ASSIGNMENT

Course Code : MS-44

Course Title : Security Analysis and Portfolio Management
Assignment Code: MS-44/TM/2021

1. What is the significance of investment risk? Explain the various risks that may
influence the investment risk.

Investment Risk: The investment risk definition is the risk of a particular investment. Furthermore,
an investment risk assessment usually contains several different forms ranging from interest
rate risks to currency risks. Investment risk contains several different measures, including the
following:

9 types of investment risk

1. Market risk
The risk of investments declining in value because of economic developments or other events that
affect the entire market. The main types of market risk are equity risk, interest rate
risk and currency risk.
 Equity risk – applies to an investment in shares. The market price of shares varies all the time
depending on demand and supply. Equity risk is the risk of loss because of a drop in the market
price of shares.
 Interest rate risk – applies to debt investments such as bonds. It is the risk of losing money
because of a change in the interest rate. For example, if the interest rate goes up, the market
value of bonds will drop.
 Currency risk – applies when you own foreign investments. It is the risk of losing money because
of a movement in the exchange rate. For example, if the U.S. dollar becomes less valuable
relative to the Canadian dollar, your U.S. stocks will be worth less in Canadian dollars.

2. Liquidity risk
The risk of being unable to sell your investment at a fair price and get your money out when you
want to. To sell the investment, you may need to accept a lower price. In some cases, such
as exempt market investments, it may not be possible to sell the investment at all.

3. Concentration risk
The risk of loss because your money is concentrated in 1 investment or type of investment. When
you diversify your investments, you spread the risk over different types of investments, industries
and geographic locations.

4. Credit risk
The risk that the government entity or company that issued the bond will run into financial
difficulties and won’t be able to pay the interest or repay the principal at maturity. Credit
risk applies to debt investments such as bonds. You can evaluate credit risk by looking at the credit
rating of the bond. For example, long-term Canadian government bonds have a credit rating of AAA,
which indicates the lowest possible credit risk.

5. Reinvestment risk
The risk of loss from reinvesting principal or income at a lower interest rate. Suppose you buy a
bond paying 5%. Reinvestment risk will affect you if interest rates drop and you have to reinvest the
regular interest payments at 4%. Reinvestment risk will also apply if the bond matures and you have
to reinvest the principal at less than 5%. Reinvestment risk will not apply if you intend to spend the
regular interest payments or the principal at maturity.

6. Inflation risk
The risk of a loss in your purchasing power because the value of your investments does not keep up
with inflation. Inflation erodes the purchasing power of money over time – the same amount of
money will buy fewer goods and services. Inflation risk is particularly relevant if you own cash or
debt investments like bonds. Shares offer some protection against inflation because most
companies can increase the prices they charge to their customers. Share prices should therefore
rise in line with inflation. Real estate also offers some protection because landlords can increase
rents over time.

7. Horizon risk:
The risk that your investment horizon may be shortened because of an unforeseen event, for
example, the loss of your job. This may force you to sell investments that you were expecting to
hold for the long term. If you must sell at a time when the markets are down, you may lose money.

8. Longevity risk
The risk of outliving your savings. This risk is particularly relevant for people who are retired, or are
nearing retirement.

9. Foreign investment risk

The risk of loss when investing in foreign countries. When you buy foreign investments, for
example, the shares of companies in emerging markets, you face risks that do not exist in Canada,
for example, the risk of nationalization.

2. What are Primary and Secondary markets? Explain the Principal steps involved in
floating a Public Issue and discuss the SEBI guidelines for floating Initial Public
Offering (IPO) with help of a care example.
Primary Markets : The primary market is where securities are created. It's in this market that firms
sell (float) new stocks and bonds to the public for the first time. An initial public offering, or IPO, is
an example of a primary market. These trades provide an opportunity for investors to buy securities
from the bank that did the initial underwriting for a particular stock. An IPO occurs when a private
company issues stock to the public for the first time.

The Secondary Market: For buying equities, the secondary market is commonly referred to as
the "stock market." This includes the New York Stock Exchange (NYSE), Nasdaq, and all major
exchanges around the world. The defining characteristic of the secondary market is that investors
trade among themselves.
That is, in the secondary market, investors trade previously issued securities without the issuing
companies' involvement. For example, if you go to buy Amazon (AMZN) stock, you are dealing only
with another investor who owns shares in Amazon. Amazon is not directly involved with the
transaction.
 IPO Process Steps: Companies typically go public to raise huge amount of capital in exchange for
securities. Once a private company is convinced about the need to become a public company, it
kick-starts the process of IPO. One should note that the entire IPO process is regulated by the
‘Securities and Exchange Board of India (SEBI)’. This is to check the likelihood of a scam and protect
investor interest.

Step 1: Hiring Of An Underwriter Or Investment Bank

To start the initial public offering process, the company will take the help of financial experts, like
investment banks. The underwriters assure the company about the capital being raised and act as
intermediaries between the company and its investors. The experts will also study the crucial
financial parameters of the company and sign an underwriting agreement. The underwriting
agreement will usually have the following components:
 Details of the deal
 Amount to be raised
 Details of securities being issued

Step 2: Registration For IPO

This IPO step involves the preparation of a registration statement along with the draft prospectus,
also known as Red Herring Prospectus (RHP). Submission of RHP is mandatory, as per the
Companies Act. This document comprises all the compulsory disclosures as per the SEBI and
Companies Act. Here’s a look at the key components of RHP:
 Definitions: It contains the definitions of the industry-specific terms.
 Risk Factors: This section discloses the possibilities that could impact a company’s finances.
 Use of Proceeds: This section discloses how the money raised from investors will be used.
 Industry Description: This section details the working of the company in the overall industry
segment. For instance, if the company belongs to the IT segment, the section will provide forecasts
and predictions about the segment.
 Business Description: This section will detail the core business activities of the company.
 Management: This section provides information about key management personnel.
 Financial Description: This section comprises financial statements along with the auditor's report.
 Legal and Other Information: This section details the litigation against the company along with
miscellaneous information.
This document has to be submitted to the registrar of companies, three days before the offer opens to
the public for bidding. Alongside, the submitted registration statement has to be compliant with the
SEC rules. Post-submission, the company can make an application for an IPO to SEBI.

Step 3: Verification by SEBI:

Market regulator, SEBI then verifies the disclosure of facts by the company. If the application is
approved, the company can announce a date for its IPO.

Step 4: Making An Application To The Stock Exchange

The company now has to make an application to the stock exchange for floating its initial issue.

Step 5: Creating a Buzz By Roadshows

Before an IPO opens to the public, the company endeavors to create a buzz in the market by
roadshows. Over a period of two weeks, the executives and staff of the company will advertise the
impending IPO across the country. This is basically a marketing and advertising tactic to attract
potential investors. The key highlights of the company are shared with various people, including
business analysts and fund managers. The executives adopt various user-friendly measures, like
Question and Answer sessions, multimedia presentations, group meetings, online virtual roadshows,
and so on.

