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Mentorship Session II Will Showers – Director of Mentorship Welcome Back What we covered last time What is the the Investments Committee? What is our investment philosophy? Equity vs. Debt Time Value of Money “Dollar today is worth more than a dollar tomorrow” Risk Interest and discounting Long vs short Mentorship || Session 2 Quiz 1 Review You are considering an equity investment in one of two companies. One, an oil company is nearing default on its debt, while the other, a utility, is in relatively stable condition and the yield on its bonds is 3%. Additionally, banks are currently paying 1.5% for you to keep your money in a CD (assume this is risk-free). With this in mind, what would be a reasonable return expectation should you choose to invest in the oil company? Think about risk! Mentorship || Session 2 Today’s Topics Modern Portfolio Theory Accounting Fundamentals Beta, Covariance Diversification Risk/reward Income Statement Balance Sheet Statement of Cash Flows Ask questions! Mentorship || Session 2 Modern Portfolio Theory Risk aversion, diversification, portfolio optimization, Mentorship || Session 2 Modern Portfolio Theory Theory on how risk-averse investors construct portfolios to maximize expected return given a level of market risk Risk aversion Humans like to avoid risk Investing is inherently risky! Not all investors feel the same about risk Example Investor A is extremely risk averse Two investments: US Treasuries or Tesla Motors? Which will he be more inclined to choose? Mentorship || Session 2 Modern Portfolio Theory Theory on how risk-averse investors construct portfolios to maximize expected return given a level of market risk Portfolio A range of investments held by an investor Could include a range of stocks from different sectors, some bonds, and maybe even some currencies, commodities, or other ‘alternative’ investments Why is portfolio construction so important? Investor A has $10,000. He can invest all of it into a single company, or he can invest $1000 into ten different companies across the market. Option 1: After investing all of his money into company A, he reads the news and sees that one of Company A’s manufacturing plants burnt down. He loses A LOT. Option 2: After investing all of his money across ten different companies, he reads the same news. He still loses a bit of money, but the next article was an earnings report for another company he holds. This caused “Company B’s” stock price to go up. The other 8 companies tracked the market and were ‘up’ for the day. Now, a disaster in one of his investments has only lost him a little money, if any at all! Mentorship || Session 2 Modern Portfolio Theory Theory on how risk-averse investors construct portfolios to maximize expected return given a level of market risk Expected Return The amount an investor would ‘expect’ to receive from an investment Based off of historical returns and implies risk Remember, we expect riskier investments to have higher returns If not, we would never invest in them! Mentorship || Session 2 Modern Portfolio Theory Theory on how risk-averse investors construct portfolios to maximize expected return given a level of market risk Market Risk (‘Systematic’ risk) Possibility of losses due to factors that affect the overall performance of financial markets Recessions, legislation, certain commodity prices (e.g. oil), expectations Goal is to maximize our expected returns given a level of ‘exposure’ to market risk that we want to hold All companies are not exposed to equal levels of market risk Kraft Foods vs Cole Haan Whether the economy is strong or weak, consumers will still demand ‘staple’ foods from Kraft. BUT, if we are in a recession, how many consumers will shop at Cole Haan? Mentorship || Session 2 Measuring Market Risk Question: We have three companies: Kraft Foods, Ralph Lauren, and Boeing Kraft is a very stable company; relatively less affected by recessions Ralph Lauren sells ‘luxury’ products; relatively more affected by recessions Boeing sells airplanes. Many corporations need airplanes, but vacation travel is a ‘luxury’. Therefore, Boeing will be affected averagely by a recession So let’s say markets perform poorly and drop an average of 1% in value How do we expect our three company to perform respectively? How does this relate to Market Risk? Mentorship || Session 2 Measuring Market Risk Market Beta Measure of the market risk of a security or a portfolio in comparison to the market as a whole rp = a series of returns for a security or portfolio rb is a series of average returns