Acounting: .

Accounting can be defined as the process of identifying,

Measuring, recording and communicating the required information relating
To the economic events of an organisation to the interested users
An economic event is known as a happening of consequence to a business organisation which
consists of transactions and which are measurable in monetary terms

Transaction: An event involving some value between two or more entities. It can be a purchase
of goods, receipt of money, payment to a creditor, incurring expenses, etc. It can be a cash
transaction or a credit transaction.

Assets: Assets are economic resources of an enterprise that can be usefully expressed
in monetary terms. Assets are items of value used by the business in its
operations.
Assets can be broadly classified into two types: current and Non-current

Liabilities: Liabilities are obligations or debts that an enterprise has to pay at some time in
the future. They represent creditors’ claims on the firm’s assets. Both small and
big businesses find it necessary to borrow money at one time or the other, and
to purchase goods on credit. Liabilities are classified as current and non-current

Capital: Amount invested by the owner in the firm is known as capital. It may be brought
in the form of cash or assets by the owner for the business entity capital is an
obligation and a claim on the assets of business. It is, therefore, shown as capital
on the liabilities side of the balance sheet.

Revenues: These are the amounts of the business earned by selling its products or providing
services to customers, called sales revenue. Other items of revenue common to
many businesses are: commission, interest, dividends, royalities, rent received,
etc. Revenue is also called income.

Expenses: Costs incurred by a business in the process of earning revenue are known as
expenses. Generally, expenses are measured by the cost of assets consumed or
services used during an accounting period. The usual items of expenses are:
depreciation, rent, wages, salaries, interest, cost of heater, light and water,
telephone, etc.

Expenditure: Spending money or incurring a liability for some benefit, service or property
received is called expenditure. Purchase of goods, purchase of machinery,
purchase of furniture, etc. are examples of expenditure. If the benefit of
expenditure is exhausted within a year, it is treated as an expense (also called
revenue expenditure). On the other hand, the benefit of an expenditure lasts for
more than a year, it is treated as an asset (also called capital expenditure) such
as purchase of machinery, furniture, etc.
Profit: The excess of revenues of a period over its related expenses during an accounting
year is profit. Profit increases the investment of the owners.

Gain: A profit that arises from events or transactions which are incidental to business
such as sale of fixed assets, winning a court case, appreciation in the value of
an asset.

Loss: The excess of expenses of a period over its related revenues its termed as loss. It
decreases in owner’s equity. It also refers to money or money’s worth lost (or
cost incurred) without receiving any benefit in return, e.g., cash or goods lost by
theft or a fire accident, etc. It also includes loss on sale of fixed assets.

Voucher: The documentary evidence in support of a transaction is known as voucher. For

example, if we buy goods for cash, we get cash memo, if we buy on credit, we get
an invoice; when we make a payment we get a receipt and so on.

Generally Accepted Accounting Principles: In order to maintain uniformity and consistency in

accounting records, certain rules or principles have been developed which are generally accepted
by the accounting profession. These rules are called by different names such as principles,
concepts, conventions, postulates, assumptions and modifying principles.
Thus, Generally Accepted Accounting Principles (GAAP) refers to the rules or guidelines
adopted for recording and reporting of business transactions, in order to bring uniformity in the
preparation and the presentation of financial statements.
example, one of the important rule is to record all transactions on the basis of historical cost

Business Entity Concept: The concept of business entity assumes that business has a distinct
and separate entity from its owners. It means that for the purposes of accounting, the business
and its owners are to be treated as two separate entities. Keeping this in view, when a person
brings in some money as capital into his business, in accounting
records, it is treated as liability of the business to the owner.
Money Measurement Concept: The concept of money measurement states that only those
transactions and happenings in an organisation which can be expressed in terms of money
such as sale of goods or payment of expenses or receipt of income, etc., are to be recorded in the
book of accounts.

Going Concern Concept: The concept of going concern assumes that a business firm would
continue to carry out its operations indefinitely, i.e. for a fairly long period of time and would
not be liquidated in the foreseeable future. This is an important assumption of accounting as it
provides the very basis for showing the value of assets in the balance sheet.

Accounting Period Concept: Accounting period refers to the span of time at the end of which
the financial statements of an enterprise are prepared, to know whether it has earned profits or
incurred
losses during that period and what exactly is the position of its assets and liabilities at the end of
that period.
Cost Concept: The cost concept requires that all assets are recorded in the book of accounts
at their purchase price, which includes cost of acquisition, transportation,
installation and making the asset ready to use

Dual Aspect Concept: Dual aspect is the foundation or basic principle of accounting. It provides
the
very basis for recording business transactions into the book of accounts. This concept states that
every transaction has a dual or two-fold effect and should therefore be recorded at two places.

Revenue Recognition (Realisation) Concept: The concept of revenue recognition requires that
the revenue for a business transaction should be included in the accounting records only when it
is realised.

Consistency Concept: The accounting information provided by the financial statements would
be
useful in drawing conclusions regarding the working of an enterprise only when it allows
comparisons over a period of time as well as with the working of other enterprises. Thus, both
inter-firm and inter-period comparisons are required to be made. This can be possible only when
accounting policies and practices followed by enterprises are uniform and are consistent over the
period of time.

Under the cash basis, entries in the book of accounts are made when cash is Received or paid
and not when the receipt or payment becomes due.
Under the accrual basis, however, revenues and costs are recognized in the period in which they
occur rather when they are paid.

IFRS: IFRS helps in global harmonisation. Unless accounting activities are regulated, different
countries will apply different set of accounting rules and regulations are prevalent in each
country. Hence, IFRS promotes global standards for each of business growth.

Goods and Services Tax: GST is a destination based tax on consumption of goods and services.
It is proposed to be levied at all stages right from manufacture up to final consumption with
credit of taxes paid at previous stages available as setoff. In a nutshell, only value addition will
be taxed and burden of tax is to be borne by the final consumer
The concept of destination based tax on consumption implies has the tax would accrue to the
taxing authority which has jurisdiction over the place of consumption which is also termed as
place of supply
GST has a dual aspect with the Centre and States simultaneously levying on a common tax base.
There are three main components of GST which are CGST, SGST, CGST means Central Goods
and Services Tax. Taxes collected under CGST will constitute the revenues of the Central
Government . The present central taxes like central excise duty, additional excise duty, special
excise duty, central sales tax etc., will be subsumed under CGST. SGST means State Good and
Services Tax. A collection of SGST is the revenue of the State Government. With GST all state
taxes like VAT, entertainment tax, luxury tax, entry tax etcWith GST all state taxes like VAT,
entertainment tax, luxury tax, entry tax etc, will be merged with GST. For example, Ramesh a
dealer in Punjab sell goods to Seema in Punjab worth ` 10,000. If the GST rate is 18%, i.e., 9%
CGST and 9% SGST, ` 900 will go to Central Government and 900 will go to Punjab
Government.
IGST means Integrated Goods and Services Tax. Revenue collected under IGST is divided
between Central and State Government as per the rates specified by the Government. IGST is
charged on transfer of goods and services from one state to another. Import of goods and services
are also covered under IGST. For example, if the goods are transferred from Madhya Pradesh to
Rajasthan then this transaction will attract IGST. Lets extend the above example to understand
SGST. If Ramesh in Madhya Pradesh sell goods to Anand in Rajasthan worth 1,000,000.
Applicable GST late is 18% i.e., 9% CGST and 9% SGST. In this case, the dealer will charge
18,000 as IGST and will go the Central Government.

Rules of Debit and Credit

For recording changes in Assets/Expenses (Losses):
(i) “Increase in asset is debited, and decrease in asset is credited.”
(ii) “Increase in expenses/losses is debited, and decrease in expenses/
losses is credited.”

For recording changes in Liabilities and Capital/Revenues (Gains):

(i) “Increase in liabilities is credited and decrease in liabilities is debited.”
(ii) “Increase in capital is credited and decrease in capital is debited.”
(iii) “Increase in revenue/gain is credited and decrease in revenue/gain
is debited

Journal: The book in which the transaction is recorded for the first time is called journal or book
of original entry. The source document, as discussed earlier, is required to record the transaction
in the journal. This practice provides a complete record of each transaction in one place and links
the debits and credits for each transaction.

Ledger: The ledger is the principal book of accounting system. It contains different accounts
where transactions relating to that account are recorded. A ledger is the collection of all
the accounts, debited or credited,

Provision: A provision is an amount set aside from a company’s profits to cover an

expected liability or a decrease in the value of an asset, even though the specific amount
might be unknown
Reserve: A reserve is gains that have been allotted for a specific purpose. Reserves
are usually set up to bys fixed assets, pay bonuses, pay an expected legal settlement,
pay for repairs & maintenance and pay off debt.

What Is Fundamental Analysis?

Fundamental analysis (FA) is a method of measuring a security's intrinsic value by
examining related economic and financial factors. Fundamental analysts study anything
that can affect the security's value, from macroeconomic factors such as the state of the
economy and industry conditions to microeconomic factors like the effectiveness of the
company's management.

The end goal is to arrive at a number that an investor can compare with a security's
current price in order to see whether the security is undervalued or overvalued.

What Is Intrinsic Value?

In financial analysis this term is used in conjunction with the work of identifying, as
nearly as possible, the underlying value of a company and its cash flow. In options
pricing it refers to the difference between the strike price of the option and the current
price of the underlying asset.

The intrinsic value of both call and put options is the difference between the underlying
stock's price and the strike price
intrinsic value only measures the profit as determined by the difference between the
option's strike price and market price.
Example of an Option's Intrinsic Value
Let's say a call option's strike price is $15, and the underlying stock's market price is
$25 per share. The intrinsic value of the call option is $10 or the $25 stock price minus
the $15 strike price. If the option premium paid at the onset of the trade were $2, the
total profit would be $8 if the intrinsic value was $10 at expiry.

On the other hand, let's say an investor purchases a put option with a strike price of $20
for a $5 premium when the underlying stock was trading at $16 per share. The intrinsic
value of the put option would be calculated by taking the $20 strike price and
subtracting the $16 stock price or $4 in-the-money. If the intrinsic value of the option
were only worth $4 at expiry, combined with the premium paid of $5, the investor would
have a loss despite the option being in-the-money.