Step 6: Pricing of IPO

The company can now initiate pricing of IPO either through Fixed Price IPO or by Book Binding
Offering. In the case of Fixed Price Offering, the price of the company’s stocks is announced in
advance. In the event of Book Binding Offering, a price range of 20% is announced, following which
investors can place their bids within the price bracket. For the bidding process, the investors have to
place their bids as per the company’s quoted Lot price, which is the minimum number of shares to be
purchased. Alongside, the company also provides for IPO Floor Price, which is the minimum bid
price and IPO Cap Price, which is the highest bidding price. The booking is typically open from three
to five working days and investors can avail the opportunity of revising their bids within the
stipulated time. After completion of the bidding process, the company will determine the Cut-Off
price, which is the final price at which the issue will be sold.

Step 7: Allotment of Shares

Once the IPO price is finalised, the company along with the underwriters will determine the number
of shares to be allotted to each investor. In the case of over-subscription, partial allotments will be
made. The IPO stocks are usually allotted to the bidders within 10 working days of the last bidding
date.

Step 1: Hire an investment bank: A company seeks guidance from a team of under-writers or
investment banks to start the process of IPO. More often than not, they take services from more
than one bank. The team will study the company’s current financial situation, work with their assets
and liabilities, and then they plan to cater to the financial needs. An underwriting agreement will be
signed, which will have all the details of the deal, the amount that will be raised, and the securities
that will be issued. Though the under-writers assure on the capital they will raise, they won’t make
promises. Even the investment banks will not shoulder all the risks involved in the money
movement.

Step 2: Register with the SEC: The Company and the under-writers, together, file the
registration statement, which comprises of all the fiscal data and business plans of the company. It
will also have to declare how the Company is going to utilise the funds it will raise from the IPO and
about the securities of public investment.
If the registration statement is compliant with the stringent guidelines set by the SEC, which ensures
that the company has disclosed every detail a potential investor should know, then it gets a green
signal. Or else it is sent back with comments. The company should then work on the comments and
file for registration again.
Step 3: Draft the Red Herring document: An initial prospectus, which contains the
probable price estimate per share and other details regarding the IPO, is shared with the
people who are involved with the IPO. It is called a red herring document because the first
page of the prospectus contains a warning which states that this is not a final prospectus.
This phase tests the waters for the IPO among the potential investors.

Step 4: Go on a road show: Before the IPO goes public, this phase happens over an action-
packed two weeks. The executives of the Company travel around the country marketing
the upcoming IPO to the potential investors, mostly QIBs. The agenda of the marketing
includes presentation of facts and figures, which will drum up the most positive interest.

5: IPO is priced: Based on whether Company wants to float a Fixed Price IPO or Book
Building Issue, the price or price band is fixed. A fixed price IPO will have a fixed price in the
order document, and the book building issue will have a price band within which an investor
can bid. The number of shares that will be sold is decided. The Company should also decide
the stock exchange where it be going to list their shares. The Company asks the SEC to
announce the registration statement as effectual, so that purchases can be made.

Step 6: Available to the public: On a planned date, the prospectus and application forms
are made available to public, online and offline. People can get a form, from any designated
banks or broker firms. Once they fill in the details, they can submit them with a cheque, or
online, as well. SEBI has fixed the period of availability of an IPO to the public, which is
usually 5 working days.

Step 7: Going through with the IPO: After the IPO price is finalized, the stakeholders and
under-writers work together to decide how many shares will every investor will receive.
Investors will usually get full securities unless it is oversubscribed. The shares are credited to
their demat account. The refund is given if the shares are oversubscribed. Once the
securities are allotted, the stock market will start trading the Company’s IPO.
Overview of the IPO Process

This guide will break down the steps involved in the process, which can take anywhere from
six months to over a year to complete. Below are the steps a company must undertake to go
public via an IPO process:

Step 1: Select an investment bank

The first step in the IPO process is for the issuing company to choose an investment bank to
advise the company on its IPO and to provide underwriting services. The investment bank is
selected according to the following criteria:

 Reputation
 The quality of research
 Industry expertise
  Distribution, i.e., if the investment bank can provide the issued securities to more
institutional investors or to more individual investors
 Prior relationship with the investment bank

Step 2: Due diligence and regulatory filings

Underwriting is the process through which an investment bank (the underwriter) acts as a
broker between the issuing company and the investing public to help the issuing company
sell its initial set of shares. The following underwriting arrangements are available to the
issuing company:

 Firm Commitment: Under such an agreement, the underwriter purchases the whole
offer and resells the shares to the investing public. The firm commitment
underwriting arrangement guarantees the issuing company that a particular sum of
money will be raised.
 Best Efforts Agreement: Under such an agreement, the underwriter does not
guarantee the amount that they will raise for the issuing company. It only sells the
securities on behalf of the company.
 All or None Agreement: Unless all of the offered shares can be sold, the offering is
canceled.
 Syndicate of Underwriters: Public offerings can be managed by one underwriter
(sole managed) or by multiple managers. When there are multiple managers, one
investment bank is selected as the lead or book-running manager. Under such an
agreement, the lead investment bank forms a syndicate of underwriters by forming
strategic alliances with other banks, each of which then sells a part of the IPO. Such
an agreement arises when the lead investment bank wants to diversify the risk of an
IPO among multiple banks.

An underwriter must draft the following documents:

Engagement Letter: A letter of engagement typically includes:

1. Reimbursement clause: This clause mandates that the issuing company must cover all
out-of-the-pocket expenses incurred by the underwriter, even if the IPO is withdrawn
during the due diligence stage, the registration stage, or the marketing stage.
2. Gross spread/underwriting discount: Gross spread is arrived at by subtracting the
price at which the underwriter purchases the issue from the price at which they sell
the issue.

Gross spread = Sale price of the issue sold by the underwriter – Purchase price of the issue
bought by the underwriter

Typically, the gross spread is fixed at 7% of the proceeds. The gross spread is used to pay a
fee to the underwriter. If there is a syndicate of underwriters, the lead underwriter is paid
20% of the gross spread. 60% of the remaining spread, called “selling concession”, is split
between the syndicate underwriters in proportion to the number of issues sold by the
underwriter. The remaining 20% of the gross spread is used for covering underwriting
expenses (for instance, road show expenses, underwriting counsel, etc.).

Letter of Intent: A letter of intent typically contains the following information:

1. The underwriter’s commitment to enter an underwriting agreement with the issuing

company
2. A commitment by the issuing company to provide the underwriter with all relevant
information and, thus, fully co-operate in all due diligence efforts.
3. An agreement by the issuing company to provide the underwriter with a 15%
overallotment option.

The letter of intent does not mention the final offering price.

Underwriting Agreement: The letter of intent remains in effect until the pricing of the
securities, after which the Underwriting Agreement is executed. Thereafter, the underwriter
is contractually bound to purchase the issue from the company at a specific price.

