Javier Estrada, The Essential Financial Toolkit: Everything You Always Wanted To Know About Finance

But Were Afraid To Ask. (New York: Palgrave MacMillan, 2011).

Estrada explains in the introduction to The Essential Financial Toolkit that his intention was to

provide students in his executive education programs with a comprehensive introduction to corporate

finance. Estrada’s book is designed as an overview of a typical MBA program in corporate finance for an

audience that can easily handle algebraic equations. Using a Socratic method of a dialogue between a

Witty Professor and Insightful Student, Estrada covers ten interrelated topics, explaining financial theory

in some depth and providing illustrative examples. Estrada begins with two chapters on returns, then

introduces risk, reviewing how both the standard deviation and beta can be used to measure it. This is

followed by a presentation of the CAPm equation, then an analysis of the semideviation and downside

risk, and concludes with chapters on the absolute valuation method of the Internal Rate of Return and

calculating bond values with the IRR.

Assigning the entire book for a one class session on investments might be too much. Estrada

currently teaches a Massive Online Open Course at IESE via Coursera that relies on this book, but he

never provides more than two chapters to students in a particular week. However, there are limitations

on assigning single chapters in Estrada’s book as the material is cumulative. If you assign only the

chapter on the CAPm, it is not self-contained-- it relies on discussions found prior chapters on beta and

returns. It is also true that the final chapter on bonds is not self-contained, as it relies on a previous

chapter on the IRR. A similar problem exists with the seventh chapter. The discussion of Sortino’s ratio

in Tool 7 identifies the semideviation as part it, but an in-depth discussion of the semideviation appears

in an earlier chapter, the sixth chapter on downside risk.

If you use this book at all, you might want to assign four chapters. You may be pleased that

three of the topics that you hoped to discuss in the class on investments--beta, the CAPm and Jensen’s

alpha- are presented in the third, fifth and seventh chapters of this book. Another chapter you may

want to assign is the ninth chapter on multiples because it has a review of investment basics like

earnings and the Price-to-Earnings ratio (P/E). You might want to students to read the ninth chapter

before the other three. Some of your students may have a rudimentary understanding of companies

and the stock market and might find the reading assignment more accessible by beginning with earnings

and P/E in the ninth chapter. Based on this understanding, the four chapters that seem to be the best

for your stated purposes for the investments class are: Tool 9 – Multiples; Tool 3 - Risk: Standard

Deviation and Beta; Tool 5 – Required Returns and the CAPm; Tool 7 – Risk-Adjusted Returns. To avoid

the problem with Sortino’s ratio and the seventh chapter you may want to assign just the portions of the

seventh chapter that pertain to the topic that you truly wanted your students to know, Jensen’s alpha.

If you ask students to buy this book and read just those those four chapters, they will have the other

chapters available as reference material to review on their own or use in connection with Estrada’s

MOOC. The remainder of this summary is an analysis of the four recommended chapters.

Tool 9 - Multiples

The ninth chapter focuses on relative valuation. (Although this chapter contains the suggestion

that relative valuation is not absolute valuation, it is not necessary to also read the eighth chapter on

absolute valuation in order to understand the contents of this chapter on Tool 9. That was not the case

with the chapters on the CAPm , bonds and the section of chapter seven on Sortino’s ratio which

depend on detailed explanations in other chapters to communicate the topic.) Estrada shows how

relative valuation is based on benchmarking the price of the stock to a fundamental value of a

company—such as sales and earnings. (I note that benchmarking to cash flow is also mentioned and

you do not intend to review cash flow in your class on accounting.) Estrada discusses earnings in greater

detail, explaining how they might be calculated either on a trailing (past) or forward (projected) basis.

The next few pages are focused on the P/E ratio, which can be analyzed on its own as well as compared

to temporal or cross-sectional benchmarks. Temporal benchmarks are explained to be past P/E ratios

for the company in prior years or periods and cross-sectional benchmarks reveal how one company’s

P/E ratio compares to a similar company in its industry or the aggregate P/E of the industry. Estrada’s

ninth chapter provides greater detail on earnings and P/E than Kansas’s Wall Street Journal Guide does

(see previous review). Estrada is not so comprehensive as Professor Bob Taggart’s Chapter 5 focused on

financial statement analysis, which provides ample details on many of the ratios that may be used to

evaluate a stock or company—Return on Equity, Return on Assets, DuPont as well as the market value

ratio of the P/E. (If we want to use or assign material from this chapter from Professor Taggart’s book,

we would need his permission.)

