CAPITAL MARKETS & INVESTMENTS
F I NANCIAL MA N AG EM ENT - R 4 8
D R . L I B E RAT O R E Y E S
Ateneo-Regis MBA Program
Gotengco - Herrera - Sarmiento
Liway Gotengco
Procurement & Supply
Chain Manager
Carlo Herrera
Assistant Director of Global
Marketing & Communications
Elmer Sarmiento
AMCOR PHILIPPINES
CG HOSPITALITY GLOBAL
PERSONIV
Director of Finance &
Accounting
TODAY'S
TOPICS
• Importance of an investment mandate and its implications
on asset allocation and security selection
• Valuation of securities as well as the relationship between
risk and return
• Capital Asset Pricing Model
• Interpreting measures of risk and return of an investment
portfolio
• Effects of efficient market hypotheses on investment
management
Investment Mandates,
Implications on Asset
Allocation and Security
Selection
Definition of an Investment Mandate
An investment mandate is an order to manage a pool of funds using a certain plan that is put in place to help
guide the actions and choices of the fund's manager. It also lays out the level of risk that the owner of the money
would permit. The mandate can vary and depends on the goals the owner has for that money.
How Investment Mandates Work
Whether they are used by private investors or the managers of large funds, mandates work by laying out a
framework for how to allocate and invest money. The manager must follow the guides laid out in the
mandate when choosing assets to buy, hold, or sell.
Investment mandates play a big role in the control of pooled funds. Mandates may include rules on:
•
•
•
•
Priorities and goals
Benchmarks
Acceptable levels of risk
Types of funds to be either used or avoided
Types of Investment Mandates
An investment mandate can restrict a money manager to certain asset classes, areas, industries, sectors,
valuation levels, market capitalizations, and more.
• Small-capitalization stock: This mandate requires finding attractive firms that are below a certain market
cap size.
• Low turnover: This usually means restricting the percentage of the portfolio that can be sold in any given
year to 3% or 5%.
• Global investment: This mandate means you should own stocks in both your home country and abroad.
• International investment: This restricts the portfolio to firms that are based, or doing business mostly
outside, your home country.
• Long-term growth: This mandate prioritizes appreciation over things such as current income or volatility
risk. Stocks are a common type of holding when looking for long-term growth.
• Income: This prioritizes current passive income from sources such as dividends, interest, and rents over
long-term growth.
• Environmental, Social, and Governance (ESG): An ESG mandate instructs managers to invest in securities
that are ethical, socially responsible, and sustainable. They may do this by avoiding shares of companies that
earn their money using things such as fossil fuels, guns, or prison labor. ESG mandates might also prioritize
things such as ethical and inclusive leadership, environmental protection, and community investment.
Asset Allocation vs. Security Selection: An Overview
Asset allocation and security selection are key components of an investment strategy, but they require separate
and distinct methodologies.
Asset allocation is a broad strategy that determines the mix of assets to hold in a portfolio for an optimal riskreturn balance based on an investor's risk profile and investment objectives. Security selection is the process of
identifying individual securities within a certain asset class that will make up the portfolio.
Asset allocation refers to an investment strategy in which individuals divide their investment
portfolios between different diverse asset classes to minimize investment risks. The asset classes
fall into three broad categories: equities, fixed-income, and cash and equivalents.
Security Selection
Once a portfolio’s asset allocation is determined, an investor needs to select securities or pick the actual individual portfolio
holdings.
Sample:
60% equity (stocks) - mining, property, services industrial, holding, financials
30% fixed income (bonds)
10% real estate
In this case, an investor needs to pick securities for each asset class. So 60% of the portfolio needs to be allocated to picking
stocks or securities that invest in stocks.
To make up that 60% of your portfolio, you can also be stock picking. When considering what stocks to buy, it would be wise
to look at fundamental and technical factors.
Same goes for your other assets, you’ll need to pick funds or individual bonds to make up 30% of your portfolio. While the
last 10% can be invested in REITs, actual real estate properties, land or other real estate investments
Valuation of Securities
Zero-Growth Dividend Discount Model
The zero-growth model assumes that the dividend always stays the same, i.e., there is no growth in dividends.
Therefore, the stock price would be equal to the annual dividends divided by the required rate of return.
Stock’s Intrinsic Value = Annual Dividends / Required Rate of Return
If a common share of stock pays dividends of $1.80 per year, and the required rate of return for the stock is 8%, then what is
its intrinsic value?
Solution:
Here, we use the dividend discount model formula for zero growth dividends:
Dividend Discount Model Formula = Intrinsic Value = Annual Dividends / Required Rate of Return
Intrinsic Value = $1.80/0.08 = $22.50.
The shortcoming of the model above is that you would expect most companies to grow over time.
Constant-Growth Dividend Discount Model
The constant-growth dividend discount model or the Gordon Growth Model
assumes dividends grow by a specific percentage each year.
The constant-growth dividend discount model or DDM model gives us the present value of an infinite
stream of dividends growing at a constant rate.