Registration Statement: The registration statement consists of information regarding the

IPO, the financial statements of the company, the background of the management, insider
holdings, any legal problems faced by the company, and the ticker symbol to be used by the
issuing company once listed on the stock exchange. The SEC requires that the issuing
company and its underwriters file a registration statement after the details of the issue have
been agreed upon. The registration statement has two parts:

 The Prospectus: This is provided to every investor who buys the issued security
 Private Filings: this is comprised of information which is provided to the SEC for
inspection but is not necessarily made available to the public

The registration statement ensures that investors have adequate and reliable information
about the securities. The SEC then carries out due diligence to ensure that all the required
details have been disclosed correctly.

Red Herring Document: In the cooling-off period, the underwriter creates an initial
prospectus which consists of the details of the issuing company, save the effective date and
offer price. Once the red herring document has been created, the issuing company and the
underwriters market the shares to public investors. Often, underwriters go on roadshows
(called the dog and pony shows – lasting for 3 to 4 weeks) to market the shares to
institutional investors and evaluate the demand for the shares.

Step 3: Pricing

After the IPO is approved by the SEC, the effective date is decided. On the day before the
effective date, the issuing company and the underwriter decide the offer price (i.e., the price
at which the shares will be sold by the issuing company) and the precise number of shares
to be sold. Deciding the offer price is important because it is the price at which the issuing
company raises capital for itself. The following factors affect the offering price:
  The success/failure of the roadshows (as recorded in the order books)
 The company’s goal
 Condition of the market economy

IPOs are often underpriced to ensure that the issue is fully subscribed/ oversubscribed by
the public investors, even if it results in the issuing company not receiving the full value of
its shares.

If an IPO is underpriced, the investors of the IPO expect a rise in the price of the shares on
the offer day. It increases the demand for the issue. Furthermore, underpricing compensates
investors for the risk that they take by investing in the IPO. An offer that is oversubscribed
two to three times is considered to be a “good IPO.”

Step 4: Stabilization

After the issue has been brought to the market, the underwriter has to provide analyst
recommendations, after-market stabilization, and create a market for the stock issued.

The underwriter carries out after-market stabilization in the event of order imbalances by
purchasing shares at the offering price or below it.

Stabilization activities can only be carried out for a short period of time – however, during
this period of time, the underwriter has the freedom to trade and influence the price of the
issue as prohibitions against price manipulation are suspended.

Step 5: Transition to Market Competition

The final stage of the IPO process, the transition to market competition, starts 25 days after
the initial public offering, once the “quiet period” mandated by the SEC ends.

During this period, investors transition from relying on the mandated disclosures and
prospectus to relying on the market forces for information regarding their shares. After the
25-day period lapses, underwriters can provide estimates regarding the earning
and valuation of the issuing company.

3. Discuss the different measures of value for company valuation? Explain the
various methods used to assess and measure future value of equity shares which
are based on quantitative factors with suitable examples.

Ans. At the most basic level, business valuation is the process by which the economic worth of a
company is determined.
As we mentioned, there are different approaches to evaluating the value of a small business, but
generally, each method will involve a full and objective assessment of every piece of your company.
This being said, business valuation calculations typically include the worth of your equipment,
inventory, property, liquid assets, and anything else of economic value that your company owns.
Other factors that might come into play are your management structure, projected earnings, share
price, revenue, and more.

7 Business Valuation Methods

1. Market Value Valuation Method

First, the market value business valuation formula is perhaps the most subjective approach to
measuring a business’s worth. This method determines the value of your business by comparing it
to similar businesses that have sold.

Of course, this method only works for businesses that can access sufficient market data on their
competitors. In this way, the market value method is a particularly challenging approach for sole
proprietors, for instance, because it’s difficult to find comparative data on the sale of similar
businesses (as sole proprietorships are individually owned).

This being said, because this small business valuation method is relatively imprecise, your business’s
worth will ultimately be based on negotiation, especially if you’re selling your business or seeking an
investor. Although you may be able to convince a buyer of your business’s worth based on
immeasurable factors, it’s unlikely that this approach will be particularly useful for gaining investors.

Nevertheless, this valuation method is a good preliminary approach to gain an understanding of

what your business might be worth, but you’ll likely want to bring another, more calculated
approach to the negotiation table.

2. Asset-Based Valuation Method

Next, you might use an asset-based business valuation method to determine what your company is
worth. As the name suggests, this type of approach considers your business’s total net asset value,
minus the value of its total liabilities, according to your balance sheet.

There are two main ways to approach asset-based business valuation methods:

Going Concern

Businesses that plan to continue operating (i.e., not be liquidated) and not immediately sell any of
their assets should use the going-concern approach to asset-based business valuation. This formula
takes into account the business’s current total equity—in other words, your assets minus liabilities.

Liquidation Value

On the other hand, the liquidation value asset-based approach to valuation is based on the
assumption that the business is finished and its assets will be liquidated. In this case, the value is
based on the net cash that would exist if the business was terminated and the assets were sold.
With this approach, the value of a business’s assets will likely be lower than usual—as liquidation
value often amounts to much less than fair market value.

Ultimately, the liquidation value asset-based method operates with a sort of urgency that other
formulas don’t necessarily take into account.
3. ROI-Based Valuation Method

An ROI-based business valuation method evaluates the value of your company based on your
company’s profit and what kind of return on investment (ROI) an investor could potentially receive
for buying into your business.

Here’s an example: If you’re pitching your business to a group of investors to get equity
financing, they’ll start with a valuation percentage of 100%. If you’re asking for $250,000 in
exchange for 25% of your business, then you’re using the ROI-based method to determine the value
of your business as you present this offer to the investors. To explain, if you divide the amount by
the percentage offered, so $250,000 divided by 0.25, you receive your quick business valuation—in
this case, $1 million.

From a practical standpoint, the ROI-method makes sense—an investor wants to know what their
return on investment will look like before they invest. This being said, however, a “good”
ROI ultimately depends on the market, which is why business valuation is so subjective.

Plus, with this approach, you’ll often need more information to convince an investor or buyer of the
result. An investor or buyer will want to know:

 How long will it take to recover my original investment?

 After that, when I look at my share of the expected net income, compared with my
investment, what does my return look like?
 Is that number realistic? Ambitious? Conservative?
 Does it make me want to invest in this company?

All of these questions will inform an ROI-based business valuation.

4. Discounted Cash Flow (DCF) Valuation Method

Although the three business valuation methods above are sometimes considered the most
common, they’re not the only options out there. In fact, whereas the ROI-based and market value-
based methods are extremely subjective, some alternate approaches (as we’ll discuss) use more of
your business’s financial data to get a better evaluation of its worth.

The discounted cash flow valuation method, also known as the income approach, for
example, values a business based on its projected cash flow, adjusted (or discounted) to its present
value.

