The FT Guide to Understanding Finance
A No-Nonsense Companion to Financial Tools and Techniques
Javier Estrada, IESE Business School (Barcelona, Spain)
About the Book
Even the best read and informed financial professionals will forget some financial concepts,
and others may not have learned them properly in the first place. Some may want to broaden
the scope of their financial knowledge and others may want a desktop companion for quick
and practical help in applying the tools and techniques of finance to their everyday work.
If there is a financial concept that you find hard to understand, easy to forget, or necessary to
apply with confidence, The Financial Times Guide to Understanding Finance gives you all
the information you need.
Whether you are an executive or a student, beginner or expert, this book is designed to
explain and illustrate the working essentials of finance with clarity and speed.
The Financial Times Guide to Understanding Finance deliberately combines essential theory
with real-world application, using short, focused chapters to help you find what you need and
implement right away. Originally published as Finance in a Nutshell, this new edition
includes:
• Full coverage of risk and return including CAPM, the three-factor model, and risk-
adjusted returns.
• Stocks and bonds including versions of the DCF model, reverse valuation, relative
valuation, and issues related to fixed-income securities, pricing, and sources of risk.
• Case studies and examples from companies such as Apple, Merrill Lynch,
Microsoft, Berkshire Hathaway, and Johnson & Johnson.
• Accompanying Excel spreadsheets of all the calculations and formulas at
[Link]/estrada.
About the Author
Javier Estrada holds an MS in Finance and a PhD in Economics both from the University of
Illinois at Urbana-Champaign. He is Professor of Finance at the IESE Business School in
Barcelona, Spain, founding editor of the Emerging Markets Review, and a wealth
management advisor at Sport Global Consulting Investments, where he advises professional
athletes on how to manage their money.
He has published extensively in international journals, written many cases for class
discussion, and lectured throughout the world to undergraduate students, graduate students,
and executives.
The FT Guide to Understanding Finance
A No-Nonsense Companion to Financial Tools and Techniques
Javier Estrada, IESE Business School (Barcelona, Spain)
ENDORSEMENTS
“This delivers the essential concepts of modern finance clearly and concisely. My advice:
Buy this book and keep it close at hand!”
Mark Kritzman, President and CEO, Windham Capital Management, LLC
“Whilst there are a number of books that purport to offer a quick reference for business
professionals, this is the only one that really manages to do this in an effective way.”
Valerio Poti, Director of the MSc in Finance and Capital Markets Program, Dublin City
University Business School
“This is corporate finance served in bite-sized and digestible portions.”
Elroy Dimson, Emeritus Professor of Finance, London Business School
“Javier Estrada is to be commended for translating deep economic ideas into terms that are
immediately usable, compelling, and valuable.”
Robert F. Bruner, Dean of Darden Business School, University of Virginia
PREFACE TO THE SECOND EDITION
I had mixed feelings when I received the request to write a second edition of Finance
in a Nutshell. On the one hand it made me happy. I thought that publishers ask authors to
write a new edition of a book only when they make a positive evaluation of the previous
edition and are bullish about the prospects of a follow-up. I also thought it was a good chance
to clarify explanations, update the data, correct typos, and ultimately take a fresh look at all
the material discussed in the first edition and improve it.
But on the other hand I was not so happy. Writing a book is fun, or at least it was to
me; but rewriting it is not, or at least not nearly as much. I also had many more time
constraints than I had when I wrote the first edition. So I did think long and hard about it, at
times leaning one way and at other times leaning the other way.
It was a hard decision but in the end I accepted, as evidenced by the book you’re
holding in your hands. And I’m glad I did, because this edition retains all the positive
characteristics of the first but also improves upon the first in more than one way. If you liked
Finance in a Nutshell, I have no doubt you’ll like The FT Guide to Understanding Finance
even more.
Why do I say this? Two reasons. First, I did not try to fix what was not broken. I
received a lot of positive feedback about both the coverage and the style of the first edition.
Readers found that the topics discussed properly reflected those they considered most
relevant, and liked the conversational style in which those topics were discussed. Retaining
both the topic selection and the style, then, was a no brainer. Second, I tried to repair what
was damaged. Very often when working on this second edition, I found things that I could
have explained better than I did in the first edition. So whatever readers thought it was well
done in the first edition, I’m sure it’s better done in this one.
