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The Connections Between Valuation, Risk and Return: The Case for Buying at a Discount

The Connections Between Valuation, Risk and Return: The Case for Buying at a Discount. Berkeley Investment Advisors’ AAII Seminar April 2, 2009. Presented by Ray Meadows MBA, CPA, CFA. Introduction. Source: Yahoo Finance. Wall Street Experience + Record. 3. Risk Concepts: Volatility.

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The Connections Between Valuation, Risk and Return: The Case for Buying at a Discount

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  1. The Connections Between Valuation, Risk and Return: The Case for Buying at a Discount Berkeley Investment Advisors’ AAII Seminar April 2, 2009 Presented by Ray Meadows MBA, CPA, CFA

  2. Introduction Source: Yahoo Finance

  3. Wall Street Experience + Record 3

  4. Risk Concepts: Volatility Under Standard Academic Efficiency Assumption • Long run volatility is σ * √ T • Annual Volatility of 45% -> 2.8% daily standard dev. • Annual Return of 15% - > .06% daily – 45 times less • But over 5 years: Expected Return = 101% and Standard Deviation = 101% • Ratio of signal to noise drops to 1-1

  5. Drivers of Daily Volatility • Liquidity Trading: Noise Traders • Changes in Required Risk Premiums: I.e. Psychology and Emotion

  6. What About Long Run Risk? Price Effects of Liquidity Trades Quickly Disappear – Use Patience and Limit Orders Changes in Risk Premiums can have Long Lasting Effects on Valuations Long Run Mean Reversion in Risk Premiums & Prudent Buying can Mitigate this Risk Implication is: Focus on Analyzing & Managing Fundamental Risks

  7. Valuation Risk: Overpriced Stocks Source: Standard and Poors – based on reported earnings

  8. Connections Between Valuations and Risk and Return Two determinants of stock returns: A Company’s Returns on Capital: Cash Flows it Generates on it’s Investments How those Cash Flows are Valued by the Market Cash Flows put a Floor on where the Market can go. There is No Ceiling on Over-Valuation 8

  9. Historical Context This is a histogram of month end S&P 500 P/E ratios since 1950 using the average of 10 year trailing earnings as per Gary Shiller’s calculations. The blue bar is the average. The lower histogram shows only the months when the U.S. was in a recession.

  10. Mathematical Treatment NOTATION Vt= Our intrinsic valuation of the company at period t (Warren Buffet Analysis) Pt = Market price of the company at period t BVt = Book value of the company at period t ROEt = Expected Return on Equity at period t R = Our required return per period for this stock given its fundamental risks T = number of periods until ROE and R converge so that VT = BVT We calculate Intrinsic Value as: V0 = BV0*1+ ROE1 * 1+ ROE2 * 1+ ROE3 * . . . . 1+ ROET 1 + R 1 + R 1 + R 1 + R If P0 < V0 we expect to earn a return higher than what we require for the risk - So we have some “cushion” which effectively lowers our risk of not achieving R. Another Interpretation: We’re looking at expected ROE compared to our required returns to determine an appropriate Price to Book Value Ratio Note that P/E = P/B * 1/ROE so we’re also evaluating P/E ratios.

  11. Numerical Example - Undervalued Book Value = $100 We expect 1st Year ROE =30% then ROE = 12% thereafter Our required return R = 12% We calculate Intrinsic Value as V0 = $100 * (1.30/1.12) = $116.07 If P0 = $100 then the market is requiring a much higher return than we do so we would buy this stock. During the period the company earns $30 so BV = $130. If the stock price falls below BV the company can buy back stock to boost ROE in subsequent periods.

  12. Numerical Example - Overvalued Book Value = $100 You expect ROE =30% is sustainable for 5 years (but it in fact drops to 12% in the second year) Our required return R = 12% You pay $200 for the stock since V0 = $100 * (1.30/1.12)5 = $210.68 The company earns $30 in year 1 so P/E is only 7 and things look good, but in the 2nd year earnings drop to $15.60 (=12% * $130) This drop of almost 50% in earnings will likely cause the stock to drop to book value - $145.60 giving you a loss of 27% over 2 years.

  13. A Look At Amazon Price = 73.50 BV = $6.24, P/E = 49 P/B = 11.8 ROE = 33% Need to grow 21% per year for 20 years to justify -> implies 550Bn in Sales (2008 dollars)

  14. Apartment Investment Mgmt Co • Selling at 5 times projected 2009 Cash Flow • Management is selling assets at 8-9% yield • Can buy back stock at 18% yield to boost returns further.

  15. Implementation Foliofn – diversification without high trading costs Spend the time to do your homework OR Hire a Good Money Manager: Berkeley Investment Advisors Questions??

  16. Key Investor Attributes • Patience and Persistence • Time for Analysis • Flexibility • Focus on Detail and Invest in What you Know

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