The DCF method can be particularly useful if your profits are not expected to remain consistent in
the future. As you’ll see in the CFI business valuation example below, however, the DCF method
requires significant detail and careful calculations:

5. Capitalization of Earnings Valuation Method

Next, the capitalization of earnings valuation method calculates a business’s future profitability
based on its cash flow, annual ROI, and expected value.

This approach, unlike the DCF method, works best for stable businesses, as the formula assumes
that calculations for a single time period will continue. In this way, this method bases a business’s
current value on its ability to be profitable in the future.
6. Multiples of Earnings Valuation Method

Similar to the capitalization of earnings valuation method, the multiple of earnings valuation
method also determines a business’s value by its potential to earn in the future.

This being said, however, this small business valuation method, also known as the time revenue
method, calculates a business’s maximum worth by assigning a multiplier to its current revenue.
Multipliers vary according to industry, economic climate, and other factors.

7. Book Value Valuation Method

Finally, the book value method calculates the value of your business at a given moment in time by
looking at your balance sheet.

With this approach, your balance sheet is used to calculate the value of your equity—or total assets
minus total liabilities—and this value represents your business’s worth.

The book value approach may be particularly useful if your business has low profits, but valuable
assets

Special Considerations: Methods of Valuation

There are numerous ways a company can be valued. You'll learn about several of
these methods below.

1. Market Capitalization
Market capitalization is the simplest method of business valuation. It is calculated by
multiplying the company’s share price by its total number of shares outstanding. For
example, as of January 3, 2018, Microsoft Inc. traded at $86.35.1 With a total number
of shares outstanding of 7.715 billion, the company could then be valued at $86.35 x
7.715 billion = $666.19 billion.

2. Times Revenue Method

Under the times revenue business valuation method, a stream of revenues
generated over a certain period of time is applied to a multiplier which depends on
the industry and economic environment. For example, a tech company may be
valued at 3x revenue, while a service firm may be valued at 0.5x revenue.

3. Earnings Multiplier
Instead of the times revenue method, the earnings multiplier may be used to get a
more accurate picture of the real value of a company, since a company’s profits are
a more reliable indicator of its financial success than sales revenue is. The earnings
multiplier adjusts future profits against cash flow that could be invested at the current
interest rate over the same period of time. In other words, it adjusts the current P/E
ratio to account for current interest rates.

4. Discounted Cash Flow (DCF) Method

The DCF method of business valuation is similar to the earnings multiplier. This
method is based on projections of future cash flows, which are adjusted to get the
current market value of the company. The main difference between the discounted
cash flow method and the profit multiplier method is that it takes inflation into
consideration to calculate the present value.

5. Book Value
This is the value of shareholders’ equity of a business as shown on the balance
sheet statement. The book value is derived by subtracting the total liabilities of a
company from its total assets.

6. Liquidation Value
Liquidation value is the net cash that a business will receive if its assets were
liquidated and liabilities were paid off today.

5 Common Business Valuation Methods

1. Asset Valuation: Your company’s assets include tangible and intangible items. Use the book
or market value of those assets to determine your business’s worth. Count all the cash, equipment,
inventory, real estate, stocks, options, patents, trademarks, and customer relationships as you
calculate the asset valuation for your business

2. Historical Earnings Valuation: A business’s gross income, ability to repay debt, and
capitalization of cash flow or earnings determines its current value. If your business struggles to
bring in enough income to pay bills, its value drops. Conversely, repaying debt quickly and
maintaining a positive cash flow improves your business’s value. Use all of these factors as you
determine your business’s historical earnings valuation.

3. Relative Valuation: With the relative valuation method, you determine how much a similar
business would bring if they were sold. It compares the value of your business’s assets to the value
of similar assets and gives you a reasonable asking price.

4. Future Maintainable Earnings Valuation: The profitability of your business in the future
determines its value today, and you can use the future maintainable earnings valuation method for
business valuation when profits are expected to remain stable. To calculate your business’s future
maintainable earnings valuation, evaluate its sales, expenses, profits, and gross profits from the
past three years. These figures help you predict the future and give your business a value today.

5. Discount Cash Flow Valuation: If profits are not expected to remain stable in the future,
use the discount cash flow valuation method. It takes your business’s future net cash flows and
discounts them to present day values. With those figures, you know the discounted cash flow
valuation of your business and how much money your business assets are expected to make in the
future.
What are the Main Valuation Methods?

When valuing a company as a going concern, there are three main valuation
methods used by industry practitioners: (1) DCF analysis, (2) comparable company
analysis, and (3) precedent transactions. These are the most common methods of
valuation used in investment banking, equity research, private equity, corporate
development, mergers & acquisitions (M&A), leveraged buyouts (LBO), and most
areas of finance.

As shown in the diagram above, when valuing a business or asset, there are three
different methods or approaches one can use. The Cost Approach looks at what it
costs to rebuild or replace an asset. The cost approach method is useful in valuing
real estate, such as commercial property, new construction, or special use
properties. Finance professionals do not typically use it to value a company that is
a going concern.

Next is the Market Approach, which is a form of relative valuation and frequently
used in the industry. It includes Comparable Analysis and Precedent Transactions.

Finally, the discounted cash flow (DCF) approach is a form of intrinsic

valuation and is the most detailed and thorough approach to valuation modeling.
We will describe the methods used in the Market and DCF approaches below.

Method 1: Comparable Analysis (“Comps”)

Comparable company analysis (also called “trading multiples” or “peer group

analysis” or “equity comps” or “public market multiples”) is a relative valuation
method in which you compare the current value of a business to other similar
businesses by looking at trading multiples like P/E, EV/EBITDA, or other
ratios. Multiples of EBITDA are the most common valuation method.
The “comps” valuation method provides an observable value for the business,
based on what other comparable companies are currently worth. Comps are the
most widely used approach, as they are easy to calculate and always current. The
logic follows that if company X trades at a 10-times P/E ratio, and company Y has
earnings of $2.50 per share, company Y’s stock must be worth $25.00 per share
(assuming the companies have similar attributes).

Method 2: Precedent Transactions

Precedent transactions analysis is another form of relative valuation where you

compare the company in question to other businesses that have recently been
sold or acquired in the same industry. These transaction values include the take-
over premium included in the price for which they were acquired.

The values represent the en bloc value of a business. They are useful for M&A
transactions but can easily become stale-dated and no longer reflective of the
current market as time passes. They are less commonly used than Comps or
market trading multiples

Method 3: DCF Analysis

Discounted Cash Flow (DCF) analysis is an intrinsic value approach where an

analyst forecasts the business’ unlevered free cash flow into the future and
discounts it back to today at the firm’s Weighted Average Cost of Capital (WACC).

A DCF analysis is performed by building a financial model in Excel and requires an

extensive amount of detail and analysis. It is the most detailed of the three
approaches and requires the most estimates and assumptions. However, the
effort required for preparing a DCF model will also often result in the most
accurate valuation. A DCF model allows the analyst to forecast value based on
different scenarios and even perform a sensitivity analysis.

