Fundamentals of Investments V A L U A T I O N A N D M A N A G E M E N T jjoorr6611663399__ffmm__ii--xxlliivv..iinndddd ii 2200//1122//1133 99::5599 AAMM The McGraw-Hill/Irwin Series in Finance, Insurance, and Real Estate Stephen A. 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Jordan Thomas W. Miller Jr. University of Kentucky Mississippi State University Steven D. Dolvin, CFA Butler University jjoorr6611663399__ffmm__ii--xxlliivv..iinndddd iiiiii 2200//1122//1133 99::5599 AAMM FUNDAMENTALS OF INVESTMENTS: VALUATION AND MANAGEMENT, SEVENTH EDITION Published by McGraw-Hill Education, 2 Penn Plaza, New York, NY 10121. Copyright © 2015 by McGraw-Hill Education. All rights reserved. Printed in the United States of America. Previous editions © 2012, 2009, and 2008. No part of this publication may be reproduced or distributed in any form or by any means, or stored in a database or retrieval system, without the prior written consent of McGraw-Hill Education, including, but not limited to, in any network or other electronic storage or transmission, or broadcast for distance learning. Some ancillaries, including electronic and print components, may not be available to customers outside the United States. This book is printed on acid-free paper. 1 2 3 4 5 6 7 8 9 0 DOW/DOW 1 0 9 8 7 6 5 4 ISBN 978-0-07-786163-6 MHID 0-07-786163-9 Senior Vice President, Products & Markets: Kurt L. Strand Vice President, Content Production & Technology Services: Kimberly Meriwether David Managing Director: Douglas Reiner Executive Brand Manager: Chuck Synovec Executive Director of Development: Ann Torbert Development Editor II: Jennifer Lohn Upton Director of Digital Content: Doug Ruby Digital Development Editor: Kevin Shanahan Executive Marketing Manager: Melissa S. Caughlin Director, Content Production: Terri Schiesl Content Project Manager: Brian Nacik Senior Buyer: Debra R. Sylvester Design: Matt Diamond Cover Image: Veer Images Typeface: 10/12 Times Roman Compositor: MPS Limited Printer: R. R. Donnelley All credits appearing on page or at the end of the book are considered to be an extension of the copyright page. Library of Congress Cataloging-in-Publication Data Jordan, Bradford D. Fundamentals of investments : valuation and management / Bradford D. Jordan, University of Kentucky, Thomas W. Miller Jr., Mississippi State, Steven D. Dolvin, CFA, Butler University.—Seventh edition. pages cm. — (The McGraw-Hill/Irwin series in fi nance, insurance, and real estate) Includes index. ISBN 978-0-07-786163-6 (alk. paper)—ISBN 0-07-786163-9 (alk. paper) 1. Investments. I. Miller, Thomas W. II. Dolvin, Steven D. III. Title. HG4521.C66 2015 332.6—dc23 2013039057 The Internet addresses listed in the text were accurate at the time of publication. The inclusion of a website does not indicate an endorsement by the authors or McGraw-Hill Education, and McGraw-Hill Education does not guarantee the accuracy of the information presented at these sites. www.mhhe.com jjoorr6611663399__ffmm__ii--xxlliivv..iinndddd iivv 2200//1122//1133 1100::0000 AAMM To my late father, S. Kelly Jordan Sr., a great stock picker. BDJ To my parents, Tom and Kathy Miller, my wife Carolyn, and #21 —Thomas W. Miller III. TWM Jr. To my wife, Kourtney, and the “three L’s”—my greatest investment in this life. SDD v jjoorr6611663399__ffmm__ii--xxlliivv..iinndddd vv 2200//1122//1133 1100::0000 AAMM About the Authors Bradford D. Jordan Gatton College of Business and Economics, University of Kentucky Bradford D. Jordan is Professor of Finance and holder of the Richard W. and Janis H. Furst Endowed Chair in Finance at the University of Kentucky. He has a long-standing interest in both applied and theoretical issues in investments, and he has extensive experience teach- ing all levels of investments. Professor Jordan has published numerous research articles on issues such as valuation of fi xed-income securities, tax effects in investments analysis, the behavior of security prices, IPO valuation, and pricing of exotic options. He is co-author of F undamentals of Corporate Finance and E ssentials of Corporate F inance, two of the most widely used fi nance textbooks in the world. Thomas W. Miller Jr. College of Business, Mississippi State University T om Miller is Professor of Finance and holder of the Jack R. Lee Chair in Financial and Consumer Finance at Mississippi State University. Professor Miller has a long- standing interest in derivative securities and investments and has published numerous a rticles on various topics in these areas. Professor Miller has been honored with many research and teaching awards. Professor Miller is a co-author (with David Dubofsky) of Derivatives: Valuation and Risk Management (Oxford University Press). Professor Miller’s interests include golf, skiing, American saddlebred horses, and playing tenor saxophone. Steven D. Dolvin, CFA College of Business, Butler University S teven D. Dolvin, CFA, is an Associate Professor of Finance at Butler University. He teaches primarily in the area of investments, but he also oversees student-run portfolios in both public and private equity. He has received multiple teaching awards and has also published n umerous articles in both academic and practitioner outlets. His principal areas of interest are IPOs, venture capital, fi nancial education, retirement investing, and behavioral fi nance. His prior experience includes work in both corporate fi nance and investments, and he cur- rently does investment consulting for both individuals and businesses. Professor D olvin is also a CFA charterholder and is actively involved in his local CFA society. vi jjoorr6611663399__ffmm__ii--xxlliivv..iinndddd vvii 2200//1122//1133 1100::0000 AAMM Preface So why did we write this