield proposed by Reilly is not standard terminology.
Readers have to take a note of it.

Annual Holding Period Return can be calculated from HPR

Annual HPR = HPR^(1/n)
where n = number of years investment is held

Annual Holding Period Yield
Annual HPY = Annual HPR - 1

Arithmetic Mean of Annual HPY can be a measure of past annual average yield

Geometric Mean of past HPYs can also be a measure of average past yield.

For a Portfolio of Investments

The mean historical rate of return for a portfolio of investments is measured as the weighted average of the HPYs for the individual investments in the portfolio.

Expected Rates of Return (Future orientation - what is likely to happen in future)

Risk is uncertainty that an investment will earn its expected rate of return
Probability is the likelihood of an outcome

Estimates for the future are made based on the past data.

Risk Aversion
The assumption that most investors will choose the least risky alternative, all else being equal and that they will not accept additional risk unless they are compensated in the form of higher return

Measuring the Risk of Expected Rates of Return

Standard Deviation of the data is a measure of the Risk of Expected Rates of Return


Standard Deviation is the square root of the variance

Coefficient of variation (CV) a measure of relative variability that indicates risk per unit of return
= Standard Deviation of Returns/Expected Rate of Returns


Determinants of Required Rates of Return for Individual investments (Different types of assets, and specific securites in an asset category)

Time value of money
Expected rate of inflation
Risk involved

The Real Risk Free Rate (RRFR)

This rate is arrived at on the basis of:
Assumes no inflation.
Assumes no uncertainty about future cash flows.
Influenced by time preference for consumption of income and investment opportunities in the economy

Nominal Risk-Free Rate

Inflation is factored in.

Dependent upon
Conditions in the Capital Markets
Expected Rate of Inflation

Nominal RFR =
(1+Real RFR) x (1+Expected Rate of Inflation) - 1

Return required by investors will NRFR plus risk premium

Facets of Fundamental Risk

Business risk
Financial risk
Liquidity risk
Exchange rate risk
Country risk

Risk Premium is a function of (Business Risk, Financial Risk, Liquidity Risk, Exchange Rate Risk, Country Risk)

From modern portfolio theory based on equilibrium conditions, it was derived that in equilibrium risk premium depends only on systematic risk.

Systematic risk refers to the portion of an individual asset’s total variance attributable to the variability of the total market portfolio

Beta measures this systematic risk of an asset

R-B-Ch.10 Points to Refresh

Major Financial Statements

Corporate shareholder annual and reports must include

Balance sheet
Income statement
Statement of cash flows

Reports filed with Securities and Exchange Commission (SEC)
10-K and 10-Q


Generally Accepted Accounting Principles (GAAP)

In USA formulated by the Financial Accounting Standards Board (FASB)
In India, Institute of Chartered Accountants.
Provides some choices of accounting principles
Financial statements footnotes must disclose which accounting principles are used by the firm


Balance Sheet

Shows resources (assets) of the firm and how it has financed these resources

Indicates current and fixed assets available at a point in time

Financing is indicated by its mixture of current liabilities, long-term liabilities, and owners’ equity

Income Statement

Indicates the flow of sales, expenses, and earnings during a time period.

Statement of Cash Flows

Integrates the information on the balance sheet and income statement

Shows the effects on the firm’s cash flow of income flows and changes in various items on the balance sheet

It has three sections:

Cash Flow from Operating Activities – the sources and uses of cash that arise from the normal operations of a firm
Cash Flow from Investing activities – change in gross plant and equipment plus the change in the investment account
Cash Flow from Financing activities– financing sources minus financing uses

Alternative Measures of Cash Flow

While the cash flow statement and its format are of recent origin, investment community was using certain other concepts of cash flow earlier. Also some other concepts of cash flow are being used by analytical models and investors/analysts.

Traditional cash flow equals net income plus depreciation expense and deferred taxes

Free cash flow recognizes that some investing activities are critical to ongoing success of the firm. hence deducts the capital expenditure required to sustain the current operations from the cash flow.


Purpose of Financial Statement Analysis

Evaluate management performance in three areas by current investors and creditors:

Profitability
Efficiency of operations
Risk

Evaluate company performance in three areas by potential equity investors and lenders:
Profitability
Efficiency of operations
Risk


Information from the Financial Statements

One can the amount of sales in year, profit made in a year, the size of balance sheet, the amount debt carried etc. from a single balance sheet and profit and loss statement.

But ratios contain some more information. Some authors mention that they are more valuable than raw numbers.

Ratios provide meaningful relationships between individual values in the financial statements

Importance of Relative Financial Ratios

Compare to other entities
Examine a firm’s performance relative to:
-The aggregate economy
-Its industry or industries
-Its major competitors within the industry
-Its past performance (time-series analysis)

Five Categories of Financial Ratios

1. Internal liquidity (solvency)
2. Operating performance
a. Operating efficiency
b. Operating profitability
3. Risk analysis
a. Business risk
b. Financial risk
4. Growth analysis
5. External liquidity (marketability)


Common Size Statements

Normalize balance sheets and income statement items to allow easier comparison of different size firms
A common size balance sheet expresses accounts as a percentage of total assets
A common size income statement expresses all items as a percentage of sales

These statements very useful for forecasting future profit and loss account.

Evaluating Internal Liquidity

Internal liquidity (solvency) ratios indicate the ability to meet future short-term financial obligations
Current Ratio examines current assets and current liabilities
Quick Ratio adjusts current assets by removing less liquid assets
Cash Ratio is the most conservative liquidity ratio
Receivables turnover examines the quality of accounts receivable
Receivables turnover can be converted into an average collection period
Inventory turnover relates inventory to sales or cost of goods sold (CGS)
Average inventory processing time can be computed from Inventory turnover.
Cash conversion cycle combines information from the receivables turnover, inventory turnover, and accounts payable turnover

Evaluating Operating Performance

Ratios that measure how well management is operating a business
(1) Operating efficiency ratios
Examine how the management uses its assets and capital, measured in terms of sales dollars generated by asset or capital categories
(2) Operating profitability ratios
Analyze profits as a percentage of sales and as a percentage of the assets and capital employed

Operating efficiency ratios

Total asset turnover ratio indicates the effectiveness of a firm’s use of its total asset base (net assets equals gross assets minus depreciation on fixed assets).- Net sales/net total assets.
Net fixed asset turnover reflects utilization of fixed assets - net sales/net fixed assets

Operating profitability ratios

Gross profit margin measures the rate of profit on sales (gross profit equals net sales minus the cost of goods sold)