For larger businesses, the DCF value is commonly a sum-of-the-parts analysis,

where different business units are modeled individually and added together. To
learn more, see CFI’s DCF model infographic.

Methodologies-
1. Net Asset Value (NAV) Method
2. Discounted Cash Flow Method
3. Profit or Dividend Yield Method
4. PE Ratio Method
1. Net Asset Value (NAV) Method
Net Asset represent Net worth of the Company. After reduction of preference share Capital
value from net worth of the Company we get value of company to the Equity share holders.
Figures of net assets from last audited balance sheet can be taken.
Calculation under NAV Method Rs.
a. Total Asset excluding Misc Expenditure & P&L Dr Balance Say 5,00,00,000
b. Less- Total Liability excluding contingent liability Say 3,00,00,000
c. Net Assets Value (a-b) 2,00,00,000
d. Less- Preference shares value –
e. Value of net assets attributable to Equity Share Holders (c-d) 2,00,00,000
f. Number of Equity Shares Say 5,00,000
g. Value of Share (e/f) 40.00

Important Notes –

1. Value of Assets can be modify from audited figures by taking market value of
Properties, Listed Investments etc.
2. Rules 11UA of Income tax Rules allows only audited balance sheet figures for
valuation of equity shares by net assets value method, however value of Liability will
not include provisions made for meeting liabilities, other than ascertained liabilities
like provision for gratuity & others and net provision for taxation.
3. Partly paid up shares should be made equivalent to fully paid up shares by reducing
in numbers in proportion to their lesser paid up amount.

2. Discounted Cash Flow Method (DCF)

Discounted Cash Flow Method (DCF) is a complex calculation however it considers not just
Companies present situation but also take in to figure, future of the Company. DCF also
works for start-up Companies Valuations which do not have track records but has valuation
based on business idea & current resources.
Value of firm derived by discounting future cash flows to the company by expected rate of
return of Equity & Debt holders. Valuation through DCF imbibe expectation of owners &
lenders by considering expected rate of return of both Equity & Debt holders.
DCF becomes more relevant since any decision related to investment is taken considering
future return on it & DCF figures out valuation based on future cash flows of the Company.
Process of valuation is as under –
Step 1: Arrive at Projected Profit after Tax
Step 2: Add back non-cash costs i.e. depreciation etc
Step 3: Subtract capital expenditures.
Step 4: Subtract Increases in working capital.
Step 5: Take into account the effect of changes in Debts.
Step 6: Discount the FCFF for each year at the cost of capital.
Step 7: Add the terminal value accruing in the final year.
Step 8: Arrive value of Equity by subtracting debt value.
Step 9: Arrive Value of Equity Share by diving number of shares to value of Equity
Cost of Capital can be derived as under –
Equity Share Holders expected rate of return vary from industry to industry which can be
calculated by adding extra return for taking industry specific risk to market expected rate of
return.
Technically its equals to Beta*(Expected Return- Risk free return) + Risk free Return
Debt Holder expected rate of return would be after tax interest rate on debt.
and cost of capital is derived by weighted averaging the above rates of return as per total
value of Capital & Debt.
3. Profit OR Divided Yield Method
Profit after tax or dividend is divided by Normal rate of return to derive Capitalized Value &
the same is divided by number of shares to get value per share.
Capitalize Value = ( Profit / Dividend ) / Normal Rate of Return
Value per Share = Capitalize Value / Number of shares
Generally We take Average profit of 5 years to rule out higher or lower side valuation.
Preference Share Dividend to be subtracted from profit to find profit attributable to equity
share holders.
4. Price-Earnings Ratio Method
This method is generally used to calculate listed Company Share Value. It uses Earning Per
Share (EPS) & Market Price of Share (MPS) to calculate value of share.
PE Ratio is determined as follow- MPS/ EPS
Investor can average out PE Ratio Companies in same sector to rule out higher or lower
side valuation based on one company data.
Value per share – EPS x P/E Ratio
Whenever Company declare its Qrtly results & EPS, Investor by using particular sector PE
Ratio can find Value of Share to take investment decision.
Selection of Method Decision
Discounted Cash Flow Method & Net Assets Value Method are the most used methods to
value Shares since both method uses wide range of data & capture lot of figures to derive
Value of Share.
It is always advisable to Value Share by Earning OR Market Based Method i.e. Discounted
Cash Flow Method for Companies in to Manufacturing & Service. Net Asset Value Method
is used by Investment Companies.

How to choose the share valuation method

There are various reasons for adopting a particular method for share valuation; it generally

depends upon the purpose of valuation. Using a combination of methods generally provides

a more reliable valuation. Let’s see under each approach what the main reason is:
i. Assets Approach: If a company is a capital-intensive company and invested a large

amount in capital assets or if the company has a large volume of capital work in progress

then an asset-based approach can be used. This method is also applicable for valuing the

shares during amalgamation, absorption or liquidation of companies.

ii. Income Approach: This approach has two different methods namely Discounted Cash

Flow (DCF) or Price Earning Capacity (PEC) method. DCF method uses the projection of

future cash flows to determine the fair value and if this data is reasonably available, DCF

method can be used. PEC method uses historical earnings and if an entity is not in the

business for a long time and just started its operations, then this method cannot be applied.

iii. Market Approach: Under this approach, the market value of the shares is considered for

valuation. However, this approach is feasible only for listed companies whose share prices

can be obtained in the open market. If there are a set of peer companies that are listed and

engaged in a similar business, then such a company’s share public prices can also be used.

What are Methods of Share Valuation : There is no one valuation method that will fit any

purpose, hence there are various methods of share valuation depending upon the purpose,

data availability, nature and volume of the company etc.

i. Asset-based : This approach on based on the value of the company’s assets and

liabilities which includes intangible assets and contingent liabilities. This approach may be

very useful to manufacturers, distributors etc where a huge volume of capital assets are

used. This approach is also used as a reasonableness check to confirm the conclusions

derived under the income or market approaches. Here, the company’s net assets value is

divided by the number of shares to arrive at the value of each share. Following are some of

the important points to be considered while valuing shares under this method:
 All the asset base of the company including current assets and liabilities such as
receivables, payables, provisions should be considered.

 Fixed assets have to be considered at their realizable value.

 Valuation of goodwill as a part of intangible assets is important

 Even unrecorded assets and liabilities to be considered

 The fictitious assets such as preliminary expenses, discount on issue of shares and
debentures, accumulated losses etc. should be eliminated.

