Chapter 17: Performance measurement (2)

Question 1

Portfolio risk and return analysis

Answer 1

Involves plotting the TWRR from a portfolio over a period against the ‘riskiness’ of the portfolio. It is used to assess whether superior investment has been obtained by taking more risk or by superior market and stock selection/timing.

Question 2

In practice, how can control over risk be achieved?

Answer 2

• Guidlines on asset allocations and stock weightings
• Specifying a maximum under-performance over specified periods
• Downside measures of risk may be of use here

Question 3

Problems with regular risk and return analysis

Answer 3

• Creeping change in portfolio composition (and overall volatility as more risky stocks are included which don’t show up in the std dev immediately)
• A successful investment manager may be treated unfairly by the measurement system
• The manager may disagree with the market view of a stock’s or market’s prospects and/or the uncertainty attached to those prospects

Important that the manager can demonstrate a realistic and convincing rationale for investment decisions

Question 4

Measuring the performance of equities using market price. Refinements that should be considered

Answer 4

• total return is of interest to the investor so dividends must be allowed for
• equity prices may be influenced by short-term concerns whereas many investors are focused on the long term

Question 5

Using NPV to measure the performance of equities

Answer 5

The absolute result from an estimate of NPV may be of limited use because it depends on many assumptions which results in a wide variety of results

Differences between market price and an investor’s estimate of NPV can derive from:

1. differences in the profile between a particular investor and the average investor
2. differences in computation method, information used or assumptions. These are part of the range of value estimates that give rise to the current market price

The trend of NPV estimates and their relationship to market prices may be helpful.

Question 6

Using NAV to measure the performance of equities

Answer 6

• The NAV of a company or the NAV per share is only one component of overall value.
• All things equal, a share with higher proportion of its share price represented by NAV should be cheaper than a share that has less asset backing.
• This difference is likely to be eliminated in an efficient market where the market value is driven by supply and demand dynamics.
• Share price in an efficient market will reflect factors other than NAV.
• Goodwill must be evaluated for relevance, and removed if inappropriate, to make a valid comparison with the company which has grown organically.
• NAV is a readily available accounting number, which may require adjustments (e.g. to allow for e.g. non-quoted assets).
• NAV may not allow for the extent that some businesses may be more capital intensive than others.
• Intangibles e.g. human capital, may be difficult to value and unlikely to be included in NAV.
• NAV does not reflect risk.
• NAV may not be appropriate to compare companies in different industries / sectors.
• NAV does not currently account for environmental and other less quantifiable socially responsible impacts.

Question 7

CAPM suggests that if capital assets are priced correctly then:

Answer 7

• returns in excess of the risk-free rate will only be generated from taking risks
• the risk-adjusted return on capital should be equal to the risk-free rate

Question 8

Risk-adjusted return formula

Answer 8

Question 9

Main difficulty when using the risk-adjusted return on capital approach to assess company performance

Answer 9

To correctly and accurately identify both the company’s ‘capital’ and the ‘return’ on capital.

Intangible assets are likely a major component of CAPM capital for service-based companies, which may have little in the way of tangible assets.

Question 10

Generally, what does a high actual return on capital imply?

Answer 10

Using normal accounting measures and a starting measure of the market capitalisation, it implies the successful creation of intangible assets and shareholder value.
The company would therefore be an attractive investment proposition.

Question 11

Calculating capital for the risk-adjusted return

Answer 11

Include and value:

• Goodwill from mergers/takeovers
• Internally generated goodwill
• Any other intangible assets
• All tangible assets

Ultimately, the best measure of the capital in a company, including all the intangibles, is likely the market capitalisation itself.

Question 12

Calculating return for the risk-adjusted return

Answer 12

• add back to profits any investment in the creation of new intangible assets and in the expansion and purchase of intangible assets
• continue to deduct any expenses incurred defending and servicing existing tangible and intangibe assets

Question 13

State the security market line relationship

Answer 13