book? A s we toiled away, we asked ourselves this question many times, and the answer was always the same: Our students made us. Traditionally, investments textbooks tend to fall into one of two camps. The fi rst type has a greater focus on portfolio management and covers a signifi cant amount of portfolio theory. The second type is more concerned with security analysis and generally contains fairly detailed coverage of fundamental analysis as a tool for equity valuation. Today, most texts try to cover all the bases by including some chapters drawn from one camp and some from another. The result of trying to cover everything is either a very long book or one that forces the instructor to bounce back and forth between chapters. This frequently leads to a noticeable lack of consistency in treatment. Different chapters have completely different approaches: Some are computational, some are theoretical, and some are descriptive. Some do macroeco- nomic forecasting, some do mean-variance portfolio theory and beta estimation, and some do fi nancial statements analysis. Options and futures are often essentially tacked on the back to round out this disconnected assortment. The goal of these books is different from the goal of our students. Our students told us they come into an investments course wanting to learn how to make investment decisions. As time went by, we found ourselves supplying more and more supplemental materials to the texts we were using and constantly varying chapter sequences while chasing this elusive goal. We fi nally came to realize that the fi nancial world had changed tremendously, and investments textbooks had fallen far behind in content and relevance. What we really wanted, and what our students really needed, was a book that would do several key things: • Focus on the students as investment managers by giving them information they can act on instead of concentrating on theories and research without the proper context. • Offer strong, consistent pedagogy, including a balanced, unifi ed treatment of the main types of fi nancial investments as mirrored in the investment world. • Organize topics in a way that would make them easy to apply—whether to a portfo- lio simulation or to real life—and support these topics with hands-on activities. W e made these three goals the guiding principles in writing this book. The next several sections explain our approach to each and why we think they are so important. Who Is This Book For? This book is aimed at introductory investments classes with students who have relatively little familiarity with investments. A typical student may have taken a principles of fi nance class and had some exposure to stocks and bonds, but not much beyond the basics. The i ntroductory investments class is often a required course for fi nance majors, but students from other areas often take it as an elective. One fact of which we are acutely aware is that this may be the only investments class many students will ever take. We intentionally wrote this book in a relaxed, informal style that engages the student and treats him or her as an active participant rather than a passive information absorber. We think the world of investments is exciting and fascinating, and we hope to share our consid- erable enthusiasm for investing with the student. We appeal to intuition and basic principles vii jjoorr6611663399__ffmm__ii--xxlliivv..iinndddd vviiii 2200//1122//1133 1100::0000 AAMM whenever possible because we have found that this approach effectively promotes under- standing. We also make extensive use of examples throughout, drawing on material from the world around us and using familiar companies wherever appropriate. By design, the text is not encyclopedic. As the table of contents indicates, we have a total of 20 chapters. Chapter length is about 30 to 40 pages, so the text is aimed at a single-term course; most of the book can be covered in a typical quarter or semester. Aiming the book at a one-semester course necessarily means some picking and choosing, with regard to both topics and depth of coverage. Throughout, we strike a balance by intro- ducing and covering the essentials while leaving some of the details to follow-up courses in security analysis, portfolio management, and options and futures. How Does the Seventh Edition of This Book Expand upon the Goals Described Above? B ased on user feedback, we have made numerous improvements and refi nements in the seventh edition o f Fundamentals of Investments: Valuation and Management. We updated an appendix containing useful formulas. We updated every chapter to refl ect current market practices and conditions, and we signifi cantly expanded and improved the end-of-chapter material. Also, our chapters devoted to market effi ciency and to behavioral fi nance continue to rate highly among readers. To give some examples of our additional new content: • Chapter 1 contains updates on historical returns for small-company stocks, large-company stocks, long-term government bonds, Treasury bills, as well as U.S. infl ation rates. • Chapter 2 contains new material on AAII asset allocation models. • Chapter 3 incorporates the new ticker symbols for exchange-traded options. • Chapter 4 contains new material on the key difference between two popular S&P 500 ETFs. • Chapter 5 contains new material on the Flash Crash of 2010 as well as updated material on circuit breakers. • Chapter 6 contains a new section on enterprise value ratios. It also contains a detailed new example showing how to value Procter & Gamble Company using the models presented in the chapter. • Chapter 8 contains new material on why investors fi nd it diffi cult to sell losers. Students have an opportunity to take an online