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61
TheBondholders’DefenseAgainstStockholderExcesses
AswathDamodaran
61
¨ Morerestric9vecovenantsoninvestment,financinganddividendpolicyhavebeenincorporatedintobothprivatelendingagreementsandintobondissues,topreventfuture“Nabiscos”.
¨ Newtypesofbondshavebeencreatedtoexplicitlyprotectbondholdersagainstsuddenincreasesinleverageorotherac9onsthatincreaselenderrisksubstan9ally.Twoexamplesofsuchbonds¤ PuFableBonds,wherethebondholdercanputthebondbacktothefirm
andgetfacevalue,ifthefirmtakesac9onsthathurtbondholders¤ Ra9ngsSensi9veNotes,wheretheinterestrateonthenotesadjuststo
thatappropriateforthera9ngofthefirm¨ Morehybridbonds(withanequitycomponent,usuallyintheform
ofaconversionop9onorwarrant)havebeenused.Thisallowsbondholderstobecomeequityinvestors,iftheyfeelitisintheirbestintereststodoso.
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TheFinancialMarketResponse
AswathDamodaran
62
¨ Whileanalystsaremorelikelys9lltoissuebuyratherthansellrecommenda9ons,thepayofftouncoveringnega9venewsaboutafirmislargeenoughthatsuchnewsiseagerlysoughtandquicklyrevealed(atleasttoalimitedgroupofinvestors).
¨ Asinvestoraccesstoinforma9onimproves,itisbecomingmuchmoredifficultforfirmstocontrolwhenandhowinforma9ongetsouttomarkets.
¨ Asop9ontradinghasbecomemorecommon,ithasbecomemucheasiertotradeonbadnews.Intheprocess,itisrevealedtotherestofthemarket.
¨ Whenfirmsmisleadmarkets,thepunishmentisnotonlyquickbutitissavage.
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TheSocietalResponse
AswathDamodaran
63
¨ Iffirmsconsistentlyfloutsocietalnormsandcreatelargesocialcosts,thegovernmentalresponse(especiallyinademocracy)isforlawsandregula9onstobepassedagainstsuchbehavior.
¨ Forfirmscateringtoamoresociallyconsciousclientele,thefailuretomeetsocietalnorms(evenifitislegal)canleadtolossofbusinessandvalue.
¨ Finally,investorsmaychoosenottoinvestinstocksoffirmsthattheyviewassociallyirresponsible.
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TheCounterReac9on
AswathDamodaran
64
STOCKHOLDERS
Managers of poorly run firms are puton notice.
1. More activistinvestors2. Hostile takeovers
BONDHOLDERSProtect themselves
1. Covenants2. New Types
FINANCIAL MARKETS
SOCIETYManagers
Firms arepunishedfor misleadingmarkets
Investors andanalysts becomemore skeptical
Corporate Good Citizen Constraints
1. More laws2. Investor/Customer Backlash
65
Sowhatdoyouthink?
AswathDamodaran
65
¨ Atthispointin9me,thefollowingstatementbestdescribeswhereIstandintermsoftherightobjec9vefunc9onfordecisionmakinginabusinessa. Maximizestockprice,withnoconstraintsb. Maximizestockprice,withconstraintsonbeingagoodsocialci9zen.c. Maximizestockholderwealth,withgoodci9zenconstraints,and
hope/praythatthemarketcatchesupwithyou.d. Maximizeprofitsorprofitabilitye. Maximizeearningsgrowthf. Maximizemarketshareg. Maximizerevenuesh. Maximizesocialgoodi. Noneoftheabove
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TheModifiedObjec9veFunc9on
AswathDamodaran
66
¨ Forpubliclytradedfirmsinreasonablyefficientmarkets,wherebondholders(lenders)areprotected:¤ MaximizeStockPrice:Thiswillalsomaximizefirmvalue
¨ Forpubliclytradedfirmsininefficientmarkets,wherebondholdersareprotected:¤ Maximizestockholderwealth:Thiswillalsomaximizefirmvalue,butmightnotmaximizethestockprice
¨ Forpubliclytradedfirmsininefficientmarkets,wherebondholdersarenotfullyprotected¤ Maximizefirmvalue,thoughstockholderwealthandstockpricesmaynotbemaximizedatthesamepoint.
¨ Forprivatefirms,maximizestockholderwealth(iflendersareprotected)orfirmvalue(iftheyarenot)
THEINVESTMENTPRINCIPLE:RISKANDRETURNMODELS“YoucannotswinguponaropethatisaFachedonlytoyourownbelt.”