Tool 3 – Risk: Standard Deviation and Beta

The third chapter defines, compares and contrasts the standard deviation and beta. The

standard deviation is defined in Estrada as “the square root of the average squared deviation from the

mean.”1 This definition is similar to the presentation of this term I read in a classic political science

textbook by V.O. Key: “The square root of the sum of the squares of the individual deviations from the

mean.” Estrada defines beta as a “relevant measure of an asset’s risk only when you hold the asset

within a widely diversified portfolio.“2 How does this compare to the definition of beta in other

textbooks I have seen? Professor Taggart defines beta as “the extent to which (a company’s) returns

tend to move with the market, or the extent to which its returns are exposed to market risk.” 3 The

glossary of Professor Alan Marcus’s textbook includes this definition of beta: “The tendency of a

security’s returns to respond to swings in the market.”4 Taggart’s and Marcus’s definitions of beta may

be slightly more descriptive, as they say that beta is a tendency rather than an expression of the more

generic term measure. Marcus’s definition also contains the more effective phrasing, swings in the

market, as opposed to a less meaningful comparison of the risk of an asset to a portfolio of assets. But

Estrada’s definition has merit —beta can be viewed as relative riskiness of a stock as compared to a

larger collection of securities. Estrada goes on to explain that the standard deviation and beta are both

1 Estrada, p. 38.

2 Estrada, p. 43.

3 Taggart Chapter 7, p. 12.

4 Bodie, Kane and Marcus, p. G-1.

measures of volatility. Then, the contrasting differences are noted—the standard deviation is a measure

of total risk, while beta describes systematic risk. Like Estrada, Frey’s IvyBytes Guide, which I reviewed

previously, provides an accessible treatment of beta. While Estrada gives a better theoretical treatment

of beta than Frey’s IvyBytes Guide, Frey’s Guide still has some practical tips on how beta should be used

in decision-making on investments.

Tool 5 – Required Returns and the CAPm

The fifth chapter in Estrada’s book presents detailed descriptions all of the variables needed to

solve the CAPm equation with the exception of the beta. Estrada presents how CAPm equation may be

solved to determine the rate of return on a particular “investment,” and equals the risk-free rate plus

the Market Risk Premium (MRP) multiplied by the beta.5 Estrada discusses returns in another set of

chapters but the chapters on returns need not be read in order to grasp the meaning of the CAPm. It is

useful to compare Estrada’s definition of the risk-free rate to Professor Marcus’s definition. Estrada

expresses the risk-free rate as the purchasing power of money invested in something besides the stock.

Here is Professor Marcus’s definition: “the rate you can earn by leaving money in risk-free assets.”

Again, there is a difference. Professor Marcus’s definition is more accessible to a new investor because

it is presented as the opportunity cost of investing in a risk-free financial instrument. Estrada estimates

the risk-free rate to be the rate of a ten-year treasury bond. Most Boston College professors use that

rate, but also note that there may be some room for fluctuation, ranging from shorter-term 5-year

treasuries to something significantly more long-term, like the rate of a 30-year T-Bill. MRP is defined by

Estrada as “the additional compensation required for investing in relatively riskier stocks rather than in

relatively safer bonds.”6 The books by Professors Taggart and Marcus use the term risk premium rather

than Estrada’s term Market Risk Premium. Both Professors state that the risk premium is the difference

between an expected market portfolio and the risk-free rate. Investopedia also defines the MRP, and

states it as “the difference between the expected return of a market portfolio and the risk-free rate.”7

The slightly more intuitive definitions appear in Professors Taggart and Marcus texts and Investopedia,

as they describe the manner in which the market risk premium might be calculated, subtracting the

chosen risk-free rate from the expected market portfolios returns. Estrada suggests that values to be

used to calculate the market risk premium may be obtained from tables listing the average stock market

returns for a particular country’s exchange or exchanges. A source for the rates tables is not identified

in Estrada. As I learned in Professor Hotchkiss’s class at BC, these rates may be obtained from tables

that have been compiled and presented on New York University Professor Aswath Damordaran’s web

site at http://pages.stern.nyu.edu/~adamodar/.