for the ‘market’. Think of it as a measure of Volatility: Something that is highly volatile is liable to change rapidly and unpredictably Mentorship || Session 2 Market Beta Market Beta shows the expected percent change in the value of an asset given an average percent change in the market If you have a company with a Beta of 1.2, and the value of the S&P 500 goes up 1.0%, you would expect your asset’s value to have gone up 1.2% Remember Returns of any asset are expressed as the change in the value of that asset relative to its previous price If stock A’s price increases from $50 to $100, my return was 100% Return = (New Price – Old Price) / Old Price Mentorship || Session 2 Measuring Market Risk Market Beta is assessing returns Market Returns So how do we measure the returns of the ‘market’ as a whole? Theoretically, it would be the average return across all securities in a market for a given time period (e.g. 1 day) Measuring this is not realistic though Instead, we use an index Market Index S&P 500, Dow Jones Industrial Average Provide us with a ‘proxy’ for the average performance of the market Mentorship || Session 2 Market Beta So what does Beta tell us about “Market Risk”? Think about reactions: How will my investment react if the market changes by “X%”? There is risk implied in this: If your asset has a high beta, you may lose A LOT of money when the average security in the market only lost a little BUT, this also means that you may gain A LOT of money while the average security in the market only makes a little Doesn’t that sound exactly like if we have varying levels of risk? Mentorship || Session 2 Expected Returns Capital Asset Pricing Model (CAPM) is the most popular method for computing expected returns E(R) = Rf + b(RM – Rf) Rf = Risk-free Rate of Return b = Market Beta RM = Expected Average Return of the Market Expected Average Return of the Market Usually measured as the expected return of the S&P 500 Historically, it has been 5% - 8% As you can see, E(R) increases as b increases This implies that Beta is a measurement of systematic risk Mentorship || Session 2 Diversification As discussed earlier, we want to hold more than one asset at a time in order to diversify our holdings, thus lowering our risk Company-specific risk Risk unrelated to the macro-economy “Apple Inc’s CEO is indicted for fraud” This is bad for the company, and will ONLY affect Apple’s stock price The point of diversification is to eliminate us facing this risk as an investor If we hold 20 different assets, it is more likely that, when Apple’s stock price plummets from their CEO being indicted, IBM may develop a revolutionary product that causes their stock price to soar If you hold both, you have neutralized (or at least reduced) company-specific risk! Mentorship || Session 2 Diversification Example Hold a single stock in the Energy Industry (graphs in order of holdings) Exxon Mobil: -14.4% ConocoPhillips: -42.14% Schlumberger: -18.8% Or hold ALL of them Energy Select ETF: -26.7% Mentorship || Session 2 Measuring Total Risk All risk can be expressed through standard deviation of returns Smaller variations, smaller risk, smaller rewards Would you want your investments to be up 100% one day and down 50% the next? Sharpe Ratio Method of measuring risk by looking at risk taken to achieve excess returns over risk-free rate Mentorship || Session 2 Putting it all together… We now know how to eliminate unnecessary company-specific risk through diversification We know that risk-aversion is a measurement of our willingness to invest in risky assets We also know that Beta is a measurement of undiversifiable risk Using Beta, we can calculate our expected returns using the CAPM Mentorship || Session 2 Putting it all together… Using all of that information: We want to maximize our Risk/Reward given how much risk we feel comfortable taking on Reward is maximized for a given level of risk if we have completely diversified away company-specific risk and are faced only with systematic risk You control this via your Portfolio Beta Portfolio Beta The weighted-average Beta of all of the securities in a given portfolio Example: If you hold two assets, A & B, where A has a Beta of 1.5 and B has a Beta of 0.8, and you invest $5000 in each, your portfolio beta will be as follows: BetaP = 0.5*1.5 + 0.5*0.8 = 1.15 Mentorship || Session 2 Final Note How can two investors with different levels of riskaversion hold the same portfolio of risky investments? Combine it with a risk-free asset! US Treasuries are considered risk-free A riskless portfolio can be held if you invest all of your