Question

Please give us one example from your research, work, or personal life explaining

• The difference between risk and return in owning stocks.
• The concepts of the Capital Asset Pricing Model.
• How to determine a firm's future profit potential and relation to stock price.

Answer 1

1. Difference between risk & Return from owning stock:

Risk: Stock returns are not based on contractual obligations and hence, not guaranteed. (Even in the case of a guaranteed payment, risk is there based on the capability of the guarantor to fulfill he obligation). Hence there is a possibility of incurring losses or not getting the rate of return as anticipated. For example, the cost of one share of company acquired today, is $100. The investor expects dividend yield @10% every year and capital appreciation of 8%, proportionate to the period of holding. However, neither of these returns are assured. The company may end up in less profits or in losses. Price realization on selling the share afterwards might be less than 8% per year or even less than the cost incurring capital loss. This uncertainty of receiving returns is the risk from owning stock.

Return: The return on stock is the profit or loss a person receives from investing in any particular stock. For the same stock purchased above, if the stock price increases to $150, we have a gain of $50 on a purchase of $100. This is a 50% gain ($50/$100). Now had the asset value dropped to $20, this is a loss of 80% (($20-$100)/$100).The return on investing in any stock usually consists of 2 components: 1) Component from price move 2) Component from dividends. It is usually represented by the formulae:

Total Stock Return = { (P1-P0)+D}/P0

                     Where P1=Stock price at time 1

                                  P0=Stock price at time 0

                                  D=Dividend component                          

2. Concept of CAPM

Capital Asset Pricing Model or CAPM is a model that is used to calculate the expected return on investment as a function of the market return & the risk free rate. Expected return using CAPM is calculated using the formulae:

Re= Rf + [β * (Rm-Rf)]

Where Re denotes expected return on the security, Rf is the risk free rate of return, β is the beta of the stock which in turn measures the volatility of stock price vis-à-vis market movements and Rm is the expected return of the market.

Taking the example discussed above, the investor intends to buy a share at the cost of $100 per share today. Dividend yield is 10%. Beta of the stock is 1.2. Yield on Treasury bonds of maturity similar to the holding period of share is 3% which forms the proxy for risk-free rate of return. Expected yield from stock market during this period is 8%.

Then the Expected Return from the stock based on CAPM is 10% + [1.2*(8%-3%)]= 16%.

3. How to determine a firm's future profit potential and relation to stock price.

Stock price in future is dependant on the market perception regarding earnings capability of the company along with the systematic factors influencing the industry and/or economy.

Earnings and profit potential is mainly assessed using fundamental analysis. This involves measuring the efficiency and profitability of the company from the historical data and earnings forecast. The tools generally employed for this purpose are growth in production/ sales and its consistency, gross profit and net profit ratios, Return on Assets etc.

Return on Equity measures the income generating capacity of the firm, vis-à-vis equity capital employed. Computed in percentage terms, by dividing net income during the given period (normally one year) by the amount of equity funds outstanding. Since equity funds represents total assets less borrowings, this ratio is also called Return on Net Assets.

Better ratios and consistency in performance make the investment attractive and hence, cause increase in stock price

Price Earning Ratio (PE multiple) is the quick indicator of the valuation of the stock, existing as well as anticipated. This is arrived at by dividing Market Price of the share by Earning Per share (EPS).

Apart from the fundamentals of the company, industry prospects and possibility of changes in fiscal policies play major roles in determining stock price.