AswathDamodaran 67
68
FirstPrinciples
AswathDamodaran
68
69
Theno9onofabenchmark
AswathDamodaran
69
¨ Sincefinancialresourcesarefinite,thereisahurdlethatprojectshavetocrossbeforebeingdeemedacceptable.Thishurdleshouldbehigherforriskierprojectsthanforsaferprojects.
¨ Asimplerepresenta9onofthehurdlerateisasfollows:Hurdlerate= RisklessRate+RiskPremium
¨ Thetwobasicques9onsthateveryriskandreturnmodelinfinancetriestoanswerare:¤ Howdoyoumeasurerisk?¤ Howdoyoutranslatethisriskmeasureintoariskpremium?
70
WhatisRisk?
AswathDamodaran
70
¨ Risk,intradi9onalterms,isviewedasa‘nega9ve’.Webster’sdic9onary,forinstance,definesriskas“exposingtodangerorhazard”.TheChinesesymbolsforrisk,reproducedbelow,giveamuchbeFerdescrip9onofrisk
危机¨ Thefirstsymbolisthesymbolfor“danger”,whilethesecond
isthesymbolfor“opportunity”,makingriskamixofdangerandopportunity.Youcannothaveone,withouttheother.
¨ Riskisthereforeneithergoodnorbad.Itisjustafactoflife.Theques9onthatbusinesseshavetoaddressisthereforenotwhethertoavoidriskbuthowbesttoincorporateitintotheirdecisionmaking.
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Agoodriskandreturnmodelshould…
AswathDamodaran
71
1. Itshouldcomeupwithameasureofriskthatappliestoallassetsandnotbeasset-specific.
2. Itshouldclearlydelineatewhattypesofriskarerewardedandwhatarenot,andprovideara9onaleforthedelinea9on.
3. Itshouldcomeupwithstandardizedriskmeasures,i.e.,aninvestorpresentedwithariskmeasureforanindividualassetshouldbeabletodrawconclusionsaboutwhethertheassetisabove-averageorbelow-averagerisk.
4. Itshouldtranslatethemeasureofriskintoarateofreturnthattheinvestorshoulddemandascompensa9onforbearingtherisk.
5. Itshouldworkwellnotonlyatexplainingpastreturns,butalsoinpredic9ngfutureexpectedreturns.
72
TheCapitalAssetPricingModel
AswathDamodaran
72
1. Usesvarianceofactualreturnsaroundanexpectedreturnasameasureofrisk.
2. Specifiesthatapor9onofvariancecanbediversifiedaway,andthatisonlythenon-diversifiablepor9onthatisrewarded.
3. Measuresthenon-diversifiableriskwithbeta,whichisstandardizedaroundone.
4. Translatesbetaintoexpectedreturn-ExpectedReturn=Riskfreerate+Beta*RiskPremium
5. Worksaswellasthenextbestalterna9veinmostcases.
73
1.TheMean-VarianceFramework
AswathDamodaran
73
¨ Thevarianceonanyinvestmentmeasuresthedisparitybetweenactualandexpectedreturns.
Expected Return
Low Variance Investment
High Variance Investment
74
HowriskyisDisney?Alookatthepast…
AswathDamodaran
74
-25.00%
-20.00%
-15.00%
-10.00%
-5.00%
0.00%
5.00%
10.00%
15.00%
20.00%
25.00%
Oct-08
Dec-08
Feb-09
Apr-09
Jun-09
Aug-09
Oct-09
Dec-09
Feb-10
Apr-10
Jun-10
Aug-10
Oct-10
Dec-10
Feb-11
Apr-11
Jun-11
Aug-11
Oct-11
Dec-11
Feb-12
Apr-12
Jun-12
Aug-12
Oct-12
Dec-12
Feb-13
Apr-13
Jun-13
Aug-13
ReturnsonDisney-2008-2013Averagemonthlyreturn=1.65%Averagemonthlystandarddevia9on=7.64%Averageannualreturn=21.70%Averageannualstandarddevia9on=26.47%
75
Doyouliveinamean-varianceworld?
AswathDamodaran
75
¨ Assumethatyouhadtopickbetweentwoinvestments.Theyhavethesameexpectedreturnof15%andthesamestandarddevia9onof25%;however,investmentAoffersaverysmallpossibilitythatyoucouldquadrupleyourmoney,whileinvestmentB’shighestpossiblepayoffisa60%return.Wouldyoua. beindifferentbetweenthetwoinvestments,sincetheyhavethe
sameexpectedreturnandstandarddevia9on?b. preferinvestmentA,becauseofthepossibilityofahighpayoff?b. preferinvestmentB,becauseitissafer?