Which brings me to the following recommendation to whoever is considering buying
this book. If you liked Finance in a Nutshell, you’ll find The FT Guide to Understanding
Finance to be an improved and updated version of the original. If you never read Finance in a
Nutshell but heard a good thing or two about it, see for yourself why the original was well
received. And if you never even heard about Finance in a Nutshell, well, give a chance to this
book which at least is not nearly as expensive or heavy as the typical 900-page textbook!
This second edition is divided into the same four parts and thirty chapters the first
edition was. The first part consists of twelve chapters and tackles issues related to risk and
return. It covers a wide range of topics such as different ways of calculating returns and mean
returns; different ways of assessing risk; diversification; the CAPM, the three factor-model,
required returns, and the cost of capital; risk-adjusted returns; and portfolio optimization.
The second part consists of eight chapters and focuses on the valuation of stocks and
bonds. It covers different models of stock valuation including four different versions of the
discounted cash flow model, reverse valuation, and multiples. It also discusses bonds, their
valuation, their return, and the different factors that affect their risk.
The third part consists of six chapters that, unlike those in the other three parts of the
book, are not closely related to each other. These are topics that, in my view, no book of
essential tools could afford not to cover, which include project evaluation through NPV, IRR,
and real options; corporate value creation; derivatives such as options, futures, and forwards;
and currencies.
Finally, the last part provides some statistical background. It covers some widely-used
statistical magnitudes, such as the mean, median, variance, standard deviation, covariance,
and correlation; two widely-used distributions, the normal and the lognormal; and regression
analysis.
Readers of Finance in a Nutshell will find that The FT Guide to Understanding
Finance retains the same thirty topics (chapters) of the first edition. As already mentioned, I
received positive feedback on the topic selection, which gave me no reason to fix what was
not broken. But beyond that, my fresh look at the whole book did not bring to mind any topic
that I considered essential and was missing.
Having said that, I did receive some requests from Finance in a Nutshell readers to
include this or that topic in subsequent editions of the book. Some of those topics include
Market Efficiency, Capital Structure, and Dividend Policy, to name but a few. But however
important or interesting those topics are, this is not a Corporate Finance textbook. The latter
typically contains several topics not discussed in this book, but also omits several topics
discussed in this book. In other words, they are very different books.
One of the reasons I strongly resist considering this book a textbook is because the
latter is typically thought of as 900-page volume, 5 pounds heavy, and with unbearably long
chapters. This book is a reaction to that! I tried to make it short, light, and with chapters short
enough so that they can be read in one sitting, without falling asleep.
Yes, this book discusses many issues typically covered in a Corporate Finance
textbook. But it also discusses many issues typically covered in an Investments textbook. In
fact, I think this book is much closer to that latter than to the former. But again, this is no
textbook. Hold this book in your hand and curl your arm ten times, or put it in your purse and
walk around a few blocks; you probably can’t do either with a textbook, but you can with this
book!
Wide coverage, short chapters, conversational style, intuitive explanations, and real-
world examples are the trademarks of this book. And that’s why, as was the case with
Finance in a Nutshell, I think The FT Guide to Understanding Finance will appeal to a wide
range of current and future finance practitioners, as well as to all those who always wanted to
know a bit more about finance but found it intimidating to begin with.
As was also the case with the first edition, this second edition shows how to
implement in Excel all the tools discussed. Which brings me to a couple of points you should
keep in mind. First, I have used and described everything for Excel 2007. Most of the
commands discussed in this book are virtually identical across different versions of Excel, but
if yours is not the 2007 version and have trouble implementing something, keep this point in
mind.
Second, if you want to reproduce precisely all the calculations discussed in this book,
it’s important that you use the data in the accompanying Excel file. I have performed all
calculations in spreadsheets, which remember many more decimals than would be wise to
report in a book. If you try to reproduce the calculations discussed in the following chapters,
with the figures discussed in those chapters, you may find that your results are close but not
exactly equal to those reported. If you use the Excel file that contains the data I used instead,
you should have no such problem.
I wrote every word and crunched every number in this book, but that doesn’t mean I
didn’t receive any help. First and foremost, I would like to thank students and executives in
countless programs without whose encouragement this book would have never existed. I
would also like to thank readers of Finance in a Nutshell for their comments, suggestions,
feedback, and ideas; had I felt that the first edition of this book was ignored, I wouldn’t have
had the enthusiasm to write this second edition.
