Copyright © 2003 South-Western/Thomson Learning All rights reserved. Chapter 10 Rates of Return On Common Stock Investments

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Measures of Stock Performance Averages and Indices Different means to calculate an average –Price-weighted –Value-weighted –geometric

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. A Price-weighted Average Price of stock A $10 Price of stock B $20 Price-weighted average is ($ )/$2 = $15

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. A Value-weighted Average Weights the prices by the number of shares outstanding

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. A Value-weighted Average If number of shares outstanding of stocks A and B are –A 1,000,000 –B 10,000,000

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Total Value of Each Stock A $10,000,000 B $200,000,000

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Weighted Average Price –$210,000,000/(1,000, ,000,000) = $19.09

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. An Equal-weighted Average Equal dollar amount invested in each stock If prices are $10 and $20 –buy two shares of A for every share of B –$20 invested in each stock Average price of a share: $40/3 = $13.33

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. A Geometric Average Instead of dividing, take the 1/n root (the reciprocal of n) Average price of a share: (10)(20).5 = $14.14

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Averages and Indices Compare prices over time or use one year as a base In an index subsequent prices are expressed relative to the base year

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Differences in Measures Different methods for calculating averages The selection of a base year Can produce different measures of stock performance

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Aggregate Measures of the Stock Market Include: Dow Jones industrial average Standard & Poor's 500 stock index NYSE composite index Value Line Stock average

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Price Movements and Graphs How stock prices appear to have changed is affected by the presentation Impact of absolute and relative scales

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Price Movements and Graphs

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Dow Jones Industrial Average Absolute Scale

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Price Movements and Graphs

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Dow Jones Industrial Average Relative Scale

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Price Movements and Graphs

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Additional Aggregate Measures of the Stock Market Russell 1000 Russell 2000 Russell 3000 S&P 400 MidCap S&P 600 SmallCap S&P 1500 Nasdaq Index Wilshire 5000 Index

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Aggregate Measures of the Stock Market Tend to move together Highly correlated

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Stock Prices May be deflated to determine investors' increase in purchasing power

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Percentage Change in Real Terms

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. The Holding Period Return (HPR) The percentage earned on an investment during a period of time HPR = P 1 + D - P 0 P 0

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. The Holding Period Return Major weakness : Does not consider the length of time One year and ten years are the same

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Rate of Return Rate that equates –the cost of an investment (cash outflow) with –the cash inflows generated Gives the true annualized (compound) return

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Internal Rate of Return (r) Also called the dollar-weighted rate of return P 0 = D 1 + D 2 + … + D n + P n (1+r) (1+r) 2 (1+r) n (1+r) n

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Issues with the Internal Rate of Return Assumes cash flows are reinvested at that internal rate of return Adjustments are necessary if more than one purchase or sale are made

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Time-weighted Rate of Return An alternative to the internal rate of return Ignores the dollar amount invested Uses the return for each time period Computes the geometric average return

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Investment Returns Studies indicate stocks earn 9 to 12 percent annually The Ibbotson results (the industry benchmark) –Large company stocks: 11.3% –Small company stocks: 12.6%

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Ibbotson Results For different time periods

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Ibbotson Results For different time periods

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Ibbotson Results For different time periods

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Ibbotson Results For different time horizons

Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Averaging Strategies Dollar cost averaging - the periodic purchase Averaging down - buying additional shares after prices fall