¨ Wouldyouranswerchangeifyouwerenottoldthatthereisasmallpossibilitythatyoucouldlose100%ofyourmoneyoninvestmentAbutthatyourworstcasescenariowithinvestmentBis-50%?
76
TheImportanceofDiversifica9on:RiskTypes
AswathDamodaran
76
Actions/Risk that affect only one firm
Actions/Risk that affect all investments
Firm-specific Market
Projects maydo better orworse thanexpected
Competitionmay be strongeror weaker thananticipated
Entire Sectormay be affectedby action
Exchange rateand Politicalrisk
Interest rate,Inflation & news about economy
Figure 3.5: A Break Down of Risk
Affects fewfirms
Affects manyfirms
Firm can reduce by
Investing in lots of projects
Acquiring competitors
Diversifying across sectors
Diversifying across countries
Cannot affect
Investors can mitigate by
Diversifying across domestic stocks Diversifying across asset classes
Diversifying globally
77
Whydiversifica9onreduces/eliminatesfirmspecificrisk
AswathDamodaran
77
¨ Firm-specificriskcanbereduced,ifnoteliminated,byincreasingthenumberofinvestmentsinyourporpolio(i.e.,bybeingdiversified).Market-wideriskcannot.Thiscanbejus9fiedoneithereconomicorsta9s9calgrounds.
¨ Oneconomicgrounds,diversifyingandholdingalargerporpolioeliminatesfirm-specificriskfortworeasons-a. Eachinvestmentisamuchsmallerpercentageoftheporpolio,
mu9ngtheeffect(posi9veornega9ve)ontheoverallporpolio.
b. Firm-specificac9onscanbeeitherposi9veornega9ve.Inalargeporpolio,itisargued,theseeffectswillaverageouttozero.(Foreveryfirm,wheresomethingbadhappens,therewillbesomeotherfirm,wheresomethinggoodhappens.)
78
TheRoleoftheMarginalInvestor
AswathDamodaran
78
¨ Themarginalinvestorinafirmistheinvestorwhoismostlikelytobethebuyerorselleronthenexttradeandtoinfluencethestockprice.
¨ Generallyspeaking,themarginalinvestorinastockhastoownalotofstockandalsotradethatstockonaregularbasis.
¨ Sincetradingisrequired,thelargestinvestormaynotbethemarginalinvestor,especiallyifheorsheisafounder/managerofthefirm(LarryEllisonatOracle,MarkZuckerbergatFacebook)
¨ Inallriskandreturnmodelsinfinance,weassumethatthemarginalinvestoriswelldiversified.
79
Iden9fyingtheMarginalInvestorinyourfirm…
AswathDamodaran
79
Percent of Stock held
by Institutions
Percent of Stock held by
Insiders
Marginal Investor
High Low Institutional Investor
High High Institutional Investor, with insider influence
Low High (held by
founder/manager of firm)
Tough to tell; Could be insiders but only if they
trade. If not, it could be individual investors.
Low High (held by wealthy
individual investor)
Wealthy individual investor, fairly diversified
Low Low Small individual investor with restricted
diversification
80
Gaugingthemarginalinvestor:Disneyin2013
Aswath Damodaran
81
Extendingtheassessmentoftheinvestorbase
¨ Inallfiveofthepubliclytradedcompaniesthatwearelookingat,ins9tu9onsarebigholdersofthecompany’sstock.
Aswath Damodaran
82
TheLimi9ngCase:TheMarketPorpolio
AswathDamodaran
82
¨ Thebigassump9ons&thefollowup:Assumingdiversifica9oncostsnothing(intermsoftransac9onscosts),andthatallassetscanbetraded,thelimitofdiversifica9onistoholdaporpolioofeverysingleassetintheeconomy(inpropor9ontomarketvalue).Thisporpolioiscalledthemarketporpolio.
¨ Theconsequence:Individualinvestorswilladjustforrisk,byadjus9ngtheiralloca9onstothismarketporpolioandarisklessasset(suchasaT-Bill):Preferredrisklevel Alloca?ondecisionNorisk 100%inT-BillsSomerisk 50%inT-Bills;50%inMarketPorpolio;AliFlemorerisk 25%inT-Bills;75%inMarketPorpolioEvenmorerisk 100%inMarketPorpolioAriskhog.. Borrowmoney;Investinmarketporpolio
83
TheRiskofanIndividualAsset
AswathDamodaran
83
¨ Theessence:TheriskofanyassetistheriskthatitaddstothemarketporpolioSta9s9cally,thisriskcanbemeasuredbyhowmuchanassetmoveswiththemarket(calledthecovariance)
¨ Themeasure:Betaisastandardizedmeasureofthiscovariance,obtainedbydividingthecovarianceofanyassetwiththemarketbythevarianceofthemarket.Itisameasureofthenon-diversifiableriskforanyassetcanbemeasuredbythecovarianceofitsreturnswithreturnsonamarketindex,whichisdefinedtobetheasset'sbeta.