money into a risk-free asset Why? Granted, your returns will be very low What if you invest half of your money in the risk-free asset and the other half in your risky portfolio? Mentorship || Session 2 Accounting Fundamentals Financial Statements, major line-items, and flow-through Mentorship || Session 2 This is investing, why do I need accounting? What’s available to us as investors? Financial statements Financial Reports Income Statement, Balance Sheet, Statement of Cash Flows e.g. 10-k’s, 10-q’s, etc Public information on assets is usually in the form of accounting line-items Revenue, Earnings, Expenses, Interest, Total Debt, etc. Mentorship || Session 2 The Big Picture The Income Statement The Balance Sheet Details a company’s operating performance Revenues & costs “A snapshot in time” Distribution of assets, liabilities, and stockholders’ equity Statement of Cash Flows Where is a firm’s cash coming from (inflows)? Where is a firm’s cash going (outflows)? Mentorship || Session 2 Income Statement Displays aggregate financial performance for a firm over a given interval of time Usually one quarter or one fiscal year Revenues (Cost of Goods Sold) = Gross Profit (Operating Expenses) = Operating Income (EBIT) (Interest Expense) = Pre-tax Income (Income Taxes) = Net Income Mentorship || Session 2 Income Statement Importance What drives growth in a company? Increased sales, decreased expenses, new sources of revenue If we are an equity investor: The value of our shares goes up if the business grows! We are concerned with earnings (Net Income) because this is the amount of income left after all expenses have been paid If earnings is going down, the intrinsic value attributable to our shares is going down If we are a debt investor (holding a bond): We are worried about bankruptcy If revenue is decreasing, they may not be able to cover their interest obligations in the future! Mentorship || Session 2 Balance Sheet Called a ‘snapshot in time’ Reflects the company’s assets, liabilities and shareholder’s equity at a given point in time Items are listed in order of liquidity Assets = Liabilities + Shareholder Equity Mentorship || Session 2 Balance Sheet Mentorship || Session 2 Balance Sheet Gives us three main things What the company owns (assets) What the company owes (liabilities) How much shareholders have invested in the company (Shareholders’ Equity) Assets Organized by ‘liquidity’ Current Assets are those that can be reasonably expected to be converted into cash within a year Inventories, short-term investments, accounts receivable Assets = Liabilities + Shareholders’ Equity Mentorship || Session 2 Balance Sheet Liabilities Also organized by ‘liquidity’ Accounts for what is owed by the firm Accounts payable, commercial paper, long-term debt, etc Shareholders’ Equity Measures the value of the firm to actual owners of the firm (shareholders) Common Stock Additional paid-in capital ‘Par value’ of common equity issued Excess amount paid upon issuance of shares over par value Retained Earnings Net income that is not distributed to shareholders in the form of dividends is accounted for in retained earnings Mentorship || Session 2 Statement of Cash Flows Cash coming in and Cash flowing out Cash is King 3 primary components: CF from Operations CF from Investing Activities The cash flows from running the business Starts with Net Income and accounts for any non-cash expenses The cash flows from investments either into the company or into other marketable securities CF from Financing Activities The cash flows from issuing debt, issuing stock, paying dividends to shareholders, repurchasing shares, or repayment of debt Mentorship || Session 2 Statement of Cash Flows Total change in cash Cash on Balance Sheet from Previous = Starting cash for the period Period Starts with Net Income from Income + Cash Flow from Operations Statement from Current Period + Cash Flow from Investing Activities + Cash Flow from Financing Activities Cash on Balance Sheet for Current = Total Change in Cash Period Mentorship || Session 2 Statement of Cash Flows Mentorship || Session 2 Walk-throughs Seeing how common actions for corporations affect all three of the financial statements This is difficult! Don’t expect to understand this perfectly the first time through Ask questions as we go Mentorship || Session 2 What happens when we buy an asset? Let’s say we buy a new production plant for $10,000 Balance Sheet Income Statement Cash $10,000 Property, Plant, Equipment $10,000 No changes here for now Will see depreciation expense one year from now Statement of Cash Flows Under “Investing