Question while trying to model my own portfolio optimization
So I've learnt the theory, bits and pieces of it, through CFA and what not. and I have to admit my knowledge has gone abit dry.
I'm trying to apply the theory into practice and I'm running into 'practical' problems
So I've picked a few shares, created models out of it. Lets say I have 3 mid cap stocks A B and C
Using DCF, and WACC and CAPM etc.
A is currently priced at $500, my valuation came to $800 per share.
B at 300, my valuation at 400 per share
C at 400, valuation at 500 per share.
Now I have these three shares in my portfolio and I'm trying to work out what the optimal weight is.
Now here's my trouble.
I can work out the standard deviation (let's say at a monthly s.d.) is.
but how do I know what my "expected return" is? is it simply the return I hope to make as the price converges back to my calculated intrinsic value (i.e. 60% for A, 33% for B, 25% for C)
it sort of makes sense, but then I wouldn't know whether that would be appropriate as a "monthly expected return" as I have no timeframe for how long it would take for the price to return to my calculated intrinsic value (whether it be days weeks or years)
or alternatively, would my "expected return" be based on the IRR that makes the future cashflows in my DCF equal to the current share price?
I know this doesn't answer your entire question, but IMO you're trying to ask for too many separate parts at once and over simplifying what you're looking for... Here is my take on the expected return issue. This is a super simplified answer, so I'm sure people will think they're BSD's by correcting it, but here is a short take on your issue without diving too far into the weeds:
Your cost of equity is the essentially the expected return. CAPM is one way to calculate this, but fyi, most studies show it's very inaccurate.
The IRR is the return of the firm value as a whole including debt, because the sum of the DCF is the enterprise value discounted by the WACC, which is capital structure neutral. This would not be correct IRR to evaluate your proposed equity position. You need to use CF to equity and find the IRR (which would be the cost of equity/expected return based on your assumptions) to find what you are looking for.
Look at it as two separate items you are calculating: theoretical return & your assumed return. Cost of equity is the theoretical return you should see on the stock based on it's systematic risk, which based on CAPM is the only risk you are rewarded for taking on. The IRR you are calculating (if you change the DCF to be equity value instead of enterprise value), is your expected return based on the assumptions you have made about growth, margins, etc.
Therefore, assuming your assumptions are 100% correct, if the IRR is greater than the Cost of Equity based on systematic risk, you should buy that stock in a diversified portfolio b/c you will earn extra return (alpha) in addition to the return based on the market risk you are taking on.
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