quiz about overconfi dence. • Chapter 11 contains new material on the fallacy of time diversifi cation. • Chapter 13 contains new material on the Sortino ratio. • Chapter 15 contains new material on weekly options. The chapter also has updated material on credit default swaps (CDSs). • Chapter 17 contains an updated valuation for Starbucks Corporation. • Chapter 18 combines material on corporate, U.S. federal government, and municipal bonds previously contained in two separate chapters. • Chapter 19 is a new chapter on global economic activity and industry analysis. This new chapter contains material relevant to investors striving to identify how best to allocate their portfolio weights. In addition, we have updated learning objectives for each chapter. We have reworked our chapter summaries to refl ect the chapter’s learning objectives. F or the seventh edition, we signifi cantly expanded and improved the end-of-chapter m aterial. We added new problems throughout, and we have signifi cantly increased the CFA™ content. We updated the questions that test understanding of concepts with no calcu- lations involved. Additionally, our What’s on the Web? questions give students assignments viii Preface jjoorr6611663399__ffmm__ii--xxlliivv..iinndddd vviiiiii 2200//1122//1133 1100::0000 AAMM to perform based on information they retrieve from various Web sites. Finally, in selected chapters, we have included spreadsheet assignments, which ask students to create certain types of spreadsheets to solve problems. We continue to emphasize the use of the Web in investments analysis, and we integrate Web-based content in several ways. First, wherever appropriate, we provide a commented link in the margin. These links send readers to selected, particularly relevant Web sites. Second, our Work the Web feature, expanded and completely updated for this edition, appears in most chapters. These boxed readings use screen shots to show s tudents how to a ccess, use, and interpret various types of key fi nancial and market data. Finally, as previously noted, new end-of-chapter problems rely on data retrieved from the Web. We continue to provide Spreadsheet Analysis exhibits, which we have enhanced for this edition. These exhibits illustrate directly how to use spreadsheets to do certain types of im- portant problems, including such computationally intensive tasks as calculating Macaulay duration, fi nding Black-Scholes option prices, and determining optimal portfolios based on Sharpe ratios. We also continue to provide, where relevant, readings from The Wall Street Journal , which have been thoroughly updated for this edition. CFA™ Mapping Consider this description provided by the CFA Institute: “First awarded in 1963, the Chartered Financial Analyst (CFA) charter has become known as the gold standard of professional credentials within the global investment community. Investors recognize the CFA designation as the defi nitive standard for measuring competence and integrity in the fi elds of portfolio management and investment analysis.” The importance and growing signifi cance of the CFA charter are compelling reasons to integrate CFA cur- riculum material into our seventh edition. Among the requirements to earn the CFA charter, candidates must pass three sequential levels of comprehensive exams. Each exam asks questions on a wide array of subject areas concerning the investment process. To help candidates study for the exams, the exams at each level are divided into so-called study sessions. Each of these study sessions has a core set of readings designed to help prepare the candidate for the exams. We carefully examined the content of each reading (updated for the 2012 exams), as well as the stated learning outcomes, to determine which areas we covered in the sixth edition. Importantly, we also considered which areas might be added to the seventh edition. As a result of this thorough process, in our seventh edition we expanded coverage on seven readings and added completely new coverage of three readings. In total, our textbook c ontains material that touches over 75 percent of the readings from Level 1 of the CFA exam. Topics that we do not address from Level 1, such as basic statistics, accounting, and economics, are likely addressed in prerequisite courses taken before the investments course. In addition, we present some higher-level material: We touch on about 35 percent of the readings from the Level 2 and 3 exams. Of course, we make no claim that our textbook is a substitute for the CFA exam readings. Nonetheless, we believe that our seventh edition provides a terrifi c framework and introduction for students looking to pursue a career in investments—particularly for those interested in even- tually holding the CFA charter. To provide a sense of studying for the CFA, the seventh edition continues to include an end-of-chapter case review. Schweser, a leading purveyor of CFA exam preparation packages, graciously provided extensive material from which we chose these case reviews. We provide a mapping between the textbook and the CFA curriculum as follows: Each chapter opens with a CFA Exam box citing references to specifi c readings from the CFA curriculum that are covered within the chapter. The topic is identifi ed and we indicate which level and study session the reading comes from. We label these topics CFA1, CFA2, CFA3, and so on, for easy reference. End-of-chapter problems in the book and in Connect are also labeled with these tags. Over 95 percent of our end-of-chapter material is related to the CFA exam. We believe that this integration adds tremendous value to the seventh edition. Preface ix jjoorr6611663399__ffmm__ii--xxlliivv..iinndddd iixx 2200//1122//1133 1100::0000 AAMM