Last but certainly not least, I would like to deeply thank my research assistant,
Gabriela Giannattasio. Her extremely-detailed comments on each and every chapter were of
invaluable help. And because I knew her attention to detail is such that she’d find any
mistake I could have made, I had the peace of mind I needed to write this book. Needless to
say, I’m the only one to blame for any mistakes that may remain in the following chapters.
Regardless of how many more books I write, Finance in a Nutshell will always be the
first one. But as much as I’ll always hold dear that first little guy, I have to admit that The FT
Guide to Understanding Finance you hold in your hands is better.
Barcelona, November, 2010
PREFACE TO THE FIRST EDITION
I always thought I’d write a book but never quite knew when or on what topic. I never
felt the need of doing it and, to be honest, I never set it as a goal for myself. But eventually I
got to a point when I decided to surrender to the evidence: Too many people were asking for
the same thing, and the market, in my opinion, had not delivered. So I thought I’d deliver
myself.
A brief history of this book
It happened many times. During the course of an executive education program, I’d
come in to give a few sessions on finance topics. After finishing those sessions, someone
would come to me and say something like, ‘Listen, this was very interesting and though my
job is only marginally related to finance, I’d like to know more about it. What would you
advise me to read?’ Or something like, ‘Hey, I work in finance but my job is so specialized
that I feel I need to refresh my knowledge of the basics. Can you recommend some book that
covers a wide range of essential topics?’
Depending on the topic I had discussed in the program and what the participant had
asked, I usually did one (or both) of the following: Recommend a few short books that, when
put together, would cover a wide range of topics; or recommend a textbook, which as you are
well aware usually contains between 600 and 900 pages and chapters no less than 20 pages
long. Often, I would show the recommended references to the inquiring participant.
And that’s when I started getting the two standard replies. If I recommended the few
short books, the reply would be something like, ‘Well, all these books look very interesting,
but isn’t there one book that tackles all these topics?’ If I recommended the textbook, the
reaction would be something like, ‘Listen, I’m sure this book is very good, but I really have
no time to read so many pages, or even half of them. Plus, you don’t expect me to carry this
book around with me, do you? They’d charge me for excess luggage at the airport!’ (OK, I’m
dramatizing a bit.) I can’t really tell how many times I went through similar exchanges, but I
do know that eventually there was a straw that broke the camel’s back.
But wait, it wasn’t then that I decided to write this book. In fact, it was then that I
decided to do something that would take a lot less of my time: I decided to look for a book I
could recommend to all these people. I made a mental list of the characteristics that were in
high demand and started my search. And, to my surprise, such a book didn’t exist. Or maybe
I didn’t find it. Either way, it was then, and only then, that I thought I had to write this book.
Distinctive features
The stylized story above happened many times, give or take a few details, in many
executive programs. It also happened many times while teaching in MBA and executive
MBA programs. And it happened often while talking with former students who needed to
refresh or broaden their knowledge of finance. After failing in my search for a book to
recommend, and starting to think that maybe I should write the book myself, I thought long
and hard about the characteristics of the book the market had, in my opinion, failed to deliver.
This was, more or less, my list:
The book needs to be comprehensive. It doesn’t have to address a few issues in depth;
rather, it should cover a wide variety of topics, concepts, and tools that professionals
forget, find hard to understand, and need or would like to know more about.
The book needs to be easy to read. Professionals are put off by academic books
written in academic style. There is a need for a book written in a way that sounds
pretty much like having an instructor talking right in front of them.
The book needs to be relatively short. Not an 800-page, 5-pound book, but one that
could be easily taken around from the office to home, and from the hotel to the
airport. Something that could be always at hand, like a desktop companion.
The book needs to have relatively short chapters. Most professionals dislike starting a
chapter and not being able to finish it after two or three sittings. There is a need for a
book with short chapters that can be read in one sitting. Short chapters would also
make it easy for readers to quickly grasp the essentials of a concept or tool.
The book needs to contain some elementary theory and many real-world examples.
It’s a lot easier to understand and remember concepts and tools when an elementary
conceptual framework and its application are discussed together. And if the
application is not hypothetical but about an actual situation the reader can quickly
identify with, even better.