It's important to note the intrinsic value does not include the premium meaning it's not
the true profit of the trade since it doesn't include the initial cost. Intrinsic value only
shows how in-the-money an option is considering its strike price and the market price of
the underlying asset.

What Is a Business Valuation?

A business valuation is a general process of determining the economic value of a whole
business or company unit. Business valuation can be used to determine the fair value of
a business for a variety of reasons, including sale value, establishing partner ownership,
taxation, and even divorce proceedings. Owners will often turn to professional business
evaluators for an objective estimate of the value of the business. Asset=lia

Methods of Valuation

Market Capitalization
Market capitalization is the simplest method of business valuation. It is calculated by
multiplying the company’s share price by its total number of shares outstanding. For
example, as of January 3, 2018, Microsoft Inc. traded at $86.35. 1 With a total number of
shares outstanding of 7.715 billion, the company could then be valued at $86.35 x 7.715
billion = $666.19 billion.

2. Times Revenue Method

Under the times revenue business valuation method, a stream of revenues generated
over a certain period of time is applied to a multiplier which depends on the industry and
economic environment. For example, a tech company may be valued at 3x revenue,
while a service firm may be valued at 0.5x revenue.

4. Discounted Cash Flow (DCF) Method

The DCF method of business valuation is similar to the earnings multiplier. This method
is based on projections of future cash flows, which are adjusted to get the current
market value of the company. The main difference between the discounted cash flow
method and the profit multiplier method is that it takes inflation into consideration to
calculate the present value

5. Book Value
This is the value of shareholders’ equity of a business as shown on the balance sheet
statement. The book value is derived by subtracting the total liabilities of a company
from its total assets.

6. Liquidation Value
Liquidation value is the net cash that a business will receive if its assets were liquidated
and liabilities were paid off today.

What Is Valuation?
Valuation is the analytical process of determining the current (or projected) worth of an
asset or a company. There are many techniques used for doing a valuation. An analyst
placing a value on a company looks at the business's management, the composition of
its capital structure, the prospect of future earnings, and the market value of its assets,
among other metrics.
Fundamental analysis is often employed in valuation, although several other methods
may be employed such as the capital asset pricing model (CAPM) or the dividend
discount model (DDM)

 The Two Main Categories of Valuation Methods

Absolute valuation models

 attempt to find the intrinsic or "true" value of an investment based only on

fundamentalsLooking at fundamentals simply means you would only focus on such
things as dividends, cash flow, and the growth rate for a single company, and not worry
about any other companies. Valuation models that fall into this category include the
dividend discount model, discounted cash flow model, residual income model,
and asset-based model

What Is Absolute Value?

Absolute value, also known as an intrinsic value, refers to a business valuation method
that uses discounted cash flow (DCF) analysis to determine a company's financial worth

 Absolute value refers to a business valuation method that uses discounted cash

flow analysis to determine a company's financial worth.
 Investors can determine if a stock is currently under or overvalued by comparing
what a company's share price should be given its absolute value to the stock's
current price.
 There are some challenges with using the absolute value analysis including
forecasting cash flows, predicting accurate growth rates, and evaluating
appropriate discount rates.
 Absolute value, unlike relative value, does not call for the comparison of
companies in the same industry or sector.
Examples of methods used under the DCF model include the following models:

 Dividend discount model

 Discounted asset model
 Discounted residual income method
 Discounted FCF method

All of these models require a rate of return or discount rate which is used to discount a
firm’s cash flows—dividends, earnings, operating cash flow (OCF), or free cash flow
(FCF)—to get the absolute value of the firm. Depending on the method employed to run
a valuation analysis, the investor or analyst could use either the cost of equity or
the weighted average cost of capital (WACC) as a discount rate
What Is Discounted Cash Flow (DCF)?
Discounted cash flow (DCF) is a valuation method used to estimate the value of an
investment based on its future cash flows. DCF analysis attempts to figure out the value
of an investment today, based on projections of how much money it will generate in
the future

 Discounted cash flow (DCF) helps determine the value of an investment based
on its future cash flows.
 The present value of expected future cash flows is arrived at by using a discount
rate to calculate the discounted cash flow (DCF).
 If the discounted cash flow (DCF) is above the current cost of the investment, the
opportunity could result in positive returns.
 Companies typically use the weighted average cost of capital for the discount
rate, as it takes into consideration the rate of return expected by shareholders.
 The DCF has limitations, primarily that it relies on estimations on future cash
flows, which could prove to be inaccurate
 Discounted Cash Flow
Yea
Cash Flow Discounted Cash Flow
r
1 $1 million $952,380
2 $1 million $907,029
3 $4 million $3,455,425
4 $4 million $3,290,826
5 $6 million $4,701,089
If we sum up all of the discounted cash flows, we get a value of $13,306,749.
Subtracting the initial investment of $11 million, we get a net present value (NPV) of
$2,306,749. Because this is a positive number, the cost of the investment today is worth
it as the project will generate positive discounted cash flows above the initial cost. If the
project had cost $14 million, the NPV would have been -$693,251, indicating that the
cost of the investment would not be worth it.

Disadvantages of Discounted Cash Flow

The main limitation of DCF is that it requires making many assumptions. For one, an
investor would have to correctly estimate the future cash flows from an investment or
project. The future cash flows would rely on a variety of factors, such as
market demand, the status of the economy, unforeseen obstacles, and more.
Estimating future cash flows too high could result in choosing an investment that might
not pay off in the future, hurting profits. Estimating cash flows too low, making an
investment appear costly, could result in missed opportunities. Choosing a discount rate
for the model is also an assumption and would have to be estimated correctly for the
model to be worthwhile.
What Is the Capital Asset Pricing Model?
The Capital Asset Pricing Model (CAPM) describes the relationship between systematic
risk and expected return for assets, particularly stocks. CAPM is widely used throughout
finance for pricing risky securities and generating expected returns for assets given the
risk of those assets and cost of capital.

Understanding the Capital Asset Pricing Model (CAPM)

The formula for calculating the expected return of an asset given its risk is as follows:

ERi=Rf+βi(ERm−Rf)

ERi=expected return of investment

Rf=risk-free rate

βi=beta of the investment

(ERm−Rf)=market risk premium

The beta of a potential investment is a measure of how much risk the investment will
add to a portfolio that looks like the market. If a stock is riskier than the market, it will
have a beta greater than one. If a stock has a beta of less than one, the formula
assumes it will reduce the risk of a portfolio

The goal of the CAPM formula is to evaluate whether a stock is fairly valued when its
risk and the time value of money are compared to its expected return.

For example, imagine an investor is contemplating a stock worth $100 per share today
that pays a 3% annual dividend. The stock has a beta compared to the market of 1.3,
which means it is riskier than a market portfolio. Also, assume that the risk-free rate is
3% and this investor expects the market to rise in value by 8% per year.

The expected return of the stock based on the CAPM formula is 9.5%:

9.5%=3%+1.3×(8%−3%)

Problems With the CAPM

There are several assumptions behind the CAPM formula that have been shown not to
hold in reality. Modern financial theory rests on two assumptions: (1) securities markets
are very competitive and efficient (that is, relevant information about the companies is
quickly and universally distributed and absorbed); (2) these markets are dominated by
rational, risk-averse investors, who seek to maximize satisfaction from returns on their
investments
Valuing a Company Using the Residual Income Method
There are many different methods of valuing a company or its stock. One could opt to
use a relative valuation approach, comparing multiples and metrics of a firm in relation
to other companies within its industry or sector

 Residual income is the income a company generates after accounting for the
cost of capital.
 The residual income valuation formula is very similar to a multistage dividend
discount model, substituting future dividend payments for future residual
earnings.
 Residual income models make use of data readily available from a firm's financial
statements.
 These models look at the economic profitability of a firm rather than just its
accounting profitability
 You might be asking, "but don't companies already account for their cost of
capital in their interest expense?" Yes and no. Interest expense on the income
statement only accounts for a firm's cost of its debt, ignoring its cost of equity,
such as dividend payouts and other equity costs.

 Looking at the cost of equity another way, think of it as the

shareholders' opportunity cost, or the required rate of return. The residual income
model attempts to adjust a firm's future earnings estimates to compensate for the
equity cost and place a more accurate value to a firm. Although the return to
equity holders is not a legal requirement, like the return to bondholders, in order
to attract investors firms must compensate them for the investment risk
exposure.

 In calculating a firm's residual income, the key calculation is to determine its

equity charge. Equity charge is simply a firm's total equity capital multiplied by
the required rate of return of that equity, and can be estimated using the capital
asset pricing model. The formula below shows the equity charge equation:

 Equity Charge = Equity Capital x Cost of Equity

Once we have calculated the equity charge, we only have to subtract it from the
firm's net income to come up with its residual income. For example, if Company X
reported earnings of $100,000 last year and financed its capital structure with $950,000
worth of equity at a required rate of return of 11%, its residual income would be:

Equity Charge  -  $950,000 x 0.11 = $104,500

Net Income $100,000

Equity Charge -$104,500
Residual
-$4,500
Income
So as you can see from the above example, using the concept of residual income,
although Company X is reporting a profit on its income statement, once its cost of equity
is included in relation to its return to shareholders, it is actually economically
unprofitable based on the given level of risk. This finding is the primary driver behind the
use of the residual income method. A scenario where a company is profitable on an
accounting basis, may still not be a profitable venture from a shareholder's perspective
if it cannot generate residual income.

V0=BV0+{(1+r)nRI1+(1+r)n+1RI2+⋯}

where:

BV=Present book value

RI=Future residual income

r=Rate of return

n=Number of periods

 The biggest drawback of the residual income method is the fact that it relies so heavily
on forward-looking estimates of a firm's financial statements, leaving forecasts
vulnerable to psychological biases or historic misrepresentation of a firm's financial
statements

Valuing Firms Using Present Value of Free Cash Flows

Free Cash Flows

What are free cash flows? Free cash flows refer to the cash a company generates after
cash outflows. It helps support the company's operations and maintain its assets. Free
cash flow measures profitability. It includes spending on assets but does not include
non-cash expenses on the income statement.

