When you buy a stock, you are concerned about future returns. How do you forecast future performance? In the rest of this chapter, we show you two approaches to the forecasting problem using a three-firm example. You can experiment with every facet of the investment problem (using the default data set) in the interactive learning system using this Three-Firm Case.

Suppose an economy includes three firms and one risk-free bond. The performance of the firms is affected by the general state of the economy. In particular, two firms benefit from generally good economic conditions, while the third thrives in a recession.

The two approaches to the investment problem are the financial analyst approach and the financial statistician approach. In practice, components of both approaches are used to forecast future cash flows or future returns.

The major difference between the analyst and the statistician is that the analyst attempts to forecast future cash flows, while the statistician attempts to infer them from past performance. The analyst would form an estimate of the value per share as a function of the state of the economy and assess the likelihood of each state. This involves analyzing both macro (e.g., economywide, industrywide ) and micro (firm-specific) factors, leading to a probability distribution of returns. The statistician, on the other hand, infers this distribution from past observations of returns. If these past prices are unbiased forecasts of the future, these two approaches should coincide.

To learn about the relevant factors, and to see how they affect the performance of the firms, you may want to first visit the financial analyst.

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