For determination of the net value of assets, deduct all the external liabilities from the total

asset value of the company. The net value of assets so determined has to be divided by the
number of equity shares for finding out the value of the share. The formula used is as

follows: Value per share = (Net Assets – Preference Share Capital) / (No. of Equity Shares)

ii. Income-based

This approach is used when the valuation is done for a small number of shares. Here, the

focus is on the expected benefits from the business investment i.e what the business

generates in the future. A common method used is the estimate of a business’s value by

dividing its expected earnings by a capitalization rate. There are two other methods used

such as DCF and PEC. PEC can be used by an established entity and newly started

business or companies with volatile short-term earnings expectations can use the more

complex analysis such as discounted cash flow analysis. Value per share is calculated on

the basis of the profit of the company available for distribution. This profit can be determined

by deducting reserves and taxes from net profit. Listed below are the steps to determine the

value per share under the income-based approach:

 Obtain the company’s profit (available for dividend)

 Obtain the capitalized value data

 Calculate the share value ( Capitalized value/ Number of shares)

Note: Capitalized Value is calculated as follows:

iii. Market-based

The market-based approach generally uses the share prices of comparable public traded

companies and the asset or stock sales of comparable private companies. Data related to

private companies can be obtained from various proprietary databases available in the

market. What is more important is how to choose the comparable companies – a lot of pre-

conditions to be kept in mind while selecting such as nature and volume of the business,

industry, size, financial condition of the comparable companies, the transaction date etc.

There are two different methods when using the yield method (Yield is expected rate of

return on investment) they are explained below:

i. Earning Yield

Shares are valued on the basis of expected earning and the normal rate of return. Under

this method, value per share is calculated using the below formula:
ii. Dividend Yield: Under this method, shares are valued on the basis of the expected
dividend and the normal rate of return. The value per share is calculated by applying the
following formula: Expected rate of dividend = (profit available for dividend/paid-up equity share
capital) X 100

Popular Stock Valuation Methods

Below, we will briefly discuss the most popular methods of stock valuation.

1. Dividend Discount Model (DDM)

The dividend discount model is one of the basic techniques of absolute stock
valuation. The DDM is based on the assumption that the company’s dividends
represent the company’s cash flow to its shareholders.

Essentially, the model states that the intrinsic value of the company’s stock price
equals the present value of the company’s future dividends. Note that the
dividend discount model is applicable only if a company distributes dividends
regularly and the distribution is stable.

2. Discounted Cash Flow Model (DCF)

The discounted cash flow model is another popular method of absolute stock
valuation. Under the DCF approach, the intrinsic value of a stock is calculated by
discounting the company’s free cash flows to its present value.
The main advantage of the DCF model is that it does not require any assumptions
regarding the distribution of dividends. Thus, it is suitable for companies with
unknown or unpredictable dividend distribution. However, the DCF model is
sophisticated from a technical perspective.

3. Comparable Companies Analysis

The comparable analysis is an example of relative stock valuation. Instead of

determining the intrinsic value of a stock using the company’s fundamentals, the
comparable approach aims to derive a stock’s theoretical price using the price
multiples of similar companies.

The most commonly used multiples include the price-to-earnings (P/E), price-to-
book (P/B), and enterprise value-to-EBITDA (EV/EBITDA). The comparable
companies analysis method is one of the simplest from a technical perspective.
However, the most challenging part is the determination of truly comparable
companies.

Additional Resources

CFI is the official provider of the global Financial Modeling & Valuation Analyst
(FMVA)™ certification program, designed to help anyone become a world-class
financial analyst. To keep advancing your career, the additional resources below
will be useful:

 Comparable Company Analysis

 Investing: A Beginner’s Guide
 Relative Valuation Models
 Valuation Methods

4. What is “Efficient Market Hypothesis”? Discuss the forms of Market Efficiency

and explain the empirical tests used to determine the degree of efficiency in the
stock markets.
What Is Efficient Market Hypothesis?

The Efficient Market Hypothesis (EMH) essentially says that all known information
about investment securities, such as stocks, is already factored into the prices of
those securities.1 If that is true, no amount of analysis can give you an edge over
"the market."
EMH does not require that investors be rational; it says that individual investors will
act randomly. But as a whole, the market is always "right." In simple terms, "efficient"
implies "normal."

For example, an unusual reaction to unusual information is normal. If a crowd

suddenly starts running in one direction, it's normal for you to run that way as well,
even if there isn't a rational reason for doing so.

What Are the Types of EMH?

There are three forms of EMH: weak, semi-strong, and strong.1 Here's what each
says about the market.

 Weak Form EMH: Weak form EMH suggests that all past information is priced
into securities. Fundamental analysis of securities can provide you with
information to produce returns above market averages in the short term. But
no "patterns" exist. Therefore, fundamental analysis does not provide a long-
term advantage, and technical analysis will not work.
 Semi-Strong Form EMH: Semi-strong form EMH implies that neither
fundamental analysis nor technical analysis can provide you with an
advantage. It also suggests that new information is instantly priced into
securities.
 Strong Form EMH: Strong form EMH says that all information, both public
and private, is priced into stocks; therefore, no investor can gain advantage
over the market as a whole. Strong form EMH does not say it's impossible to
get an abnormally high return. That's because there are always outliers
included in the averages.

What are the Three Forms of Market Efficiency?

Whenever you talk about you may find three forms of efficiency that exist in the market. So,
what are the three forms of market efficiency? The answer is:

1. A weak form of Efficiency

2. The semi-strong form of Efficiency
3. A strong form of efficiency

Weak Form of Efficiency in the Market

In case of a weak form of efficiency, the current price of securities is fully affected by all the
past information in the market, for this reason, you will not get any additional benefit if you
work with historical data that is your decision is based on past information. Price should
change from time to time with the change of previously available information.

Example of Weak form of Efficiency

Suppose the share price of Lanka Bangla Finance rises last seven days but we can not be sure
that whether the price of the stock will increase in the future or not because the price is
already adjusted with the past information.
Semi-Strong Form of Efficiency in the Market

Another capital market hypothesis is a semi-strong form of efficiency, where the current price
of securities is fully affected by all past information and all publicly available information.
If this form of efficiency exists in the market then you will not get any additional return in
case of relying on the past price movement and information came from print or online media.

For testing whether there is a semi-strong form of efficiency that exists or not, you can test by
two measures; one is checking how past information how it was adjusted with the price
changes and the second one is how professional managers were performed in the market for
making extra profit. Actually, in this world of capitalism, most of the capital market exists a
semi-strong form of efficiency.

Example of Semi-Strong Form of Efficiency

Suppose IDLC finance announces that the first week of the next month they will introduce a
new financial product. After the announcement, the price of their stock in the market rises
sharply. This means publicly available information creates an impact on the price of the stock
but there is no influence of insider information. If this is the case then we can say that there is
a semi-strong form of efficiency that exists in the market.

Strong Form of Efficiency in the Market

In a capital market strong form of efficiency exists when there is a reflection in the price of
securities by all publicly and privately available information. Here publicly information
available through news briefing published a journal, research paper, market update, or any
other. And privately information is inside information that can come from the insiders of the
organization. But in the real world, there is no market where the strong form of efficiency
exists.