This figure is available to all investors, who can use it to determine the overall health
and financial well-being of a company. It can also be used by future shareholders or
potential lenders to see how a company would be able to pay dividends or its debt and
interest payments.

Operating Free Cash Flow

Operating free cash flow (OFCF) is the cash generated by operations, which is
attributed to all providers of capital in the firm's capital structure. This includes debt
providers as well as equity.

Calculating the OFCF is done by taking earnings before interest and taxes (EBIT) and
adjusting for the tax rate, then adding depreciation and taking away capital expenditure,
minus the change in working capital and minus changes in other assets. Here is the
actual formula:

OFCF=EBIT×(1−T)+D−CAPEX−change in wc

where:

EBIT=earnings before interest and taxes

T=tax rate

D=depreciation

Calculating the Growth Rate

The growth rate can be difficult to predict and can have a drastic effect on the resulting
value of the firm. One way to calculate it is to multiply the return on the invested
capital (ROIC) by the retention rate. The retention rate is the percentage of earnings
that is held within the company and not paid out as dividends. This is the basic formula:

g=RR×ROIC

where:RR=average retention rate, or (1 - payout ratio)

ROIC=EBIT(1−tax)/total capital

Constant Growth
In a more mature company, you may find it more appropriate to include a constant
growth rate in the calculation. To calculate the value, take the OFCF of next period and
discount it at WACC minus the long-term constant growth rate of the OFCF.
Value of the firm=OFCF1÷(k−g)

where:

OFCF1=operating free cash flow

k=discount rate, in this case WACC

g=expected growth rate in OFCF

Multiple Growth Periods

Assuming the firm is about to see more than one growth stage, the calculation is a
combination of each of these stages. Using the supernormal dividend growth model for
the calculation, the analyst needs to predict the higher-than-normal growth and the
expected duration of such activity. After this high growth, the firm might be expected to
go back into a normal steady growth into perpetuity. To see the resulting calculations,
assume a firm has operating free cash flows of $200 million, which is expected to grow
at 12% for four years. After four years, it will return to a normal growth rate of 5%. We
will assume that the weighted average cost of capital is 10%.

Multi-Growth Periods of Operating Free Cash Flow (in Millions)

Period OFCF Calculation Amount Present Value

1 OFCF1 $200 x 1.121 $224.00 $203.64
2 OFCF 2 $200 x 1.122 $250.88 $207.34
3 OFCF 3 $200 x 1.123 $280.99 $211.11
4 OFCF 4 $200 x 1.124 $314.70 $214.95
         
5 OFCF 5 … $314.7 x 1.05 $330.44  
$6,608.7
    $330.44 / (0.10 - 0.05)  
8
    $6,608.78 / 1.105   $4,103.05
         
      NPV $4,940.09
Table 1: The two stages of the OFCF goes from a high growth rate (12%) for four years
followed by a perpetual constant 5% growth from the fifth year on. It is discounted back
to the present value and summed up to $5.35 billion dollars.

What is Free Cash Flow (FCF)?

 Free cash flow (FCF) represents the cash available for the company to repay
creditors or pay dividends and interest to investors.
 FCF reconciles net income by adjusting for non-cash expenses, changes in
working capital, and capital expenditures (CAPEX).
  However, as a supplemental tool for analysis, FCF can reveal problems in the
fundamentals before they arise on the income statement.

Understand the Difference- FCFF and FCFE”

 FCFF is actually the cash available to bond holders and stock holders after all expense
and investments have taken place whereas FCFE is the cash available to stock holders
after all expense, investments and interest payments to debt-holders on an after tax
basis.

Hence the basic difference lies because of consideration of interest payment in FCFE i.e.
in FCFE you subtract the interest expense from the cash flow to do valuations. Hence,
FCFF shows the obligations for both stockholders as well as bondholders whereas FCFE
consider only the obligations for stockholders.

Factors FCFF FCFE

Cash Flows Pre Debt Cash Flows post Debt Cash Flows
(already mentioned above) (already mentioned above)
Expected Growth Growth in Operating Income Growth in Net Income 
= Reinvestment rate * ROC = Retention ratio * ROE

Discount Rate WACC Cost of Equity

Dividend Discount Model – DDM

What Is the Dividend Discount Model?
The dividend discount model (DDM) is a quantitative method used for predicting the
price of a company's stock based on the theory that its present-day price is worth the
sum of all of its future dividend payments when discounted back to their present value.
It attempts to calculate the fair value of a stock irrespective of the prevailing market
conditions and takes into consideration the dividend payout factors and the market
expected returns. If the value obtained from the DDM is higher than the current trading
price of shares, then the stock is undervalued and qualifies for a buy, and vice versa.

The DDM model is based on the theory that the value of a company is the present worth
of the sum of all of its future dividend payments.

Expected Dividends
Estimating the future dividends of a company can be a complex task. Analysts and
investors may make certain assumptions, or try to identify trends based on past
dividend payment history to estimate future dividends.

One can assume that the company has a fixed growth rate of dividends until perpetuity,
which refers to a constant stream of identical cash flows for an infinite amount of time
with no end date. For example, if a company has paid a dividend of $1 per share this
year and is expected to maintain a 5 percent growth rate for dividend payment, the next
year’s dividend is expected to be $1.05.
Alternatively, if one spot a certain trend—like a company making dividend payments of
$2.00, $2.50, $3.00 and $3.50 over the last four years—then an assumption can be
made about this year’s payment being $4.00. Such an expected dividend is
mathematically represented by (D)

DDM Formula
Based on the expected dividend per share and the net discounting factor, the formula
for valuing a stock using the dividend discount model is mathematically represented as

Value of  Stock=EDPS/(CCE−DGR)

where:

EDPS=expected dividend per share

CCE=cost of capital equity

DGR=dividend growth rate

The most common and straightforward calculation of a DDM is known as the Gordon

growth model (GGM), which assumes a stable dividend growth rate and was named in
the 1960s after American economist Myron J. Gordon. 1
This model assumes a stable growth in dividends year after year. To find the price of a
dividend-paying stock, the GGM takes into account three variables:

D=the estimated value of next year’s dividend

r=the company’s cost of capital equity

g=the constant growth rate for dividends, in perpetuity

Price per Share= D/r−g

A third variant exists as the supernormal dividend growth model, which takes into

account a period of high growth followed by a lower, constant growth period. During the
high growth period, one can take each dividend amount and discount it back to the
present period. For the constant growth period, the calculations follow the GGM model.
All such calculated factors are summed up to arrive at a stock price.

Examples of the DDM

Assume Company X paid a dividend of $1.80 per share this year. The company expects
dividends to grow in perpetuity at 5 percent per year, and the company's cost of equity
capital is 7%. The $1.80 dividend is the dividend for this year and needs to be adjusted
by the growth rate to find D1, the estimated dividend for next year. This calculation is:
D1 = D0 x (1 + g) = $1.80 x (1 + 5%) = $1.89. Next, using the GGM, Company X's price
per share is found to be D(1) / (r - g) = $1.89 / ( 7% - 5%) = $94.50.

A look at the dividend payment history of leading American retailer Walmart Inc. (WMT)
indicates that it has paid out annual dividends totaling to $1.92, $1.96, $2.00, $2.04
and $2.08, between January 2014 and January 2018 in chronological order. 2
One can see a pattern of a consistent increase of 4 cents in Walmart's dividend each
year, which equals to the average growth of about 2 percent. Assume an investor has
a required rate of return of 5%. Using an estimated dividend of $2.12 at the beginning of
2019, the investor would use the dividend discount model to calculate a per-share value
of $2.12/ (.05 - .02) = $70.67

Shortcomings of the DDM

While the GGM method of DDM is widely used, it has two well-known shortcomings.
The model assumes a constant dividend growth rate in perpetuity. This assumption is
generally safe for very mature companies that have an established history of regular
dividend payments. However, DDM may not be the best model to value newer
companies that have fluctuating dividend growth rates or no dividend at all. One can still
use the DDM on such companies, but with more and more assumptions, the precision
decreases.

The model also fails when companies may have a lower rate of return (r) compared to
the dividend growth rate (g). This may happen when a company continues to pay
dividends even if it is incurring a loss or relatively lower earnings.

What Is Weighted Average Cost of Capital – WACC?

The weighted average cost of capital (WACC) is a calculation of a firm's cost of
capital in which each category of capital is proportionately weighted. All sources of
capital, including common stock, preferred stock, bonds, and any other long-term debt,
are included in a WACC calculation.

A firm’s WACC increases as the beta and rate of return on equity increase because
an increase in WACC denotes a decrease in valuation and an increase in risk.

WACC=E/V*Re+D/V*RD*(1-T)
  Calculation of a firm's cost of capital in which each category of capital is
proportionately weighted.
 Incorporates all sources of a company’s capital—including common stock,
preferred stock, bonds, and any other long-term debt.
 Can be used as a hurdle rate against which companies and investors can gauge
ROIC performance.
 WACC is commonly used as the discount rate for future cash flows in DCF
analyses.

Limitations of WACC
The WACC formula seems easier to calculate than it really is. Because certain elements
of the formula, like the cost of equity, are not consistent values, various parties may
report them differently for different reasons. As such, while WACC can often help lend
valuable insight into a company, one should always use it along with other metrics when
determining whether or not to invest in a company.