The book needs to explain how to implement things in Microsoft Excel. Spreadsheets
have become an inseparable tool for finance, and the book needs to show how to
implement in Excel all the concepts and tools discussed.
The book needs to have a few short problems at the end of each chapter. Many books
have them, to be sure, but this book would have just two or three that go to the heart
of the issues discussed in the chapter.
The book needs to be self-contained. Other than some elementary math, no other
previous knowledge should be required.
Well, that’s a long list! But I promised myself that I wouldn’t start writing a book
before making sure I could deliver one that had all of the characteristics above. I trust the
book you have in your hands does. So, if I had to define this book in one paragraph, it would
be this:
Many professionals have long forgotten some key financial concepts or tools;
others never learned them properly; some need to broaden the scope of their
financial knowledge; others need a desktop companion for quick reference;
and most of them have neither the time nor the motivation to dig into either
several books or an 800-page textbook. This book solves all these problems in
30 short, easy-to-read, very practical chapters full of real-world examples and
applications in Excel.
Target audience and intended use
Let me tell you first what this book is not. First, it is not a textbook; I didn’t write it as
a required reference for a specific course. Second, it is not a specialized book; it’s not for
those who want to acquire a deep knowledge of one or two topics. And third, it is not a
cookbook; I didn’t write it for those who want to blindly follow a few steps to solve a
problem without understanding what’s going on. If you’re looking for a book to satisfy any of
these needs, you’ve picked the wrong one.
The distinctive features of this book outlined above should give you an idea of who
this book is for. Again, it was born as an answer to the demand of professionals who wanted
to broaden their knowledge of finance; refresh their memory of some topics; learn other
topics from scratch; or simply have a light desktop companion covering a wide range of
essential topics in finance. And all that subject to the constraints of limited time and lack of
patience to read an academic textbook.
I firmly believe that executives, professionals, and practitioners in different areas
unrelated to finance will find this book useful. Their need to understand financial concepts
and tools at the user level was constantly in my mind as I wrote this book. I also firmly
believe that finance professionals such as investment bankers, portfolio managers, brokers
and security analysts will find this book valuable. Their need for a reference book to quickly
get up to speed on many different issues was also in my mind. In this regard, participants of
executive education programs, MBA and executive MBA students, and former students, all
of them in both finance and non-finance jobs, provided invaluable feedback.
I also trust the individual investor will find this book valuable. It provides the tools to
value assets, assess risk, diversify and optimize portfolios, evaluate performance, and invest
for retirement, to name just a few issues interesting to investors and covered in the book. And
it discusses these and many other issues from scratch, showing how to implement everything
in Excel.
Finally, I think that academics in finance and economics will find this book useful. It
could be used as a complementary or recommended reference in many general courses such
as corporate finance or investments; or in more specific courses dealing with asset pricing,
stocks, bonds, and portfolio analysis, among other topics. I also think academics themselves
will find the book useful as a personal desktop companion, a reference book to consult on a
wide range of finance topics.
Organization of the book
The book is divided into four parts. The first, entitled ‘Risk and return,’ covers a wide
range of issues that deal with different definitions of returns, different ways of assessing risk,
different ways to put risk and return together, and the optimization of portfolios.
The second part, entitled ‘Valuation,’ focuses on stocks and bonds. It covers different
models of stock valuation, including several versions of the DCF model, reverse valuation,
and relative valuation. It also covers issues related to fixed-income securities, including
pricing, sources of risk, duration, and convexity.
The third part, entitled ‘Other important topics,’ puts together several issues that no
book of essential finance tools could ignore. These include project evaluation through NPV,
IRR, and real options, as well as derivatives such as options, futures, and forwards.
Finally, the fourth part, entitled ‘Statistical background,’ contains a refresher of
essential statistical topics for practitioners, including summary statistics, the calculation of
probabilities with the normal and lognormal distributions, and regression analysis. The
discussion includes the implementation of all these concepts and tools in Excel.
How to read this book
I wrote the book thinking of professionals who needed to jump in for a specific issue.
As a result, I wrote the chapters as independent of each other as possible. This means that this
is not a book that you need to start reading at Chapter 1 and finish at Chapter 30. Some
readers will not need to read the statistical background and others will find it essential
reading; some readers will be interested in stocks and others in bonds; others may want to
focus on issues related to investing or corporate finance.
