SOLUTIONS TO
EXERCISES AND CASES
For
FINANCIAL STATEMENT ANALYSIS AND SECURITY
VALUATION
Stephen H. Penman
Fifth Edition
CHAPTER ONE
Introduction to Investing and Valuation
Concept Questions
1
,C1.1.Fundamental risk arises from the inherent risk in the business –
from sales revenue falling or expenses rising unexpectedly, for example.
Price risk is the risk of prices deviating from fundamental value. Prices
are subject to fundamental risk, but can move away from fundamental
value, irrespective of outcomes in the fundamentals. When an investor
buys a stock, she takes on fundamental risk – the stock price could drop
because the firm’s operations don’t meet expectations – but she also runs
the (price) risk of buying a stock that is overpriced or selling a stock that
is underpriced. Chapter 19 elaborates and Figure 19.5 (in Chapter 19)
gives a display.
C1.2.A beta technology measures the risk of an investment and the
required return that the risk requires. The capital asset pricing model
(CAPM) is a beta technology; is measures risk (beta) and the required
return for the beta. An alpha technology involves techniques that identify
mispriced stocks that can earn a return in excess of the required return
(an alpha return). See Box 1.1. The appendix to Chapter 3 elaborates on
beta technologies.
2
,C1.3.This statement is based on a statistical average from the historical
data: The return on stocks in the U.S. and many other countries during
the twentieth century was higher than that for bonds, even though there
were periods when bonds performed better than stocks. So, the argument
goes, if one holds stocks long enough, one earns the higher return.
However, it is dangerous making predictions from historical averages
when risky investment is involved. Averages from the past are not
guaranteed in the future. After all, the equity premium is a reward for
risk, and risk means that the investor can get hit (with no guarantee of
always getting a higher return). The investor who holds stocks (for
retirement, for example) may well find that her stocks have fallen when
she comes to liquidate them. Indeed, for the past 5-year period, the past
10-year period, and the past 25-year period up to 2010, bonds
outperformed stocks—not very pleasant for the post war baby-boomer at
retirement age at that point who had held “stocks for the long run.”
Waiting for the “long-run” may take a lot of time (and “in the long run
we are all dead”).
3
, The historical average return for equities is based on buying stocks
at different times, and averages out “buying high” and “buying low”
(and selling high and selling low). An investor who buys when prices are
high (or is forced to sell when prices are low) may not receive the
typical average return. Consider investors who purchased shares during
the stock market bubble in the 1990s: They lost considerable amount of
their retirement “nest egg” over the next few years. See Box 1.1.
C1.4.A passive investor does not investigate the price at which he buys
an investment. He assumes that the investment is fairly (efficiently)
priced and that he will earn the normal return for the risk he takes on.
The active investor investigates whether the investment is efficiently
priced. He looks for mispriced investments that can earn a return in
excess of the normal return. See Box 1.1.
4
EXERCISES AND CASES
For
FINANCIAL STATEMENT ANALYSIS AND SECURITY
VALUATION
Stephen H. Penman
Fifth Edition
CHAPTER ONE
Introduction to Investing and Valuation
Concept Questions
1
,C1.1.Fundamental risk arises from the inherent risk in the business –
from sales revenue falling or expenses rising unexpectedly, for example.
Price risk is the risk of prices deviating from fundamental value. Prices
are subject to fundamental risk, but can move away from fundamental
value, irrespective of outcomes in the fundamentals. When an investor
buys a stock, she takes on fundamental risk – the stock price could drop
because the firm’s operations don’t meet expectations – but she also runs
the (price) risk of buying a stock that is overpriced or selling a stock that
is underpriced. Chapter 19 elaborates and Figure 19.5 (in Chapter 19)
gives a display.
C1.2.A beta technology measures the risk of an investment and the
required return that the risk requires. The capital asset pricing model
(CAPM) is a beta technology; is measures risk (beta) and the required
return for the beta. An alpha technology involves techniques that identify
mispriced stocks that can earn a return in excess of the required return
(an alpha return). See Box 1.1. The appendix to Chapter 3 elaborates on
beta technologies.
2
,C1.3.This statement is based on a statistical average from the historical
data: The return on stocks in the U.S. and many other countries during
the twentieth century was higher than that for bonds, even though there
were periods when bonds performed better than stocks. So, the argument
goes, if one holds stocks long enough, one earns the higher return.
However, it is dangerous making predictions from historical averages
when risky investment is involved. Averages from the past are not
guaranteed in the future. After all, the equity premium is a reward for
risk, and risk means that the investor can get hit (with no guarantee of
always getting a higher return). The investor who holds stocks (for
retirement, for example) may well find that her stocks have fallen when
she comes to liquidate them. Indeed, for the past 5-year period, the past
10-year period, and the past 25-year period up to 2010, bonds
outperformed stocks—not very pleasant for the post war baby-boomer at
retirement age at that point who had held “stocks for the long run.”
Waiting for the “long-run” may take a lot of time (and “in the long run
we are all dead”).
3
, The historical average return for equities is based on buying stocks
at different times, and averages out “buying high” and “buying low”
(and selling high and selling low). An investor who buys when prices are
high (or is forced to sell when prices are low) may not receive the
typical average return. Consider investors who purchased shares during
the stock market bubble in the 1990s: They lost considerable amount of
their retirement “nest egg” over the next few years. See Box 1.1.
C1.4.A passive investor does not investigate the price at which he buys
an investment. He assumes that the investment is fairly (efficiently)
priced and that he will earn the normal return for the risk he takes on.
The active investor investigates whether the investment is efficiently
priced. He looks for mispriced investments that can earn a return in
excess of the normal return. See Box 1.1.
4