How Beta Works

A beta coefficient can measure the volatility of an individual stock compared to the
systematic risk of the entire market. In statistical terms, beta represents the slope of the
line through a regression of data points. In finance, each of these data points represents
an individual stock's returns against those of the market as a whole

The calculation for beta is as follows:

Beta coefficient(β)= Covariance(Re,Rm) / Variance(Rm)

Re=the return on an individual stock

Rm=the return on the overall market

Covariance=how changes in a stock’s returns arerelated to changes in the market’s returns

Variance=how far the market’s data points spreadout from their average value

The beta calculation is used to help investors understand whether a stock moves in the
same direction as the rest of the market. It also provides insights about how volatile–or
how risky–a stock is relative to the rest of the market. For beta to provide any useful
insight, the market that is used as a benchmark should be related to the stock

Ultimately, an investor is using beta to try to gauge how much risk a stock is adding to a
portfolio. While a stock that deviates very little from the market doesn’t add a lot of risk
to a portfolio, it also doesn’t increase the potential for greater returns.
Types of Beta Values
Beta Value Equal to 1.0
If a stock has a beta of 1.0, it indicates that its price activity is strongly correlated with
the market. A stock with a beta of 1.0 has systematic risk. However, the beta calculation
can’t detect any unsystematic risk. Adding a stock to a portfolio with a beta of 1.0
doesn’t add any risk to the portfolio, but it also doesn’t increase the likelihood that the
portfolio will provide an excess return.

Beta Value Less Than One

A beta value that is less than 1.0 means that the security is theoretically less volatile
than the market. Including this stock in a portfolio makes it less risky than the same
portfolio without the stock. For example, utility stocks often have low betas because
they tend to move more slowly than market averages.

Beta Value Greater Than One

A beta that is greater than 1.0 indicates that the security's price is theoretically more
volatile than the market. For example, if a stock's beta is 1.2, it is assumed to be 20%
more volatile than the market. Technology stocks and small cap stocks tend to have
higher betas than the market benchmark. This indicates that adding the stock to a
portfolio will increase the portfolio’s risk, but may also increase its expected return.

Negative Beta Value

Some stocks have negative betas. A beta of -1.0 means that the stock is inversely
correlated to the market benchmark. This stock could be thought of as an opposite,
mirror image of the benchmark’s trends. Put options and inverse ETFs are designed to
have negative betas. There are also a few industry groups, like gold miners, where a
negative beta is also common.

Disadvantages of Beta
While beta can offer some useful information when evaluating a stock, it does have
some limitations. Beta is useful in determining a security's short-term risk, and for
analyzing volatility to arrive at equity costs when using the CAPM. However, since beta
is calculated using historical data points, it becomes less meaningful for investors
looking to predict a stock's future movements.

Relative valuation models

 in contrast, operate by comparing the company in question to other similar companies.
These methods involve calculating multiples and ratios, such as the price-to-earnings
multiple, and comparing them to the multiples of similar companies.
For example, if the P/E of a company is lower than the P/E multiple of a comparable
company, the original company might be considered undervalued. Typically, the relative
valuation model is a lot easier and quicker to calculate than the
absolute valuation model, which is why many investors and analysts begin their analysis
with this model.

What Is a Relative Valuation Model?

A relative valuation model is a business valuation method that compares a company's
value to that of its competitors or industry peers to assess the firm's financial worth

 One of the most popular relative valuation multiples is the price-to-earnings (P/E)
ratio.
 A relative valuation model differs from an absolute valuation model which makes
no reference to any other company or industry average.
 A relative valuation model can be used to assess the value of a company's stock
price compared to other companies or an industry average.
 There are many different types of relative valuation ratios, such as price to free
cash flow, enterprise value (EV), operating margin, price to cash flow for real
estate and price-to-sales (P/S) for retail.

 One of the most popular relative valuation multiples is the price-to-earnings (P/E)

ratio. It is calculated by dividing stock price by earnings per share (EPS), and is
expressed as a company's share price as a multiple of its earnings

Limitations of Valuation
When deciding which valuation method to use to value a stock for the first time, it's easy
to become overwhelmed by the number of valuation techniques available to investors.
There are valuation methods that are fairly straightforward while others are more
involved and complicated.

Unfortunately, there's no one method that's best suited for every situation. Each stock is
different, and each industry or sector has unique characteristics that may require
multiple valuation methods. At the same time, different valuation methods will produce
different values for the same underlying asset or company which may lead analysts to
employ the technique that provides the most favorable output.

What Are Financial Statements?

Financial statements are written records that convey the business activities and the
financial performance of a company. 

 Balance sheet
 Income statement
 Cash flow statement.

What Is a Balance Sheet?

A balance sheet is a financial statement that reports a company's assets, liabilities and
shareholders' equity at a specific point in time, and provides a basis for computing rates
of return and evaluating its capital structure. It is a financial statement that provides a
snapshot of what a company owns and owes, as well as the amount invested by
shareholders.

Assets
Within the assets segment, accounts are listed from top to bottom in order of their
liquidity – that is, the ease with which they can be converted into cash. They are divided
into current assets, which can be converted to cash in one year or less; and non-current
or long-term assets, which cannot.

Here is the general order of accounts within current assets:

 Cash and cash equivalents are the most liquid assets and can include Treasury
bills and short-term certificates of deposit, as well as hard currency.
 Marketable securities are equity and debt securities for which there is a liquid
market.
 Accounts receivable refers to money that customers owe the company,
perhaps including an allowance for doubtful accounts since a certain proportion
of customers can be expected not to pay.
 Inventory is goods available for sale, valued at the lower of the cost or market
price.
 Prepaid expenses represent the value that has already been paid for, such as
insurance, advertising contracts or rent.

Long-term assets include the following:

 Long-term investments are securities that will not or cannot be liquidated in the

next year.
 Fixed assets include land, machinery, equipment, buildings and other durable,
generally capital-intensive assets.
 Intangible assets include non-physical (but still valuable) assets such as
intellectual property and goodwill. In general, intangible assets are only listed on
the balance sheet if they are acquired, rather than developed in-house. Their
value may thus be wildly understated – by not including a globally recognized
logo, for example – or just as wildly overstated.
Liabilities
Liabilities are the money that a company owes to outside parties, from bills it has to pay
to suppliers to interest on bonds it has issued to creditors to rent, utilities and salaries.
Current liabilities are those that are due within one year and are listed in order of their
due date. Long-term liabilities are due at any point after one year.

Current liabilities accounts might include:

 current portion of long-term debt

 bank indebtedness
 interest payable
 wages payable
 customer prepayments
 dividends payable and others
 earned and unearned premiums
 accounts payable

Long-term liabilities can include:

 Long-term debt: interest and principal on bonds issued

 Pension fund liability: the money a company is required to pay into its
employees' retirement accounts
 Deferred tax liability: taxes that have been accrued but will not be paid for
another year (Besides timing, this figure reconciles differences between
requirements for financial reporting and the way tax is assessed, such as
depreciation calculations.)

Some liabilities are considered off the balance sheet, meaning that they will not appear
on the balance sheet.

Shareholders' Equity
Shareholders' equity is the money attributable to a business' owners, meaning its
shareholders. It is also known as "net assets," since it is equivalent to the total assets of
a company minus its liabilities, that is, the debt it owes to non-shareholders.

Retained earnings are the net earnings a company either reinvests in the business or
use to pay off debt; the rest is distributed to shareholders in the form of dividends.

What is an Income Statement?

Also known as the profit and loss statement or the statement of revenue and expense,
the income statement primarily focuses on the company’s revenues and
expenses during a particular period.

The income statement focuses on four key items—revenue, expenses, gains, and

losses. It does not differentiate between cash and non-cash receipts (sales in cash
versus sales on credit) or the cash versus non-cash payments/disbursements
(purchases in cash versus purchases on credit). It starts with the details of sales, and
then works down to compute the net income and eventually the earnings per share
(EPS). Essentially, it gives an account of how the net revenue realized by the company
gets transformed into net earnings (profit or loss).

Revenues and Gains

The following are covered in the income statement, though its format may vary
depending upon the local regulatory requirements, the diversified scope of the business
and the associated operating activities:

Operating Revenue
Revenue realized through primary activities is often referred to as operating revenue.
For a company manufacturing a product, or for a wholesaler, distributor or retailer
involved in the business of selling that product, the revenue from primary activities
refers to revenue achieved from the sale of the product. Similarly, for a company (or its
franchisees) in the business of offering services, revenue from primary activities refers
to the revenue or fees earned in exchange of offering those services.

Non-Operating Revenue
Revenues realized through secondary, non-core business activities are often referred to
as non-operating recurring revenues. These revenues are sourced from the earnings
which are outside of the purchase and sale of goods and services and may include
income from interest earned on business capital lying in the bank, rental income from
business property, income from strategic partnerships like royalty payment receipts or
income from an advertisement display placed on business property.

Gains
Also called other income, gains indicate the net money made from other activities, like
the sale of long-term assets. These include the net income realized from one-time non-
business activities, like a company selling its old transportation van, unused land, or a
subsidiary company.

Revenue should not be confused with receipts. Revenue is usually accounted for in the
period when sales are made or services are delivered. Receipts are the cash received
and are accounted for when the money is actually received. For instance, a customer
may take goods/services from a company on 28 September, which will lead to the
revenue being accounted for in the month of September. Owing to his good reputation,
the customer may be given a 30-day payment window. It will give him time till 28
October to make the payment, which is when the receipts are accounted for.

Expenses and Losses

The cost for a business to continue operation and turn a profit is known as an expense.
Some of these expenses may be written off on a tax return if they meet the IRS
guidelines.
Primary Activity Expenses
All expenses incurred for earning the normal operating revenue linked to the primary
activity of the business. They include the cost of goods sold (COGS), selling, general
and administrative expenses (SG&A), depreciation or amortization, and research and
development (R&D) expenses. Typical items that make up the list are employee wages,
sales commissions, and expenses for utilities like electricity and transportation.

Secondary Activity Expenses

All expenses linked to non-core business activities, like interest paid on loan money.

Losses as Expenses
All expenses that go towards a loss-making sale of long-term assets, one-time or any
other unusual costs, or expenses towards lawsuits.

Net Income = (Revenue + Gains) – (Expenses + Losses)

What Is a Cash Flow Statement?

A cash flow statement is a financial statement that provides aggregate data regarding
all cash inflows a company receives from its ongoing operations and external
investment sources. It also includes all cash outflows that pay for business activities and
investments during a given period. 

 The cash flow statement is believed to be the most intuitive of all the financial
statements because it follows the cash made by the business in three main ways—
through operations, investment, and financing. The sum of these three segments is
called net cash flow.