Every chapter concludes with an Excel section and a Challenge section. The Excel
sections aim to show how to implement in Excel the concepts and tools discussed in the
chapter. These sections range from discussing some elementary functions, such as logs and
exponentials, to more complex issues, such as multiple regression analysis and portfolio
optimization tools. If you’re not fully familiar with Excel, I think you will find these sections
essential; and if you are familiar with Excel, these sections will probably take you a few steps
further.
The Challenge sections aim to test the essential concepts and tools discussed in each
chapter. The problems are few, short, and go straight to the key points. Most of them are
based on data from well-known companies so that you can not only test what you’ve learned
but also learn a bit about the companies too. Some people may find these sections useful and
others will probably ignore them. Your choice.
Finally, if you want to reproduce precisely all the calculations discussed in the book,
it is important that you use the data in the accompanying Excel file (see
[Link]/estrada). I have performed all calculations in Excel, which
‘remembers’ many more decimals than would be wise to report in a book. That’s why you
may find ‘rounding errors,’ particularly in calculations based on previous calculations.
Similarly, if you go over the problems in the Challenge sections, you may want to use the
data in the accompanying Excel file rather than that provided in the tables and exhibits.
Take a good look at the index and a quick look at the rest of the book. I trust you will
find the scope comprehensive, the chapters short, the style engaging, the approach practical,
and the discussions easy to follow. You will also find loads of information on many
companies that are household names, which are used throughout to keep your feet firmly on
the ground.
Acknowledgments
My deepest gratitude goes to the long list of participants in executive education
programs, MBA students, executive MBA students, and former students who directly or
indirectly encouraged me to write this book. Most of them did not actually ask me to write a
book, but their search for a book that the market had not provided was the main reason for me
to write this one.
I’m also indebted to my research assistant, Alfred Prada, who read every chapter,
checked every formula, double checked every table, and triple checked every calculation. He
put up with all my demands, which were not few, and delivered every time he had to.
Needless to say, he is in no way responsible for any errors that may remain in this book.
Those are, of course, my sole responsibility.
Finally, I want to dedicate this book to my dad, who was alive when I started writing
it but did not live to see me finish it. I know he would have been even prouder than I am for
having written this, my first book. I’m sure he would have read it just because I wrote it, and
I’m sure he would have told me that even he could understand what I was writing about. And
of course, I also dedicate this book to my mom, who will most likely not read it, but will
proudly and insistently show it to every single person that passes by within a mile of her
house.
A final word
Time will tell whether I have delivered the book that so many people seem to have
been looking for. I certainly hope so. And yet I’m also sure it can be improved. For this
reason, if you have any comments or suggestions, feel absolutely free to send me an email at
jestrada@[Link]. I would be more than glad to know your opinion.
This concludes what for me has been a long journey. And as much as I wanted to
finish, I now realize that I’ll miss working on this book. It was, above all, a whole lot of fun. I
certainly hope you enjoy reading it as much as I enjoyed writing it.
Barcelona, March, 2005
CONTENTS
Preface
PART I: RISK AND RETURN
1. Returns (I): Basic concepts
2. Returns (II): Mean returns
3. Risk (I): Total risk
4. Risk and return (I): Portfolios
5. Risk (II): Diversification
6. Risk (III): Systematic risk
7. Risk and return (II): The CAPM and the cost of capital
8. Risk and return (III): The three-factor model
9. Risk (IV): Downside risk
10. Risk and return (IV): Risk-adjusted returns
11. Risk and return (V): Portfolio optimization
12. Risk and return (VI): The long term
PART II: VALUATION
13. Stocks (I): The dividend discount model
14. Stocks (II): The WACC model
15. Stocks (III): Other DCF models
16. Stocks (IV): Reverse valuation
17. Stocks (V): Relative valuation
18. Bonds (I): Prices and yields
19. Bonds (II): Default risk and market risk
20. Bonds (III): Duration and convexity
PART III: OTHER IMPORTANT TOPICS
21. NPV and IRR
22. Real options
23. Corporate value creation
24. Options
25. Futures and forwards
26. Currencies
PART IV: STATISTICAL BACKGROUND
27. Stats (I): Summary statistics
28. Stats (II): Normality
29. Stats (III): Non-normality
30. Stats (IV): Regression analysis
Index