5 Professor Bob Taggart’s book does have a useful explanation of what the CAPm means: “when

the market is in equilibrium, so that expected returns equal required returns on all securities, the expected risk premium on any security or portfolio is proportional to the risk premium on the market portfolio, with the factor of proportionality the security or portfolio’s systematic risk level or beta.” Taggart, Chapter 7, p. 17.

6 Estrada, p. 68.

7 Source: Investopedia, http://www.investopedia.com/terms/m/marketriskpremium.asp.

Tool 7 – Risk-Adjusted Returns

The seventh chapter has a set of equations that define the risk profile of stocks—Jensen’s alpha,

Treynor’s measure, Sharpe’s ratio, the Risk Adjusted Performance (RAP), and Sortino’s ratio. I will first

focus on Jensen’s alpha which comprises the majority of the chapter. Estrada uses two examples to

explain the meaning of alpha. The first example is a comparison of a country’s stock market returns to

the returns of the world’s market. This is a metaphor for what the alpha measures--the returns of a

given portfolio as compared to the returns of the overall stock market. How does it compare to the

definition of alpha in Professor Marcus’s book? Alpha is described in the Bodie, Kane and Marcus’s text

as a “nonmarket premium” that is based on a comparison between “a security” and an “attractive

expected return.”8 These explanations of alpha are quite different, but the one that appears in the

IvyBytes Guide is similar to Estrada’s. Frey’s IvyBytes Guide states that the alpha is “the difference

between the return of a portfolio and the return of an equivalent market portfolio.” 9 In the second

example, Estrada illustrates why two companies with stock revealing the same alpha might be expected

to have the same value, but actually have different values when their betas are considered. The

company’s stock with a higher beta had a higher expected rate of return, making it less valuable than

the company’s stock with the same alpha but a lower beta. Estrada’s second example is not to be found

in the IvyBytes Guide presentation of alpha and beta.

Estrada proceeds to explain other ratios in the seventh chapter—Treynor’s ratio, Sharpe’s ratio,

RAP and Sortino’s ratio. The discussion of Treynor’s ratio follows the second alpha example. Estrada

states that Treynor’s measure is a way to know the “excess returns per unit of beta risk.”10 This is

exactly the same definition that appears in Professor Marcus’s book on page G-13. Estrada later

explains that Treynor’s ratio is most often used to rank assets.11 As concerns Sharpe’s ratio, Professor

Marcus’s book contains a more comprehensive explanation of its meaning as a reward-to-volatility

measure.12 However, Estrada’s presentation of Sharpe’s ratio does have points to recommend it.

Estrada describes Sharpe’s ratio as a way to calibrate total risk as it contains the standard deviation in

the denominator of the equation below the numerator of the rate of return on the investment minus

the risk-free rate. Estrada adds to this point by stating that the Sharpe’s ratio is more useful in

measuring the risk of several assets rather than the risk of an individual asset. After mentioning the

equation for the RAP, Estrada notes how it, like the Sharpe’s ratio, reflects total risk because the

standard deviation, a measure of total risk, appears in the denominator. Estrada articulates the

following reason why RAP is ever considered: “the RAP of an asset increases with its return and

decreases with its volatility.”13 Estrada’s treatment of RAP in the seventh chapter of the Essential

Financial Toolkit cannot be compared to Professor Marcus’s book, because the Bodie, Kane and Marcus

text does not explicitly mention this. However, Professor Marcus’s text does provide an explanation of

Sortino’s ratio. Professor Marcus identifies the Sortino’s ratio as a variant on the Sharpe’s ratio with the

8 Bodie, Kane and Marcus, p. 250.

9 Frey, p. 52.

10 Estrada, p. 107.

11 Ibid.

12 Bodie, Kane and Marcus, pp. 206-210.

13 Estrada, p. 111.

Lower Partial Standard Deviation replacing the Standard Deviation.14 Estrada’s discussion of the

equation for Sortino’s ratio makes this same point. However, students reading about the semideviation

term in the denominator of Sortino’s ratio in the seventh chapter might lack important insights, as the

semideviation is treated comprehensively in the sixth chapter on downside risk. One way to avoid

assigning another chapter in Estrada might be to ask the students to focus only on the sections of the

seventh chapter that pertain to Jensen’s alpha. As you expressed an interest in alpha as opposed to

Sortino’s ratio, assigning just the section on Jensen’s alpha in the seventh chapter might be a way

around the problem.

14

Bodie, Kane and Marcus,