Cash Flows From Operations

This is the first section of the cash flow statement covers cash flows from operating
activities (CFO) and includes transactions from all operational business activities. The
cash flows from operations section begins with net income, then reconciles all noncash
items to cash items involving operational activities. So, in other words, it is the
company's net income, but in a cash version.

This section reports cash flows and outflows that stem directly from a company's main
business activities. These activities may include buying and selling inventory and
supplies, along with paying its employees their salaries. Any other forms of in and
outflows such as investments, debts, and dividends are not included.

Companies are able to generate sufficient positive cash flow for operational growth. If
there is not enough generated, they may need to secure financing for external growth in
order to expand.
For example, accounts receivable is a noncash account. If accounts receivable go up
during a period, it means sales are up, but no cash was received at the time of sale.
The cash flow statement deducts receivables from net income because it is not cash.
The cash flows from the operations section can also include accounts payable,
depreciation, amortization, and numerous prepaid items booked as revenue or
expenses, but with no associated cash flow.

Cash Flows From Investing

This is the second section of the cash flow statement looks at cash flows from
investing (CFI) and is the result of investment gains and losses. This section also
includes cash spent on property, plant, and equipment. This section is where analysts
look to find changes in capital expenditures (capex).

When capex increases, it generally means there is a reduction in cash flow. But that's
not always a bad thing, as it may indicate that a company is making investment into its
future operations. Companies with high capex tend to be those that are growing.

While positive cash flows within this section can be considered good, investors
would prefer companies that generate cash flow from business operations—not through
investing and financing activities. Companies can generate cash flow within this
section by selling equipment or property. 

Cash Flows From Financing

Cash flows from financing (CFF) is the last section of the cash flow statement. The
section provides an overview of cash used in business financing. It measures cash flow
between a company and its owners and its creditors, and its source is normally from
debt or equity. These figures are generally reported annually on a company's 10-K
report to shareholders .

Analysts use the cash flows from financing section to determine how much money the
company has paid out via dividends or share buybacks. It is also useful to help
determine how a company raises cash for operational growth.

Cash obtained or paid back from capital fundraising efforts, such as equity or debt, is
listed here, as are loans taken out or paid back. 

When the cash flow from financing is a positive number, it means there is more money
coming into the company than flowing out. When the number is negative, it may mean
the company is paying off debt, or is making dividend payments and/or stock buybacks.

INSERT RATIOS AND FINANCIAL STATEMENT SCREENSHOTS

What Is Fundamental Analysis?

 Fundamental analysis is a method of determining a stock's real or "fair market"

value.
 Fundamental analysts search for stocks that are currently trading at prices that
are higher or lower than their real value.
 If the fair market value is higher than the market price, the stock is deemed to be
undervalued and a buy recommendation is given.
 In contrast, technical analysts ignore the fundamentals in favor of studying the
historical price trends of the stock.
Understanding Fundamental Analysis
All stock analysis tries to determine whether a security is correctly valued within the
broader market. Fundamental analysis is usually done from a macro to micro
perspective in order to identify securities that are not correctly priced by the market.

Analysts typically study, in order, the overall state of the economy and then the strength
of the specific industry before concentrating on individual company performance to
arrive at a fair market value for the stock.

Fundamental analysis uses public data to evaluate the value of a stock or any other
type of security. For example, an investor can perform fundamental analysis on a bond's
value by looking at economic factors such as interest rates and the overall state of the
economy, then
studying information about the bond issuer, such as potential changes in its credit
rating.

Qualitative Fundamentals to Consider

There are four key fundamentals that analysts always consider when regarding a
company. All are qualitative rather than quantitative. They include:

 The business model: What exactly does the company do? This isn't as
straightforward as it seems. If a company's business model is based on selling
fast-food chicken, is it making its money that way? Or is it just coasting on royalty
and franchise fees?
 Competitive advantage: A company's long-term success is driven largely by its
ability to maintain a competitive advantage—and keep it. Powerful competitive
advantages, such as Coca-Cola's brand name and Microsoft's domination of the
personal computer operating system, create a moat around a business allowing it
to keep competitors at bay and enjoy growth and profits. When a company can
achieve a competitive advantage, its shareholders can be well rewarded for
decades.
 Management: Some believe that management is the most important criterion for
investing in a company. It makes sense: Even the best business model is
doomed if the leaders of the company fail to properly execute the plan. While it's
hard for retail investors to meet and truly evaluate managers, you can look at the
 corporate website and check the resumes of the top brass and the board
members. How well did they perform in prior jobs? Have they been unloading a
lot of their stock shares lately?
 Corporate Governance: Corporate governance describes the policies in place
within an organization denoting the relationships and responsibilities between
management, directors and stakeholders. These policies are defined and
determined in the company charter and its bylaws, along with corporate laws and
regulations. You want to do business with a company that is run ethically, fairly,
transparently, and efficiently. Particularly note whether management respects
shareholder rights and shareholder interests. Make sure their communications to
shareholders are transparent, clear and understandable. If you don't get it, it's
probably because they don't want you to.

Financial Statements: Quantitative Fundamentals to Consider

Financial statements are the medium by which a company discloses information
concerning its financial performance. Followers of fundamental analysis use quantitative
information gleaned from financial statements to make investment decisions. The three
most important financial statements are income statements, balance sheets, and cash
flow statements.

The Balance Sheet

The balance sheet represents a record of a company's assets, liabilities and equity at a
particular point in time. The balance sheet is named by the fact that a business's
financial structure balances in the following manner:

Assets = Liabilities + Shareholders' Equity

Assets represent the resources that the business owns or controls at a given point in
time. This includes items such as cash, inventory, machinery and buildings. The other
side of the equation represents the total value of the financing the company has used to
acquire those assets. Financing comes as a result of liabilities or equity. Liabilities
represent debt (which of course must be paid back), while equity represents the total
value of money that the owners have contributed to the business - including retained
earnings, which is the profit made in previous years.

The Income Statement

While the balance sheet takes a snapshot approach in examining a business, the
income statement measures a company's performance over a specific time frame.
Technically, you could have a balance sheet for a month or even a day, but you'll only
see public companies report quarterly and annually.

The income statement presents information about revenues, expenses and profit that
was generated as a result of the business' operations for that period.
Statement of Cash Flows
The statement of cash flows represents a record of a business' cash inflows and
outflows over a period of time. Typically, a statement of cash flows focuses on the
following cash-related activities:

 Cash from investing (CFI): Cash used for investing in assets, as well as the
proceeds from the sale of other businesses, equipment or long-term assets
 Cash from financing (CFF): Cash paid or received from the issuing and
borrowing of funds
 Operating Cash Flow (OCF): Cash generated from day-to-day business
operations

The cash flow statement is important because it's very difficult for a business to
manipulate its cash situation. There is plenty that aggressive accountants can do to
manipulate earnings, but it's tough to fake cash in the bank. For this reason, some
investors use the cash flow statement as a more conservative measure of a company's
performance.

Absolute Value vs. Relative Value

Relative value is the opposite of absolute value. While absolute value examines the
intrinsic value of an asset or company without comparing it to any others, relative
value is based on the value of similar assets or companies. Analysts and investors who
use relative value analysis for stocks look at financial statements and other multiples of
the companies they're interested in and compare it to other, similar firms to determine if
those potential companies are over or undervalued. For instance, an investor will look at
the variables—market capitalization, revenues, sales figures, P/E ratios, etc.—for
companies like Amazon, Target, and/or Costco if they want to know the relative value of
Walmart.

Challenges of Using Absolute Value

Estimating a company’s absolute value does not come without its setbacks. Forecasting
the cash flows with complete certainty and projecting how long the cash flows will
remain on a growth trajectory is challenging. In addition to predicting an accurate growth
rate, evaluating an appropriate discount rate to calculate the present value can be
difficult.

Intrinsic Value vs. Current Market Value: An Overview

 Intrinsic value and market value are two distinct ways to value a company.
 Market value is simply a measure of how much the market values the company,
or how much it would cost to buy it.
 Market value is easy to determine for publicly traded companies but can be a
little more complicated for private companies.
 Intrinsic value is an estimate of the actual value of a company, separate from
how the market values it.
  Value investors look for companies with higher intrinsic value than market value.
They see this as a good investment opportunity.

The Comparables Approach to Equity Valuation

 There are three primary equity valuation models: the discounted cash flow
(DCF), the cost, and the comparable (or comparables) approach.
 The comparable model is a relative valuation approach.
 There are two primary comparable approaches; the first is the most common and
looks at market comparables for a firm and its peers.
 The second comparable approach looks at market transactions where similar
firms or divisions have been bought out or acquired by other rivals, private equity
firms or other classes of large, deep-pocketed investors.

What Book Value Means to Investors

 The book value of a company is the difference in value between that company's
total assets and total liabilities on its balance sheet.
 Value investors use the price-to-book (P/B) ratio to compare a firm's market
capitalization to its book value to identify potentially over- and under-valued
stocks.
 Traditionally, a P/B less than 1.0 is considered a good value, but it can be difficult
to pinpoint a "good" P/B ratio since it can vary by industry and any particular
company may have underlying financial troubles.

Liquidation Value

 Liquidation value is the total worth of a company's physical assets if it were to go

out of business and its assets sold.
 Liquidation value is determined a company's assets such as real estate, fixtures,
equipment, and inventory. Intangible assets are excluded from a company's
liquidation value.
 Liquidation value is usually lower than book value, but greater than salvage
value.
 Assets are sold at a loss during liquidation because the seller must gather as
much cash as possible within a short period.
Market vs. Book vs. Liquidation vs. Salvage
Market value typically provides the highest valuation of assets although the measure
could be lower than book value if the value of the assets has decreased due to market
demand rather than business use.
The book value is the value of the asset as listed on the balance sheet. The balance
sheet lists assets at the historical cost, so the value of assets may be higher or lower
than market prices. In an economic environment with rising prices, the book value of
assets is lower than the market value. The liquidation value is the expected value of the
asset once it has been liquidated or sold, presumably at a loss to historical cost.

Finally, the salvage value is the value given to an asset at the end of its useful life; in
other words, this is the scrap value.

