In CFAI Equity reading 35, page 56 they explain the return from convergence as the sum of the holding period return and the required rate of return. They give the example of a required return of 7.6% and a holding period return of 12.4 and say the expected return is 20%. How can this be? If the convergence is realized then your return is 12.4. That is your holding period return. What difference does it make what the required return was?
The required return is included in holding period return. Alpha = 12.4 - 7.6 = 4.8.
You realized 4.8 excess return. So it matters when there is Alpha.
Hope this helps.
According to the example PG’s market price was $63.16 based on an estimate of the required rate of return of 7.6% and according to one analyst it was undervalued as it had the intrinsic value of $71. It was undervalued by (71-63.16) / 63.16 = 12.4% so if the price converges to 71 in 1 year time then the return investor would earn is 20%. 7.6% is what the stock is offering as an opportunity cost to the investors for investing in PG’s share at $63.16, if one holds it for one year and the excess return of 12.4% based upon an analyst is what the investor would earn as the price converges. It effectively makes the expected return to be 20%.
I hope it helps.
Sorry, but this is not sinking in. If the HPR is 12.4 (which is what I calculated) then you have gained 12.4% in one year on your investment. That seems to be the mathematical reality. I get that the opportunity cost is 7.6% and I get the HPR is 12.4, I also understand that the alpha is 4.8%f as stated by rock…what still does not make sense how you would ever get a 20% return.
I don’t have the CFAI book with me right now, so I don’t know the exact wording of the example. But, it sounds to me like 12.4% is the Expected Return from Convergence (i.e., NOT the Holding Period Return). If this is the case, this analyst is expecting the share price ($63.16) to appreciate over time (perhaps a year) by the Required Rate of Return (7.6%) PLUS the Expected Return from Convergence (12.4%) (,assuming no dividend income). In other words, this analyst is not expecting the stock price in 1 year to be $71, but rather something like $71 x (1+7.6%). Hope I’m making any sense.
Sunny is right. The 71 is today’s estimated intrinsic value in the example - not the price expected in 1 year. In fact they go on to say that the price could converge in a shorter period of time as well - e.g. 9 months or even 1 day.
Suppose if retention rate is 0 it means that the whole earning is distributed in dividends.
Current market price is 63.16 with estimated required rate of return 7.6%. It makes the earnings to be $4.8 which is effectively the dividend as retention rate is 0 and all earnings are distributed. It further implies that the market price would remain same 63.16 after one year.
Analyst thinks that the price should be 71 and if the stock converges to that then the holding period return for investor would be:
(P1 - P0 + D) / P0 = (71 - 63.16 + 4.8) / 63.16 = 20.01% which is the expected rate of the investor.
Return from convergence is not holding period return rather HPR is the sum of required rate of return (consensus rate probably as the market has priced a stock based on some rate) and the convergance rate, which an investor realizes when the current price moves to the intrinsic value. It is also important to note that 71 is the intrinsic value at t=0 not at t=1.
I have arrived at dividend of 4.8 by assuming that retention rate is 0. If retention rate is 0 then g becomes 0 and using GGM > V0 = D0(1+g) / r-g
63.16 = D0 (1+0) / 7.6 - 0
Since g = 0 then D0 = D1
63.16 = D1 / 7.6
D1 = 63.16 * 7.6 = 4.8