Financial Statement Analysis

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SOLUTIONS TO
EXERCISES AND CASES

For

FINANCIAL STATEMENT ANALYSIS AND SECURITY VALUATION

Stephen H. Penman

Fifth Edition

CHAPTER ONE

Introduction to Investing and Valuation

Concept Questions

C1.1. Fundamental risk arises from the inherent risk in the business – from sales revenue falling or expenses rising unexpectedly, for example. Price risk is the risk of prices deviating from fundamental value. Prices are subject to fundamental risk, but can move away from fundamental value, irrespective of outcomes in the fundamentals. When an investor buys a stock, she takes on fundamental risk – the stock price could drop because the firm’s operations don’t meet expectations – but she also runs the (price) risk of buying a stock that is overpriced or selling a stock that is underpriced. Chapter 19 elaborates and Figure 19.5 (in Chapter 19) gives a display.

C1.2. A beta technology measures the risk of an investment and the required return that the risk requires. The capital asset pricing model (CAPM) is a beta technology; is measures risk (beta) and the required return for the beta. An alpha technology involves techniques that identify mispriced stocks than can earn a return in excess of the required return (an alpha return). See Box 1.1. The appendix to Chapter 3 elaborates on beta technologies.

C1.3. This statement is based on a statistical average from the historical data: The return on stocks in the U.S. and many other countries during the twentieth century was higher than that for bonds, even though there were periods when bonds performed better than stocks. So, the argument goes, if one holds stocks long enough, one earns the higher return. However, it is dangerous making predictions from historical averages when risky investment is involved. Averages from the past are not…...

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