Liquidation value is usually lower than book value but greater than salvage value. The
assets continue to have value, but they are sold at a loss because they must be sold
quickly.

What is Market Capitalization

Market capitalization refers to the total dollar market value of a company's
outstanding shares of stock. Commonly referred to as "market cap," it is calculated by
multiplying the total number of a company's outstanding shares by the current market
price of one share.

 Market capitalization refers to how much a company is worth as determined by

the stock market. It is defined as the total market value of all outstanding shares.
 To calculate a company's market cap, multiply the number of outstanding shares
by the current market value of one share.
 Companies are typically divided according to market capitalization: large-cap
($10 billion or more), mid-cap ($2 billion to $10 billion), and small-cap ($300
million to $2 billion)

What Is Enterprise Value – EV?
Enterprise value (EV) is a measure of a company's total value, often used as a more
comprehensive alternative to equity market capitalization. EV includes in its calculation
the market capitalization of a company but also short-term and long-term debt as well
as any cash on the company's balance sheet. Enterprise value is a popular metric used
to value a company for a potential takeover

Formula and Calculation for EV

EV=MC+Total Debt−C

MC=Market capitalization; equal to the current stockprice multiplied by the number of outstan
ding stock shares

Total debt=Equal to the sum of short-term and long-term debt
C=Cash and cash equivalents; the liquid assets ofa company, but may not include marketable se
curities

What Does Enterprise Value Tell You?

Enterprise value (EV) could be thought of like the theoretical takeover price if a
company were to be bought. EV differs significantly from simple market capitalization in
several ways, and many consider it to be a more accurate representation of a firm's
value. The value of a firm's debt, for example, would need to be paid off by the buyer
when taking over a company. As a result, enterprise value provides a much more
accurate takeover valuation because it includes debt in its value calculation.

Why doesn't market capitalization properly represent a firm's value? It leaves a lot of
important factors out, such as a company's debt on the one hand and its cash
reserves on the other. Enterprise value is basically a modification of market cap, as it
incorporates debt and cash for determining a company's valuation.

Market capitalization is not intended to represent a company's book value. Instead, it

represent's a company's value as determined by market participants

EV/EBITDA is useful in a number of situations:

 The ratio may be more useful than the P/E ratio when comparing firms with
different degrees of financial leverage (DFL).
 EBITDA is useful for valuing capital-intensive businesses with high levels
of depreciation and amortization.
 EBITDA is usually positive even when earnings per share (EPS) is not.

EV/EBITDA also has a number of drawbacks, however:

 If working capital is growing, EBITDA will overstate cash flows from operations
(CFO or OCF). Further, this measure ignores how different revenue recognition
policies can affect a company's OCF.
 Because free cash flow to the firm captures the number of capital
expenditures (CapEx), it is more strongly linked with valuation theory than
EBITDA. EBITDA will be a generally adequate measure if capital expenses equal
depreciation expenses.

Limitations of Using EV
As stated earlier, EV includes total debt, but it's important to consider how the debt is
being utilized by the company's management. For example, capital intensive industries
such as the oil and gas industry typically carry significant amounts of debt, which is
used to foster growth. The debt could be used to purchase plant and equipment. As a
result, the EV would be skewed for companies with a large amount of debt as compared
to industries with little or no debt.
Understanding Return on Equity
ROE is expressed as a percentage and can be calculated for any company if net income and
equity are both positive numbers. Net income is calculated before dividends paid to common
shareholders and after dividends to preferred shareholders and interest to lenders.

Return on Equity= Net Income/ / Average Shareholders’ Equity

Net income is the amount of income, net of expense, and taxes that a company
generates for a given period. Average shareholders' equity is calculated by adding
equity at the beginning of the period. The beginning and end of the period should
coincide with the period during which the net income is earned.

How to Value Private Companies

Comparable Valuation of Firms
The most common way to estimate the value of a private company is to use comparable
company analysis (CCA). This approach involves searching for publicly-traded
companies that most closely resemble the private or target firm.

The process includes researching companies of the same industry, ideally a direct
competitor, similar size, age, and growth rate. Typically, several companies in
the industry are identified that are similar to the target firm. Once an industry group
is established, averages of their valuations or multiples can be calculated to provide a
sense of where the private company fits within its industry.   

Private Equity Valuation Metrics

Equity valuation metrics must also be collected, including price-to-earnings, price-to-
sales, price-to-book, and price-to-free cash flow. The EBIDTA multiple can help
in finding the target firm's enterprise value (EV)—which is why it's also called the
enterprise value multiple. This provides a much more accurate valuation because it
includes debt in its value calculation.

The enterprise multiple is calculated by dividing the enterprise value by the

company's earnings before interest taxes, depreciation, and amortization (EBIDTA). The
company's enterprise value is sum of its market capitalization, value of debt, (minority
interest, preferred shares subtracted from its cash and cash equivalents.

If the target firm operates in an industry that has seen recent acquisitions,
corporate mergers, or IPOs, we can use the financial information from
those transactions to calculate a valuation. Since investment bankers and corporate
finance teams have already determined the value of the target's closest competitors, we
can use their findings to analyze companies with comparable market share to come up
with an estimate of the target's firm's valuation. 

While no two firms are the same, by consolidating and averaging the data from the
comparable company analysis, we can determine how the target firm compares to the
publicly-traded peer group. From there, we're in a better position to estimate the target
firm's value. 

Estimating Discounted Cash Flow

The discounted cash flow method of valuing a private company, the discounted cash
flow of similar companies in the peer group is calculated and applied to the target firm.
The first step involves estimating the revenue growth of the target firm by averaging the
revenue growth rates of the companies in the peer group. 

This can often be a challenge for private companies due to the company's stage in its
lifecycle and management's accounting methods. Since private companies are not held
to the same stringent accounting standards as public firms, private firms' accounting
statements often differ significantly and may include some personal expenses along
with business expenses—not uncommon in smaller family-owned businesses—along
with owner salaries, which will also include the payment of dividends to ownership.

Once revenue has been estimated, we can estimate expected changes in operating

costs, taxes and working capital. Free cash flow can then be calculated. This
provides the operating cash remaining after capital expenditures have been deducted.
Free cash flow is typically used by investors to determine how much money is available
to give back to shareholders in, for example, the form of dividends.

Calculating Beta for Private Firms

The next step would be to calculate the peer group's average beta, tax rates, and debt-
to-equity (D/E) ratios. Ultimately, the weighted average cost of capital (WACC) needs to
be calculated. The WACC calculates the average cost of capital whether it's financed
through debt and equity.

The cost of equity can be estimated using the Capital Asset Pricing Model (CAPM).

The cost of debt will often be determined by examining the target's credit history to
determine the interest rates being charged to the firm. The capital structure details
including the debt and equity weightings, as well as the cost of capital from the peer
group also need to be factored into the WACC calculations.

Determining Capital Structure

Although determining the target's capital structure can be difficult, industry averages can
help in the calculations. However, it's likely that the costs of equity and debt for the
private firm will be higher than its publicly-traded counterparts, so slight adjustments
may be required to the average corporate structure to account for these inflated costs.
Often, a premium is added to the cost of equity for a private firm to compensate for the
lack of liquidity in holding an equity position in the firm.
Once the appropriate capital structure has been estimated, the WACC can
be calculated. The WACC provides the discount rate for the target firm so that
by discounting the target's estimated cash flows, we can establish a fair value of the
private firm. The illiquidity premium, as previously mentioned, can also be added to the
discount rate to compensate potential investors for the private investment.

Valuing Startup Ventures

 If you are trying to raise capital for your start-up company, or you're thinking of
putting money into one, it's important to determine the company's worth.
 Start-up companies often look to angel or investors to raise much-needed capital
to get their business off the ground - but how does one value a brand new
company?
 Start-ups are notoriously hard to value accurately since they do not yet have
operating income or perhaps even a salable product yet, and will be spending
money to get things going.
 While some approaches like discounted cash flows can be used to value both
start-ups and established firms, other metrics like cost-to-duplicate and stage
valuation are unique to new ventures.

Cost-to-Duplicate
As the name implies, this approach involves calculating how much it would cost to build
another company just like it from scratch. The idea is that a smart investor wouldn't pay
more than it would cost to duplicate. This approach will often look at the physical
assets to determine their fair market value.2

The cost-to-duplicate a software business, for instance, might be figured as the total
cost of programming time that is gone into designing its software. For a high-technology
start-up, it could be the costs to date of research and development, patent protection,
prototype development. The cost-to-duplicate approach is often seen as a starting point
for valuing startups, since it is fairly objective. After all, it is based on verifiable, historic
expense records.

The big problem with this approach – and company founders will certainly agree here –
is that it doesn't reflect the company's future potential for generating sales, profits
and return on investment. What's more, the cost-to-duplicate approach doesn't
capture intangible assets, like brand value, that the venture might possess even at an
early stage of development. Because it generally underestimates the venture's worth,
it's often used as a "lowball" estimate of company value. The company's physical
infrastructure and equipment may only be a small component of the actual net worth
when relationships and intellectual capital form the basis of the firm.

Market Multiple
Venture capital investors like this approach, as it gives them a pretty good indication of
what the market is willing to pay for a company. Basically, the market multiple approach
values the company against recent acquisitions of similar companies in the market. 2

Let's say mobile application software firms are selling for five-times sales. Knowing what
real investors are willing to pay for mobile software, you could use a five-times multiple
as the basis for valuing your mobile apps venture while adjusting the multiple up or
down to factor for different characteristics. If your mobile software company, say, were
at an earlier stage of development than other comparable businesses, it would probably
fetch a lower multiple than five, given that investors are taking on more risk.

In order to value a firm at the infancy stages, extensive forecasts must be determined to
assess what the sales or earnings of the business will be once it is in the mature stages
of operation. Providers of capital will often provide funds to businesses when they
believe in the product and business model of the firm, even before it is generating
earnings. While many established corporations are valued based on earnings, the value
of startups often has to be determined based on revenue multiples.