¨ Theresult:Therequiredreturnonaninvestmentwillbealinearfunc9onofitsbeta:¤ ExpectedReturn=RiskfreeRate+Beta*(ExpectedReturnonthe
MarketPorpolio-RiskfreeRate)
84
Limita9onsoftheCAPM
AswathDamodaran
84
1.Themodelmakesunrealis9cassump9ons2.Theparametersofthemodelcannotbees9matedprecisely
¤ Themarketindexusedcanbewrong.¤ Thefirmmayhavechangedduringthe'es9ma9on'period'
3.Themodeldoesnotworkwell¤ -Ifthemodelisright,thereshouldbe:
n Alinearrela9onshipbetweenreturnsandbetasn Theonlyvariablethatshouldexplainreturnsisbetas
¤ -Therealityisthatn Therela9onshipbetweenbetasandreturnsisweakn Othervariables(size,price/bookvalue)seemtoexplaindifferencesinreturnsbeFer.
85
Alterna9vestotheCAPM
AswathDamodaran
85
The risk in an investment can be measured by the variance in actual returns around an expected return
E(R)
Riskless Investment Low Risk Investment High Risk Investment
E(R) E(R)
Risk that is specific to investment (Firm Specific) Risk that affects all investments (Market Risk)Can be diversified away in a diversified portfolio Cannot be diversified away since most assets1. each investment is a small proportion of portfolio are affected by it.2. risk averages out across investments in portfolioThe marginal investor is assumed to hold a “diversified” portfolio. Thus, only market risk will be rewarded and priced.
The CAPM The APM Multi-Factor Models Proxy ModelsIf there is 1. no private information2. no transactions costthe optimal diversified portfolio includes everytraded asset. Everyonewill hold this market portfolioMarket Risk = Risk added by any investment to the market portfolio:
If there are no arbitrage opportunities then the market risk ofany asset must be captured by betas relative to factors that affect all investments.Market Risk = Risk exposures of any asset to market factors
Beta of asset relative toMarket portfolio (froma regression)
Betas of asset relativeto unspecified marketfactors (from a factoranalysis)
Since market risk affectsmost or all investments,it must come from macro economic factors.Market Risk = Risk exposures of any asset to macro economic factors.
Betas of assets relativeto specified macroeconomic factors (froma regression)
In an efficient market,differences in returnsacross long periods mustbe due to market riskdifferences. Looking forvariables correlated withreturns should then give us proxies for this risk.Market Risk = Captured by the Proxy Variable(s)
Equation relating returns to proxy variables (from aregression)
Step 1: Defining Risk
Step 2: Differentiating between Rewarded and Unrewarded Risk
Step 3: Measuring Market Risk
86
WhytheCAPMpersists…
AswathDamodaran
86
¨ TheCAPM,notwithstandingitsmanycri9csandlimita9ons,hassurvivedasthedefaultmodelforriskinequityvalua9onandcorporatefinance.Thealterna9vemodelsthathavebeenpresentedasbeFermodels(APM,Mul9factormodel..)havemadeinroadsinperformanceevalua9onbutnotinprospec9veanalysisbecause:¤ Thealterna9vemodels(whicharericher)doamuchbeFerjobthan
theCAPMinexplainingpastreturn,buttheireffec9venessdropsoffwhenitcomestoes9ma9ngexpectedfuturereturns(becausethemodelstendtoshivandchange).
¤ Thealterna9vemodelsaremorecomplicatedandrequiremoreinforma9onthantheCAPM.
¤ Formostcompanies,theexpectedreturnsyougetwiththethealterna9vemodelsisnotdifferentenoughtobeworththeextratroubleofes9ma9ngfouraddi9onalbetas.
87
Applica9onTest:Whoisthemarginalinvestorinyourfirm?
AswathDamodaran
87
¨ Youcangetinforma9ononinsiderandins9tu9onalholdingsinyourfirmfrom:¤ hFp://finance.yahoo.com/¤ Enteryourcompany’ssymbolandchooseprofile.
¨ Lookingatthebreakdownofstockholdersinyourfirm,considerwhetherthemarginalinvestoris¤ Anins9tu9onalinvestor¤ Anindividualinvestor¤ Aninsider