Activities” Cash paid for PP&E $10,000 Mentorship || Session 2 What happens a year from purchase? Depreciation Used to account for an asset’s decrease in value over time Also used to distribute the cost of acquiring an asset out over time on the income statement Think new plant vs old plant – which one works better? Matching principle of accounting Depreciation is recorded in two places Periodically as an expense on the income statement Periodically as a reduction to Property, Plant, and Equipment Mentorship || Session 2 Depreciation Example Last year we bought a plant for $10,000 and decide that it will last us 10 years, and will be worth $0 at the end of those 10 years This means that our depreciation expense must reduce the value of the asset from $10,000 to $0 over the course of 10 years Most obvious way to do this: $10,000 / 10 years = $1,000 = Annual Dep. Next, at the end of the first year, things change Depreciation expense of $1000 is recorded Income Statement - Decreases Income before taxes Balance Sheet - PP&E decreases by $1000 on the balance sheet Statement of Cash Flows - Cash Flow from Operations increases because we add back depreciation since it’s a non-cash expense Mentorship || Session 2 Depreciation Example Summary at end of year 1 (assume tax rate of 40%): Pre-tax income decreases by $1,000 Net income decreases by $600 Cash Flow From Operations increases by $400 We didn’t actually lose cash from our depreciation expense We already recorded the decrease in cash in capital expenditures when we originally purchased the asset Net income decreased by $600 BUT, we pocketed the $400 that we saved in taxes! Balance Sheet Cash increased by $400 PP&E decreased by $1,000 Retained Earnings decreased by $600 Remember, Net Income flows into R/E $400 - $1000 = - $600 (assets = liabilities + shareholder’s equity) Everything balances Mentorship || Session 2 What happens when we borrow money? A corporation decides to borrow $10,000. They promise to pay 10% interest annually and repay the original $10,000 at the end of 5 years. How do we record an issuance of debt? Cash Flow from Financing Activities Cash inflow, so we record cash for the period increasing by $10,000 If cash for the period increased, then we must increase cash on the Balance Sheet by the same amount Also, our long-term borrowings must increase by the same amount on the Balance Sheet. Remember, (Assets – Liabilities – Stockholders Equity) MUST equal zero Mentorship || Session 2 What happens when we borrow money? At the end of year 1, interest must be paid Income Statement Statement of Cash Flows Interest expense of $1000 (10% of 10,000) is recorded But remember, interest expense is recorded before taxes! Assuming a tax rate of 40%, Net Income will decrease by $600 Net Income flows into the top of Cash Flow from Operations But Interest payments are not recorded on this statement because we already accounted for it as a cash expense on the Income Statement! Balance Sheet Total Cash decreased by $600 on the assets side We make this balance by having Retained Earnings also decrease by $600 (Retained Earnings is part of Shareholder’s Equity) Net Income flows directly into Retained Earnings Mentorship || Session 2 What happens when we borrow money? At the end of year 10, principal must be repaid We record the repayment of the original $10,000 in the Cash Flow from Financing section in the Statement of Cash Flows Balance Sheet Cash decreased by the $10,000 from the Statement of Cash Flows We paid off our debt so long-term borrowings decreases by $10,000 Everything balances! Income Statement Principal repayment DOES NOT affect the income statement Mentorship || Session 2 Tax Shields As you saw in the past two examples, certain expenses actually reduce our tax liability Depreciation and Interest both decrease pre-tax income This means we pay less taxes! This is a benefit of holding more physical assets (depreciation) and raising capital through debt (interest) Mentorship || Session 2 What we have learned so far Modern Portfolio Theory Diversification Risk-aversion Expected Returns Market Beta Systematic and company-specific risk Combination of risky portfolios with a risk-free asset Accounting Fundamentals The Three Financial Statements Major line-items How the three financial statements work together Mentorship || Session 2 Closing Notes Session 2 Quiz Next Time A link will be sent out shortly after the meeting Please complete it by next Tuesday! Efficient Market Hypothesis Multiples Analysis Relative Valuation Questions? Email: [email protected] Hang around after Mentorship || Session 2