The market multiple approach, arguably, delivers value estimates that come closes to
what investors are willing to pay. Unfortunately, there is a hitch: comparable market
transactions can be very hard to find. It's not always easy to find companies that are
close comparisons, especially in the start-up market. Deal terms are often kept under
wraps by early-stage, unlisted companies – the ones that probably represent the closest
comparisons. 

Valuation by Stage
Finally, there is the development stage valuation approach, often used by angel
investors and venture capital firms to quickly come up with a rough-and-ready range of
company value. Such "rule of thumb" values are typically set by the investors,
depending on the venture's stage of commercial development. The further the company
has progressed along the development pathway, the lower the company's risk and the
higher its value. A valuation-by-stage model might look something like this: 3

Estimated Company
Stage of Development
Value
$250,000 - $500,000 Has an exciting business idea or business plan
$500,000 - $1 million Has a strong management team in place to execute on the plan
$1 million – $2 million Has a final product or technology prototype
$2 million – $5 million Has strategic alliances or partners, or signs of a customer base
Has clear signs of revenue growth and obvious pathway to
$5 million and up
profitability
Again, the particular value ranges will vary, depending on the company and, of course,
the investor. But in all likelihood, start-ups that have nothing more than a business
plan will likely get the lowest valuations from all investors. As the company succeeds in
meeting development milestones, investors will be willing to put assign a higher value.

Many private equity firms will utilize an approach whereby they provide additional

funding when the firm reaches a given milestone. For example, the initial round of
financing may be targeted toward providing wages for employees to develop a product.
Once the product is proved to be successful, a subsequent round of funding is provided
to mass produce and market the invention. 

ratios: link
financialratio.pdf

Real Return

The real return is simply the return an investor receives after the rate of inflation is taken
into account. The math is straightforward: if a bond returns 4% in a given year and the
current rate of inflation is 2%, then the real return is 2%.

Real Return = Nominal Return - Inflation

Looking at Real Returns and Real Yields

These calculations exist because inflation reduces the purchasing power of each dollar
of savings you hold. If you keep your money in a safe, its nominal value remains the
same, but the real value of each dollar is diminished by the inflation rate.
Think of it this way: Assume that this year, it takes $200 to feed your family for a week.
If inflation is running at 2%, then next year that same shopping cart of food will cost
$204. If the return on your investments is just 1%, then you will have only $202 at the
end of the year because your purchasing power has been diminished by the difference
between your 1% nominal return and the 2% inflation rate. This means that your real
return is a negative 1%. In order to properly manage your investments, it’s important to
pay attention to real returns.

What Is a Mutual Fund?

A mutual fund is a type of financial vehicle made up of a pool of money collected from
many investors to invest in securities like stocks, bonds, money market instruments,
and other assets. Mutual funds are operated by professional money managers, who
allocate the fund's assets and attempt to produce capital gains or income for the fund's
investors. A mutual fund's portfolio is structured and maintained to match the investment
objectives stated in its prospectus.

Mutual funds give small or individual investors access to professionally managed

portfolios of equities, bonds, and other securities. Each shareholder, therefore,
participates proportionally in the gains or losses of the fund. Mutual funds invest in a
vast number of securities, and performance is usually tracked as the change in the
total market cap of the fund—derived by the aggregating performance of the underlying
investments.

KEY TAKEAWAYS

 A mutual fund is a type of investment vehicle consisting of a portfolio of stocks,

bonds, or other securities. 
 Mutual funds give small or individual investors access to diversified,
professionally managed portfolios at a low price.
 Mutual funds are divided into several kinds of categories, representing the kinds
of securities they invest in, their investment objectives, and the type of returns
they seek.
 Mutual funds charge annual fees (called expense ratios) and, in some cases,
commissions, which can affect their overall returns.
 The overwhelming majority of money in employer-sponsored retirement plans
goes into mutual funds

Types of Mutual Funds

Mutual funds are divided into several kinds of categories, representing the kinds of
securities they have targeted for their portfolios and the type of returns they seek. There
is a fund for nearly every type of investor or investment approach. Other common types
of mutual funds include money market funds, sector funds, alternative funds, smart-beta
funds, target-date funds, and even funds of funds, or mutual funds that buy shares of
other mutual funds.

Equity Funds
The largest category is that of equity or stock funds. As the name implies, this sort of
fund invests principally in stocks. Within this group are various subcategories. Some
equity funds are named for the size of the companies they invest in: small-, mid-, or
large-cap. Others are named by their investment approach: aggressive growth, income-
oriented, value, and others. Equity funds are also categorized by whether they invest in
domestic (U.S.) stocks or foreign equities. There are so many different types of equity
funds because there are many different types of equities. A great way to understand the
universe of equity funds is to use a style box, an example of which is below.

The idea here is to classify funds based on both the size of the companies invested in
(their market caps) and the growth prospects of the invested stocks. The term value
fund refers to a style of investing that looks for high-quality, low-growth companies that
are out of favor with the market. These companies are characterized by low price-to-
earnings (P/E) ratios, low price-to-book (P/B) ratios, and high dividend yields.
Conversely, spectrums are growth funds, which look to companies that have had (and
are expected to have) strong growth in earnings, sales, and cash flows. These
companies typically have high P/E ratios and do not pay dividends. A compromise
between strict value and growth investment is a "blend," which simply refers to
companies that are neither value nor growth stocks and are classified as being
somewhere in the middle.

Image by Julie Bang © Investopedia 2019

1

The other dimension of the style box has to do with the size of the companies that a
mutual fund invests in. Large-cap companies have high market capitalizations, with
values over $10 billion. Market cap is derived by multiplying the share price by the
number of shares outstanding. Large-cap stocks are typically blue chip firms that are
often recognizable by name. Small-cap stocks refer to those stocks with a market cap
ranging from $300 million to $2 billion. These smaller companies tend to be newer,
riskier investments. Mid-cap stocks fill in the gap between small- and large-cap.

A mutual fund may blend its strategy between investment style and company size. For
example, a large-cap value fund would look to large-cap companies that are in strong
financial shape but have recently seen their share prices fall and would be placed in the
upper left quadrant of the style box (large and value). The opposite of this would be a
fund that invests in startup technology companies with excellent growth prospects:
small-cap growth. Such a mutual fund would reside in the bottom right quadrant (small
and growth).

Fixed-Income Funds
Another big group is the fixed income category. A fixed-income mutual fund focuses on
investments that pay a set rate of return, such as government bonds, corporate bonds,
or other debt instruments. The idea is that the fund portfolio generates interest income,
which it then passes on to the shareholders.

Sometimes referred to as bond funds, these funds are often actively managed and seek
to buy relatively undervalued bonds in order to sell them at a profit. These mutual funds
are likely to pay higher returns than certificates of deposit and money market
investments, but bond funds aren't without risk. Because there are many different types
of bonds, bond funds can vary dramatically depending on where they invest. For
example, a fund specializing in high-yield junk bonds is much riskier than a fund that
invests in government securities. Furthermore, nearly all bond funds are subject
to interest rate risk, which means that if rates go up, the value of the fund goes down.

Index Funds
Another group, which has become extremely popular in the last few years, falls under
the moniker "index funds." Their investment strategy is based on the belief that it is very
hard, and often expensive, to try to beat the market consistently. So, the index fund
manager buys stocks that correspond with a major market index such as the S&P 500
or the Dow Jones Industrial Average (DJIA). This strategy requires less research from
analysts and advisors, so there are fewer expenses to eat up returns before they are
passed on to shareholders. These funds are often designed with cost-sensitive
investors in mind.

Balanced Funds
Balanced funds invest in a hybrid of asset classes, whether stocks, bonds, money
market instruments, or alternative investments. The objective is to reduce the risk of
exposure across asset classes.This kind of fund is also known as an asset allocation
fund. There are two variations of such funds designed to cater to the investors
objectives.

Some funds are defined with a specific allocation strategy that is fixed, so the investor
can have a predictable exposure to various asset classes. Other funds follow a strategy
for dynamic allocation percentages to meet various investor objectives. This may
include responding to market conditions, business cycle changes, or the changing
phases of the investor's own life.

While the objectives are similar to those of a balanced fund, dynamic allocation funds
do not have to hold a specified percentage of any asset class. The portfolio manager is
therefore given freedom to switch the ratio of asset classes as needed to maintain the
integrity of the fund's stated strategy.
Money Market Funds
The money market consists of safe (risk-free), short-term debt instruments, mostly
government Treasury bills. This is a safe place to park your money. You won't get
substantial returns, but you won't have to worry about losing your principal. A typical
return is a little more than the amount you would earn in a regular checking or savings
account and a little less than the average certificate of deposit (CD). While money
market funds invest in ultra-safe assets, during the 2008 financial crisis, some money
market funds did experience losses after the share price of these funds, typically
pegged at $1, fell below that level and broke the buck.

Income Funds
Income funds are named for their purpose: to provide current income on a steady basis.
These funds invest primarily in government and high-quality corporate debt, holding
these bonds until maturity in order to provide interest streams. While fund holdings may
appreciate in value, the primary objective of these funds is to provide steady cash flow
to investors. As such, the audience for these funds consists of conservative investors
and retirees. Because they produce regular income, tax-conscious investors may want
to avoid these funds.

International/Global Funds
An international fund (or foreign fund) invests only in assets located outside your home
country. Global funds, meanwhile, can invest anywhere around the world, including
within your home country. It's tough to classify these funds as either riskier or safer than
domestic investments, but they have tended to be more volatile and have unique
country and political risks. On the flip side, they can, as part of a well-balanced portfolio,
actually reduce risk by increasing diversification, since the returns in foreign countries
may be uncorrelated with returns at home. Although the world's economies are
becoming more interrelated, it is still likely that another economy somewhere is
outperforming the economy of your home country.

Specialty Funds
This classification of mutual funds is more of an all-encompassing category that
consists of funds that have proved to be popular but don't necessarily belong to the
more rigid categories we've described so far. These types of mutual funds forgo broad
diversification to concentrate on a certain segment of the economy or a targeted
strategy. Sector funds are targeted strategy funds aimed at specific sectors of the
economy, such as financial, technology, health, and so on. Sector funds can, therefore,
be extremely volatile since the stocks in a given sector tend to be highly correlated with
each other. There is a greater possibility for large gains, but a sector may also collapse
(for example, the financial sector in 2008 and 2009).

