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Probability Level 1

A financial analyst has analyzed a new company and estimated the following information about it:

The current value of the company is $1.1 million.

There is a 0.8 probability that the company will be worth $0.9 million in a year.

There is a 0.15 probability that the company will be worth $1.3 million in a year.

There is a 0.05 probability that the company will be worth $2.0 million in a year.

If the investment outlook is based on the expected future value of the company, what is the current investment outlook on the company?

Buy! Sell!

2 solutions

Andy Hayes
Jun 13, 2016

Relevant wiki: Expected Value - Properties

There are a couple different outcomes about how this company performs, but we can estimate the future value of the company with one number using the probabilities.

The estimated future value of the company in millions of dollars is:

$(0.8\times 0.9)+(0.15\times 1.3)+(0.05\times 2.0)=1.015$

This is less than the current value of the company, so a smart investor would sell their shares in the company.

It is not immediately apparent what the risk preferences of the individual is. If they are risk loving, this might be a BUY!

Calvin Lin Staff - 5 years ago

That is true. I changed the wording a little bit to reflect what the intended solution is.

I do hope people will still think about what different investors in different situations would do, though! It should be noted that most investors, when faced with a potential investment with high variance like this one, would lean more towards a bearish outlook rather than a bullish outlook.

Andy Hayes - 5 years ago

Right solution but slightly wrong terminology. The probability of the future value being $1.015 million is zero. In fact you mean that over a large number of "trials" the AVERAGE future value is $1.015 million so best to sell.

Steve Powers - 4 years, 3 months ago

The expected future value means just what you described: the average value over a large number of trials.

Of course, a good investor would understand that no one can predict the future, and so these estimates might not be viable. In addition, even when an expected value seems favorable, a good investor might still have a bearish outlook because of variance. Nevertheless, it is given in the problem assumptions that the investment outlook is based on expected value.

It's good to think critically about these kinds of things even if we have to stretch a bit with the assumptions to make a problem that has one correct answer.

Andy Hayes - 4 years, 3 months ago

Correction if we keep it for say end of the month worth more just saying

Billy Jr Price - 3 years, 10 months ago

As you can see, risk preferences differ. ⬆️ ⬇️

Nick Verderame - 3 years, 3 months ago

Not only risk preferences, also the other outlook of the company like dividend or how many years do you want This company in your portfolio? Or other financials like in the investor presentention and not only this, after you need to realize an algorithmic or technical analysis of the company then bought it, a smart player in the stock market and in all “game” need to know all the information or all the information you think is sufficient to determine whether or not it is a buy.

Elijah Frank - 5 months, 3 weeks ago

Charles Andrews
May 15, 2017

The conservative investor should sell based on Andy Hayes's excellent breakdown. However, not everyone is conservative, therefore, someone will take the chance

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