Example of Strong Form of Efficiency

Suppose Union Capital is doing well in the financial industry and they officially declare that
they will provide dividends at 30% of the par value of their share and also management is
thinking that within the next few months they will add a new business line with the existing
product line. The thing is the information on dividend declaration is publicly available
information and the introduction of a new product line is private information that is not yet
publicly available. But if a scenario is there where the price of a stock is changed by all these
private and public information and known to the general public then that market will be
considered as a strong form of an efficient market.

Difference among weak form, semi-strong and strong form of efficiency

The main difference among different forms of market efficiency is the availability of publicly
and privately available information and past information (historical data). Because these
actually supposed to influence the market price of securities. The main thing is how the
market behaves with the addition of new publicly and privately available information related
to the market.
5. Compare and Contrast Capital Asset Pricing Model (CAPM) with Arbitrage Pricing Theory (APT).
Which of the two is a better model for pricing risky assets and why, explain with reasons

What is CAPM:

“Expected return–beta ( or mean-beta) relationship”

“The excess return on any stock”

“The excess return on any stock”

CAPM, allows predicting the relationship between the risk of an asset and its expected

return. This provides a benchmark rate of return for evaluating asset returns. Additionally,

the CAPM model can be used to derive an expected return on yet to be traded publicly,

Capital Allocation Line (CAL) and Capital Market Line (CML)

If an investor was to choose the market portfolio, i.e. the value-weighted portfolio of all
assets in the investment universe, the capital allocation line will also become the
capital market line, as depicted above

Expected returns:

The CAPM is developed on the premise that a fair appropriate risk premium on an asset will

be determined by its contribution to the risk a portfolio. This assumes investors will demand

a risk premium based on portfolio risk contribution by each individual asset.

Risk premium:
The reward-to-risk ratio for investment in the market portfolio is:

Market risk premium / Market variance = E(RM) (Bodie, et al., 2014)

The above ratio indicates the market price of risk as it quantifies the excess return that

investors demand to bear portfolio risk.

Beta:
If the reward-to-risk ratio was better for one investment than another, investors would

implement higher weightings for the better trade-off, adding pressure on prices until the

ratios reach equilibrium. Therefore, it can be concluded that the reward-to-risk ratios of a

single asset (A) and the market portfolio should be equal.

E(RA) = Cov(RA, RM) / σM 2 x E(RM)

The ratio Cov(RGA, RM)/σM2 measures the contribution of A to the variance of the market

portfolio as a fraction of the total variance of the market portfolio — beta (β)

E(rA) = rf + β(E(rA) — E(rM)

Hence, the beta of a stock measures its contribution to the variance of the market portfolio.

Arbitrage Pricing Theory (APT)

E(R)i=E(R)f+(E(I)−E(R)f)×βn

E(R)i = Expected return on the asset

Rf = Risk-free rate of return

βn = Sensitivity of the asset price to macroeconomic factor n

Ei = Risk premium associated with factor i

Arbitrage pricing theory (APT) is a multi-factor asset pricing model based on
the idea that asset returns can be predicted through a linear relationship
between the expected returns and macroeconomic variable. It is a useful to
identify securities that may be temporarily mispriced. (NICKOLAS, 2019)

APT predicts a security market line linking expected returns to risk. It relies on three key

propositions:

1. Security returns can be described by a factor model;

2. There are enough securities to diversify away idiosyncratic risk;

3. Well-functioning security markets do not allow arbitrage opportunities.

Risk Arbitrage:
An arbitrage opportunity arises when an investor can earn riskless profits without making a

net investment. A classic example of this is if shares of a stock are sold for different prices on

two different exchanges. In this situation the Law of One Price is enforced by arbitrageurs by

simultaneously buying and selling the asset until the arbitrage opportunity is eliminated

(Bodie, et al., 2014).

APT in Summary:
 APT is a multi-factor asset pricing model that assumes asset returns can be predicted

using the linear relationship between the expected returns and several macroeconomic

variables that capture systematic risk.

 Contrary to CAPM (which assume markets are perfectly efficient), APT assumes markets

will misprice securities from time to time and eventually corrects itself when securities

move back to fair value.

 Arbitrageurs hope to take advantage of any deviations from fair market value based on

APT.

APT and CAPM:

APT is built on the foundation of well-diversified portfolios. However, even large portfolios

may have non-negligible residual risk.

CAPM requires all investors be mean-variance optimizers while APT is free of this

assumption. APT is defined by observable portfolios such as the market index while CAPM is

not even testable as it relies on an unobserved, all-inclusive portfolio.

Key Differences
Whilst CAPM and APT formulas appear similar, the CAPM has only one factor and one beta.

In contrast, APT has multiple factors that include non-company factors. APT also assumes

markets will misprice securities in contrast to CAPM’s assumption of efficient markets.

 CAPM allows investors to estimate an expected return on investment given the risk, risk-

free rate of return, expected market return, and the beta of an asset or portfolio.

 The arbitrage pricing theory is an alternative to the CAPM that uses fewer assumptions

and can be harder to implement than the CAPM.

 While both are useful, many investors prefer to use the CAPM, a one-factor model, over

APT, which requires users to quantify multiple factors.

What model would you choose between CAPM and APT?

CAPM only considers one factor and one beta, relative to the APT which uses multiple

macroeconomic factors in determining asset pricing.

Differentiate between Arbitrage Pricing and Capital Asset Pricing Theory

The capital asset pricing model (CAPM) provides a formula that calculates the
expected return on a security based on its level of risk. The formula for the capital
asset pricing model is the risk-free rate plus beta times the difference of the return on
the market and the risk-free rate. Arbitrage pricing theory (APT) is a well-known
method of estimating the price of an asset. The theory assumes an asset’s return is
dependent on various macroeconomic, market and security-specific factors.

Differentiate between Arbitrage Pricing Theory (APT) and Capital Asset Pricing
Theory –

CAPM

1. It means the capital asset pricing model.

2. CAPM is based on an investor’s portfolio demand and equilibrium arguments.
3. It is based on risk-return trade-off.
4. It is difficult to find a good proxy for market return.
5. It has a simple beta.
6. CAPM is a single factor model.
7. CAPM requires that the market portfolio be efficient.
8. CAPM assumes that the probability distributes of asset returns are normally
distributed.

APT

1. It means arbitrage pricing theory.

2. APT is based on the factors model of returns and the approximate arbitrage
arguments.
3. It is based on mathematical and statistical data theory.
4. It is difficult to identify approximate factors.
5. It has several relevant data.
6. APT is a multifactor model.
7. There is no special role in the market portfolio in APT.
8. APT does not make any assumption about the distribution of asset returns.

These are the context of differentiation between CAPM and APT.

