Introduction to Corporate Finance

PART 2: VAlUATION, RISK AND RETURN

respectively. In comparing the values of these investments in 1900 to their 2010 levels, it is important to

remember that prices of goods and services in the US were not constant over this period. The fourth line

in Figure 6.2 shows how inflation gradually changed the purchasing power of a dollar. The figure shows

that the prices increased by a factor of 25 from 1900 to 2010, which means that the purchasing power of

US$1 in 1900 was roughly equivalent to the purchasing power of US$25 in 2010.

Figure 6.3a updates this data to 2014 and takes inflation out of the picture by plotting the performance

of the three types of investments in real, inflation-adjusted terms. Even after adjusting for inflation,

Figure 6.3a demonstrates that common stocks outperformed other investments, increasing in real terms

from US$1 to US$1,396 in 115 years. As before, the increase in wealth from investing in Treasury bonds

or bills was substantially less. In fact, a one-dollar investment in Treasury bills grew, in real terms, to just

US$2.70 over this period, and this ignores taxes that investors must pay on interest, further reducing their

cumulative earnings. You have to wait a long time to get rich if you are investing in Treasury bills.

Recall that the relationship between nominal returns, real returns and inflation is given by the

following equation:

(1 + nominal) = (1 + real)(1 + inflation)

If the nominal return on a share of stock is 15% in a certain year and the inflation rate is 10%, then

we can solve for the real rate as follows:

(1 + 0.15) = (1 + real)(1 + 0.10)

(1 + real) = (1 + 0.15) ÷ (1 + 0.10)

(1 + real) = 1.0455

real = 0.0455 = 4.55%

FIGURE 6.2 THE VALUE OF $1 INVESTED IN SHARES, TREASURY BONDS AND BILLS, 1900–2010

The figure shows that US$1 invested in ordinary shares in 1900 would have grown to US$21,481 by 2010. In comparison,

US$1 invested in Treasury bonds would have grown to US$294, while US$1 invested in Treasury bills would have reached

just US$71 by 2010.

Bonds

Bills

Year

$10

$1

$100

$1,000

$10,000

$100,000

1900 1920 1940 1960 1980 2000 2010

$25

$71

$294

$21,481

Value in $ (log scale)

Stocks

Inflation

Source: Elroy Dimson, Paul Marsh and Mike Staunton, ‘Triumph of the Optimists,’ Credit Suisse Global Investment Returns Yearbook 2010.

Published by ABN AMRO, London. Updates provided by Dimson, et al. to 2009. Authors’ estimates for 2010. Reprinted with permission.

What is the difference between

an investment’s nominal return

and its real return? Which is

more important to investors?

thinking cap
question