Components of a Stock's Realized Return - Assignment Example

Identify the components of a stock's realized return. A stock’s realized return is represented by the overall gain an investor obtains from an investment. The reason people invest in common stocks is to make money. The primary components of a stock’s realized return are capital gains and dividends paid out to the investor. The dividends an investor might receive could be either a cash dividend or a stock dividend. To calculate the stock realized return you have to add the capital gain obtained at the moment of sale and the total dividends received while the investor held the common stock. The addition of these two variables would then be divided by the original price the investor paid for the stock or lot of stocks. This calculation would give the gross return. The net return is calculated by subtracting the tax expenses associated with the investment from the numerator of the formula. It is important for investors to periodically calculate the return they would achieve if they sold a stock at a particular point in time. This can help investors determine when it is the best moment to sell their stock investment. 2. Contrast systematic and unsystematic risk. There are two types of risks that investors must pay close attention to. The two types of risks are systematic and unsystematic risk. Systematic risk is a risk factor that cannot be control by the investor or the firm due to the fact that it is a market inherent risk. These risk factors affect all firms. Some examples of systematic risks include recessions, wars, inflation, and the occurrence of natural events. In the aftermath of the March 11, 2011 earthquake in Japan the valuation of most Japanese stocks when down a lot. This risk could not have been predicted by an investor. Unsystematic risk is also referred to as firm specific risk or diversifiable risk. Unsystematic risks are risks that can be controlled by the firm. Some examples of these risks include employee strikes, lawsuits, unsuccessful product launches, and the quality of the labor force hired by the firm. A way to offset the effects of unsystematic risks is through diversification. A smart investor is able to reduce the unsystematic risk of their portfolio by purchasing a wide array of investments including blue chip stocks, bonds, and mutual funds. Within the stocks selected by the investor they choose common stocks from firms from different industries. Both systematic and unsystematic risk must be considered by people that are contemplating investing in the stock market. 3. Explain why the total risk of a portfolio is not simply equal to the weighted average of the risks of the securities in the portfolio. Many people think because the expected return on a portfolio is calculated as the weighted average of the expected returns of individual stocks that the risk of a portfolio is calculated in the same. Well all those people that thought that way are wrong. Generally speaking the portfolio risk is usually smaller than the weighted average. This occurs because on many instances the risk of different stocks offset each other. A way to measure how the risk of the different stocks of a portfolio is affected is by using the correlation coefficient. The correlation coefficient measures the degree of relationship between two variables. It is possible for a portfolio of two stocks that both have risks to formulate a riskless portfolio if the risks of the two stocks cancel each other out. This can occur because the returns of each stock move in opposite directions. 4. State what beta measures and its uses. The beta coefficient measures a stock’s sensitivity to fluctuations in the stock market. The normal beta is 1.0. A 1.0 beta implies that the common stock has the same risk as the market. When a company has a beta below 1.0 the common stock of the firm is not affected too much by the market risk. Stocks that have betas above 1.0 are very sensitive to fluctuations in the stock market. A stock that has a beta coefficient of 2.0 implies that the firm is twice as volatile or risky as the average stock. The overall market is typically represented by indexes such as the Dow Jones Industrial or the S&P 500. One of the most practical uses for the beta coefficient is in the capital asset pricing model (CAPM). The formula to calculate the capital asset pricing model is Ks = Krf + B (Km – Krf) (McCracken, 2009). A legend of what each variable represents is illustrated below. Ks = required rate of return Krf = risk free rate Km = expected return of the market B = beta coefficient When an investor is forming a portfolio they should pay close attention to the beta coefficient. Investors cannot select companies that all have similar betas such as choosing a lot of companies with high betas because the risk associated with such a portfolio could skyrocket. It is preferable for the average of the betas of the individual stocks in a portfolio to be close to one. A company that estimates the beta coefficients of different public companies in the marketplace is Value Line. 5. State what WACC measures and explain the WACC assumptions used to value a project. The weighted average cost of capital (WACC) measures the combination of equity and debt used by a company to finance its operations and capital projects. The WACC metric measures the cost of capital based on the average cost of the various sources used by a firm. The two basic sources used by companies are equity and debt financing. Equity comes in the form of common stocks and preferred stocks. The most commonly used debt mechanism is bonds. The target proportions of common stock equity, preferred stock, debt, and the components of capital are used by financial analyst to calculate the WACC of a firm. Some of the assumptions made by the WACC model include the existence or non-existence of taxes, whether a firm has a constant amount of debt in dollar terms, and the frequency of debt rebalancing (Staton & Seasholes, 2005). References McCraken, M. (2009). CAPM – The Capital Asset Pricing Model. Retrieved July 18, 2011 from http://papers.ssrn.com/sol3/papers.cfm?abstract_id=837384 Stanton, R., Seasholes, M. (2005). The Assumptions and Math Behind Wacc and Avp Calculations. Retrieved July 18, 2011 from http://papers.ssrn.com/sol3/papers.cfm?abstract_id=837384 Read More