CAPM vs. Arbitrage Pricing Theory: An Overview
In the 1960s, Jack Treynor, William F. Sharpe, John Lintner, and Jan Mossin
developed the capital asset pricing model (CAPM) to determine the theoretical
appropriate rate that an asset should return given the level of risk
assumed.1 Thereafter, in 1976, economist Stephen Ross developed the arbitrage
pricing theory (APT) as an alternative to the CAPM. The APT introduced a
framework that explains the expected theoretical rate of return of an asset,
or portfolio, in equilibrium as a linear function of the risk of the asset, or portfolio,
with respect to a set of factors capturing systematic risk.2

Capital Asset Pricing Model

The CAPM allows investors to quantify the expected return on an investment given
the investment risk, risk-free rate of return, expected market return, and the beta of
an asset or portfolio. The risk-free rate of return that is used is typically the federal
funds rate or the 10-year government bond yield.

An asset's or portfolio's beta measures the theoretical volatility in relation to the

overall market. For example, if a portfolio has a beta of 1.25 in relation to the
Standard & Poor's 500 Index (S&P 500), it is theoretically 25 percent more volatile
than the S&P 500 Index. Therefore, if the index rises by 10 percent, the portfolio
rises by 12.5 percent. If the index falls by 10 percent, the portfolio falls by 12.5
percent.

Arbitrage Price Theory vs. Capital Asset Pricing

Risk is inevitable for all types of assets, but the risk level for assets can vary. It all depends on the
specific investment itself. Fortunately, even though no one can truly determine risk in an
unpredictable market, there are ways to calculate the level of risk that comes naturally with
a particular asset.

There are two popular methods you can use:

 Capital asset pricing model (CAPM)

 Arbitrage pricing model (APM)

Both are based on cost against the rate of return and have their own uses and downsides. The
theorems are a bit complicated to understand at first, but taking your time with them will help you get
an idea of how they are applied in real life.

Capital Asset Pricing Model

An asset’s risk level, when calculated using the CAPM, uses the formula:

ERi = Rf +βi(ERm-Rf)

 ERi is the expected return of investment

 Rf is the risk-free rate (Rf)
 Bi is the beta figure of the investment
 ERm is the return expected of the market

An analyst determines the Rf, Rm, and βi figures, but investors usually use a beta figure provided by
a third party. Analysts and investors use CAPM mostly to calculate an asset’s fair price during
arbitrage.

In arbitrage, two transactions are carried out at the same time in two separate markets. The investor
takes advantage of the price differences between the two. Investors generally consider this risk-free.
However, typical changing market conditions may decrease profit immensely when they
conduct CAPM evaluations.

Disadvantages of the CAPM

Issues with the CAPM are mainly due to the several assumptions it makes. These assumptions
include:

 Zero taxes and other transaction costs

 All assets are dividable as well as marketable
 Investments in assets can be made freely without restrictions
 Investors maximize their utility
 Prices are not affected by investors

Another drawback is that CAPM calculations are made for just one period, with the formula being
too linear. The biggest issue, though, is that calculations are not even consistent with empirical or
actual results.

Arbitrage Pricing Theory

The Arbitrage Pricing Theory (APT) is an alternative to CAPM. With APT, each asset’s payoff will
come out as a weighted average of all the rest in a portfolio. The APT formula is:

E(rj) = rf + bj1RP1 +bj2 RP2 +……bjnRPn

 E(rj) is the asset’s expected rate of return

 Rf is the risk-free rate
 Bj is the asset’s return sensitivity
 RP is the risk premium

The idea behind APT is that an asset’s return depends on two key factors: the macroeconomic
environment (inflation, interest rate fluctuations, etc.) and the possibility that the asset will move
according to environmental factors.

Capital Asset Pricing Model: The Capital Asset Pricing Model shows the relation between
expected return and systematic risks for stocks. The model suggests that investors often mix two types of
investments or securities; a risk-free asset and a volatile asset in the form of a stock portfolio of different assets.
CAPM also claims that investors want to be paid for owning these volatile assets on the basis of the risk inherited
from holding those assets. Over all, this kind of risk cannot be diversified (systemic risk) and, as a result, investors
deserve to be paid for taking such risks. It is used in finance for generating expected returns for invested assets with
the risk and cost of capital. Goal of such model is to measure whether stocks are equally priced as their cost and
time worth of capital are compared to their anticipated return. Here is the CAPM model:

ERi=expected return of investment

Rf=risk-free rate
βi=beta of the investment. It measures how much risk the investment will add on to a portfolio that is similar to the
market. If βi < 1, then it has less risk compared to the market and thus if βi > 1, it will have more risk.
(ERm−Rf)=market risk premium. It is the expected return from the market above Rf.
Let’s put this concept into a real life application. Let’s say you are evaluating a stock that is currently worth $100
per share where it provides a 5% dividend. The βi would be 1.5 which implies that is has more risk. Let’s also set
the Rf to 5% and ERm (what you expect the market value to behave) to 10%. Let’s put this to CAPM:
Expected return of investment ERi = 5%+1.5 * (10%-5%) = 5%
CAPM is widely used as it’s simplistic and allows for comparisons between different investment options. However,
CAPM provides the assumption that future cash flows can be estimated for the discounting process. If we can
estimate the future return of a stock with a high level of accuracy, the CAPM would not be necessary.
Alright, let’s move on to Arbitrage Pricing Theory.

Arbitrage Pricing Theory (APT): APT is a technical model which takes multiple factors
into account that shows the relation between an asset’s expected return and the risk. It uses less assumptions
compared to CAPM and can therefore be more difficult to use. It was built under the basis that the values of shares
are influenced by a variety of variables that can be sorted into macro-economic factors. It is quite difficult to apply
as it requires a significant amount of data and analysis. Here is the APT model:

E(Rp)=Expected return
Rf=Risk-free return
βn=Sensitivity to the factor of n
fn=nth factor price
Even the APT does not show the factors, change in inflation, industrial production, interest rates… are the most
important factors. For more you can look into the research of Stephen Ross & Richard Roll. Unfortunately, it will
be complex to demonstrate a real life application of APT so I won’t be doing so here.

Comparison
To establish the status quo, CAPM and APT models are models for the calculation of securities prices that suggest
the presence of a market balance.
As capital market equilibrium models, the CAPM and APT models make a major contribution to understanding the
relationship between return and risk and the value of assets in the capital market. Both models only show the linear
dependency of return and risk and the importance of systemic risk. The main distinction, however, is that
the CAPM model is basically a one-factor model, while the APT model is a multi-factor asset valuation
model that has emerged in respond to the fact that CAPM doesn’t take much into account.
APT first assumes that returns are caused by systematic factors, then on top of that assumes diversification removes
certain risks and thus there won’t be arbitrage opportunity that exists in the portfolios that are diversified. Also,
APT doesn’t imply the identity or the number of risk factors but instead for every multi-factor model assumed to
produce returns, which follows a return-generating mechanism, it provides the related expression to the predicted
return of the asset. CAPM doesn’t do this, it assumes that same efficient frontier is open to everyone.