The constant-growth dividend discount model formula is as below: –
Where:
D1 = Value of dividend to be received next year
D0 = Value of dividend received this year
g = Growth rate of dividend
Ke = Discount rate
Constant-Growth Dividend Discount Model
Sample:
If a stock pays a $4 dividend this year, and the dividend has been growing 6% annually, what will be the stock’s
intrinsic value, assuming a required rate of return of 12%?
Solution:
D1 = $4 x 1.06 = $4.24
Ke = 12%
Growth rate or g = 6%
Intrinsic stock price = $4.24 / (0.12 – 0.06) = $4/0.06 = $70.66
Differential-Growth Dividend Discount Model
The variable-growth rate dividend discount model or DDM Model is much closer to reality than the other two types of
dividend discount models. This model solves the problems related to unsteady dividends by assuming that the
company will experience different growth phases.
Variable growth rates can take different forms; you can even assume that the growth rates vary for each year.
However, the most common form is one that thinks of three different rates of growth:
• An initial high rate of growth
• A transition to slower growth
• A sustainable, steady rate of growth
Differential-Growth Dividend Discount Model
Elixir Drug Company is expected to enjoy rapid growth from the introduc?tion of its new back-rub ointment.
The dividend for a share of Elixir’s stock a year from today is
expected to be $1.15. During the next four years, the dividend is expected to grow at 15 percent
per year (g1 = 15%). After that, growth (g2) will be equal to 10 percent per year. Calculate the
present value of a share of stock if the required return (R) is 15 percent.
Growth in Dividends for Elixir Drug Company
We need to apply a two-step process
to discount these dividends. We first calculate
the present value of the dividends growing at
15 percent per annum. That is, we first calculate
the present value of the dividends at the end
of each of the first five years. Second, we
calculate the present value of the dividends
beginning
at the end of Year 6
Present Value of First Five Dividends The present values of dividend payments in Years
1 through 5 are calculated as follows:
Present Value of Dividends Beginning at End of Year 6 We use the procedure for
deferred perpetuities and deferred annuities presented in Chapter 4. The dividends
beginning at the end of Year 6 are
The growing perpetuity formula calculates present value as of one
year prior to the first payment. Because the payment begins at the end of Year 6, the
present value formula calculates present value as of the end of Year 5.
The price at the end of Year 5 is given by:
The present value of P5 as of today is:
The present value of all dividends as of today is $27 (= $22 + 5).
Industry Comparison
The Philippine Stock Exchange, Inc. (PSE) is a self-regulatory organization that provides and ensures a fair,
efficient, transparent and orderly market for the buying and selling of securities. The Exchange also offers
a convenient and efficient venue in raising capital to support the growth of businesses.
Considered one of the oldest bourses in Asia, the PSE traces its roots back to the country’s two former
bourses – the Manila Stock Exchange (formed in 1927) and the Makati Stock Exchange (formed in 1963).
The Manila and Makati bourses were unified on December 23, 1992 to form the PSE.
In 2018, the PSE moved its headquarters to Bonifacio Global City (BGC) in Taguig. The fast paced
environment in the Taguig business district is well-suited for the Exchange as it aims to fast track the
introduction of new products and services to boost investor participation and liquidity in the Philippine
stock market.
On a whole, the Philippine Stock Exchange has 275 listed companies.[4] The main index for PSE is the PSE
Composite Index (PSEi) composed of thirty (30) listed companies. The selection of companies in the PSEi is
based on a specific set of criteria.[further explanation needed] There are also six additional sector-based
indices. The PSE is overseen by a 15-member Board of Directors, chaired by José T. Pardo.
Capital Asset Pricing Model
8.83
%
7.64
%
11.55
%
What Is the Capital Asset Pricing Model?
• The Capital Asset Pricing Model (CAPM) describes the relationship between systematic risk and expected
return for assets, particularly stocks.1 CAPM is widely used throughout finance for pricing risky securities and
generating expected returns for assets given the risk of those assets and cost of capital.
Example
• Imagine an investor is contemplating a stock worth $100 per share today that pays a 3% annual
dividend. The stock has a beta compared to the market of 1.3, which means it is riskier than a
market portfolio. Also, assume that the risk-free rate is 3% and this investor expects the market to
rise in value by 8% per year.
• The expected return of the stock based on the CAPM formula is 9.5%:
9.5%=3%+1.3×(8%−3%
)
The CAPM and the Efficient Frontier
• Using the CAPM to build a portfolio is supposed to help an investor manage their risk. If an
investor were able to use the CAPM to perfectly optimize a portfolio’s return relative to risk, it
would exist on a curve called the efficient frontier, as shown in the following graph.
Problems With CAPM
There are several assumptions behind the CAPM formula that have been shown not to hold in reality.
Modern financial theory rests on two assumptions: One, securities markets are very competitive and
efficient (that is, relevant information about the companies is quickly and universally distributed and
absorbed) and two, these markets are dominated by rational, risk-averse investors, who seek to
maximize satisfaction from returns on their investments.
Practical Value of the CAPM
Considering the critiques of the CAPM and the assumptions behind its use in portfolio construction,
it might be difficult to see how it could be useful. However, using the CAPM as a tool to evaluate the
reasonableness of future expectations or to conduct comparisons can still have some value.
.
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