Lesson 2 of 3
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Holding Period Return (HPR)
r = ((Dividend + Share Price Change)/Share Price Paid)-1
Expected vs. Realized Holding Period Return
Expected HPR is based on investor expectations for share price appreciation and dividend payments; different investors may have different expectations for the same stock and would therefore have different expected HPRs.
Realized HPR is based on historical fact, as share price change and dividend payment are known values.
Required Return
This value is the minimum return that an investor demands for a specific asset based on its riskiness.
Required return reflects the opportunity cost of forgoing the next best investment.
Expected Alpha = expected return – required return
Realized Alpha = actual HPR – comparable asset return
Discount Rate
The discount rate is used to calculate the present value of future cash flows.
Generally, a single discount rate is used for all future period cash flows.
When calculating the intrinsic value of a stock, the investor will apply a discount rate that is based on the risk free rate of return plus some equity risk premium.
Internal Rate of Return (IRR)
IRR is the case of a discount rate that equalizes the present value of cash inflows with present value of cash outflows.
Within the context of a net present value analysis, when the cash inflows and outflows are known, IRR will be the rate that causes the NPV to equal zero.
Convergence to Intrinsic Value
When calculating the intrinsic value of a stock, an analyst may discover that his/her calculated value differs from the current market value.
If the investor’s calculated intrinsic value is more accurate than the current market price, then a special investment opportunity may be present.
When the market value shifts to the calculated intrinsic value over time, then convergence is taking place.
Despite a perceived mispricing, convergence may not occur over the investor’s time horizon. Quoting the legendary economist John Maynard Keynes “the market can stay irrational longer than you can stay solvent.”