Regional funds make it easier to focus on a specific geographic area of the world. This
can mean focusing on a broader region (say Latin America) or an individual country (for
example, only Brazil). An advantage of these funds is that they make it easier to buy
stock in foreign countries, which can otherwise be difficult and expensive. Just like for
sector funds, you have to accept the high risk of loss, which occurs if the region goes
into a bad recession.

Socially responsible funds (or ethical funds) invest only in companies that meet the
criteria of certain guidelines or beliefs. For example, some socially responsible funds do
not invest in "sin" industries such as tobacco, alcoholic beverages, weapons, or nuclear
power. The idea is to get competitive performance while still maintaining a healthy
conscience. Other such funds invest primarily in green technology, such as solar and
wind power or recycling.

Exchange Traded Funds (ETFs)

A twist on the mutual fund is the exchange traded fund (ETF). These ever more popular
investment vehicles pool investments and employ strategies consistent with mutual
funds, but they are structured as investment trusts that are traded on stock exchanges
and have the added benefits of the features of stocks. For example, ETFs can be
bought and sold at any point throughout the trading day. ETFs can also be sold short or
purchased on margin. ETFs also typically carry lower fees than the equivalent mutual
fund. Many ETFs also benefit from active options markets, where investors
can hedge or leverage their positions. ETFs also enjoy tax advantages from mutual
funds. Compared to mutual funds, ETFs tend to be more cost effective and more liquid.
The popularity of ETFs speaks to their versatility and convenience.

Mutual Fund Fees

A mutual fund will classify expenses into either annual operating fees or shareholder
fees. Annual fund operating fees are an annual percentage of the funds under
management, usually ranging from 1–3%. Annual operating fees are collectively known
as the expense ratio. A fund's expense ratio is the summation of the advisory or
management fee and its administrative costs.

Shareholder fees, which come in the form of sales charges, commissions, and
redemption fees, are paid directly by investors when purchasing or selling the funds.
Sales charges or commissions are known as "the load" of a mutual fund. When a
mutual fund has a front-end load, fees are assessed when shares are purchased. For a
back-end load, mutual fund fees are assessed when an investor sells his shares.

Sometimes, however, an investment company offers a no-load mutual fund, which

doesn't carry any commission or sales charge. These funds are distributed directly by
an investment company, rather than through a secondary party.

Some funds also charge fees and penalties for early withdrawals or selling the holding
before a specific time has elapsed. Also, the rise of exchange-traded funds, which have
much lower fees thanks to their passive management structure, have been giving
mutual funds considerable competition for investors' dollars. Articles from financial
media outlets regarding how fund expense ratios and loads can eat into rates of return
have also stirred negative feelings about mutual funds.
Classes of Mutual Fund Shares
Mutual fund shares come in several classes. Their differences reflect the number and
size of fees associated with them.

Currently, most individual investors purchase mutual funds with A shares through a

broker. This purchase includes a front-end load of up to 5% or more, plus management
fees and ongoing fees for distributions, also known as 12b-1 fees. To top it off, loads on
A shares vary quite a bit, which can create a conflict of interest. Financial advisors
selling these products may encourage clients to buy higher-load offerings to bring in
bigger commissions for themselves. With front-end funds, the investor pays these
expenses as they buy into the fund.

To remedy these problems and meet fiduciary-rule standards, investment companies

have started designating new share classes, including "level load" C shares, which
generally don't have a front-end load but carry a 1% 12b-1 annual distribution fee.

Funds that charge management and other fees when an investor sell their holdings are
classified as Class B shares.

A New Class of Fund Shares

The newest share class, developed in 2016, consists of clean shares. Clean shares do
not have front-end sales loads or annual 12b-1 fees for fund services. American Funds,
Janus, and MFS are all fund companies currently offering clean shares.

By standardizing fees and loads, the new classes enhance transparency for mutual fund
investors and, of course, save them money. For example, an investor who rolls $10,000
into an individual retirement account (IRA) with a clean-share fund could earn nearly
$1,800 more over a 30-year period as compared to an average A-share fund, according
to an April 2017 Morningstar report co-written by Aron Szapiro, Morningstar director of
policy research, and Paul Ellenbogen, head of global regulatory solutions. 2

Advantages of Mutual Funds

There are a variety of reasons that mutual funds have been the retail investor's vehicle
of choice for decades. The overwhelming majority of money in employer-sponsored
retirement plans goes into mutual funds. Multiple mergers have equated to mutual funds
over time.

Diversification
Diversification, or the mixing of investments and assets within a portfolio to reduce risk,
is one of the advantages of investing in mutual funds. Experts advocate diversification
as a way of enhancing a portfolio's returns, while reducing its risk. Buying individual
company stocks and offsetting them with industrial sector stocks, for example, offers
some diversification. However, a truly diversified portfolio has securities with different
capitalizations and industries and bonds with varying maturities and issuers. Buying a
mutual fund can achieve diversification cheaper and faster than by buying individual
securities. Large mutual funds typically own hundreds of different stocks in many
different industries. It wouldn't be practical for an investor to build this kind of a portfolio
with a small amount of money.

Easy Access
Trading on the major stock exchanges, mutual funds can be bought and sold with
relative ease, making them highly liquid investments. Also, when it comes to certain
types of assets, like foreign equities or exotic commodities, mutual funds are often the
most feasible way—in fact, sometimes the only way—for individual investors
to participate.

Economies of Scale
Mutual funds also provide economies of scale. Buying one spares the investor of the
numerous commission charges needed to create a diversified portfolio. Buying only one
security at a time leads to large transaction fees, which will eat up a good chunk of the
investment. Also, the $100 to $200 an individual investor might be able to afford is
usually not enough to buy a round lot of the stock, but it will purchase many mutual fund
shares. The smaller denominations of mutual funds allow investors to take advantage of
dollar cost averaging.

Because a mutual fund buys and sells large amounts of securities at a time,
its transaction costs are lower than what an individual would pay for securities
transactions. Moreover, a mutual fund, since it pools money from many smaller
investors, can invest in certain assets or take larger positions than a smaller investor
could. For example, the fund may have access to IPO placements or certain structured
products only available to institutional investors.

Professional Management
A primary advantage of mutual funds is not having to pick stocks and manage
investments. Instead, a professional investment manager takes care of all of this using
careful research and skillful trading. Investors purchase funds because they often do not
have the time or the expertise to manage their own portfolios, or they don't have access
to the same kind of information that a professional fund has. A mutual fund is a
relatively inexpensive way for a small investor to get a full-time manager to make and
monitor investments. Most private, non-institutional money managers deal only
with high-net-worth individuals—people with at least six figures to invest. However,
mutual funds, as noted above, require much lower investment minimums. So, these
funds provide a low-cost way for individual investors to experience and hopefully benefit
from professional money management.

Variety and Freedom of Choice

Investors have the freedom to research and select from managers with a variety of
styles and management goals. For instance, a fund manager may focus on value
investing, growth investing, developed markets, emerging markets, income, or
macroeconomic investing, among many other styles. One manager may also oversee
funds that employ several different styles. This variety allows investors to gain exposure
to not only stocks and bonds but also commodities, foreign assets, and real estate
 through specialized mutual funds. Some mutual funds are even structured to profit from
a falling market (known as bear funds). Mutual funds provide opportunities for foreign
and domestic investment that may not otherwise be directly accessible to ordinary
investors.

Transparency
Mutual funds are subject to industry regulation that ensures accountability and fairness
to investors.

Pros
 Liquidity

 Diversification

 Minimal investment requirements

 Professional management

 Variety of offerings

Cons
 High fees, commissions, and other expenses

 Large cash presence in portfolios

 No FDIC coverage

 Difficulty in comparing funds

 Lack of transparency in holdings

FD RATE – 3- 7.2- 8% FROM 7 DAYS,1YR TO 10 YRS

RETAIL INFLATION- 6.93%

WHOLSALE INFLATION –
What Is Expected Return?
The expected return is the profit or loss an investor anticipates on an investment that
has known or anticipated rates of return (RoR). It is calculated by multiplying potential
outcomes by the chances of them occurring and then totaling these results. For
example, if an investment has a 50% chance of gaining 20% and a 50% chance of
losing 10%, the expected return is 5% (50% x 20% + 50% x -10% = 5%).

Annual Realized Return

Realized annual return is merely how much money you gained or lost by holding onto a stock for
a year. To calculate it, add the price at the end of the year to the amount of dividends you
received and subtract the stock's price at the beginning of the year.

Let's assume you bought a share of Widget Corp. stock at $10 a year ago. It's now worth $12.10
per share, and it paid a 25-cent dividend. The realized annual return would be $12.10 plus 25
cents minus $10, or $2.35 per share.

Realized Versus Expected Returns

Realized returns are best used to gauge a stock's performance in the past rather than to project
earnings into the next year. To forecast a stock's potential returns for a year, refer to its
expected return. This measure averages the stock's annual return rates over a given period and
can be calculated by adding all rates of return for the period, divided by the number of rates of
return added.

Low risk investment options

Not being comfortable with sharp movements in your investments means you should avoid
equities. So opting for low risk investment options is a good idea. All these are low risk – low
return investments, which is natural, since risk and return go hand in hand.
 FD
Fixed deposits (FDs) are well-suited for the risk averse investor. With the proposition of
assured returns and safety of capital, FDs rank high on his to-invest list.
 PPF
The Public Provident Fund (PPF) is a government sponsored savings and retirement
planning investment. It is particularly meaningful for individuals who do not have a
structured pension plan covering them.
  Life insurance 
Securing the family’s finances in his absence is the key responsibility of the breadwinner.
The best way to achieve this is by opting for an endowment (protection) plan or a life
insurance plan.
An endowment plan is a ‘with profits’ plan that offers life cover combined with savings.
There is a payout regardless of whether the policyholder survives the term or not.
Traditional endowment plans invest primarily in fixed income securities like government
bonds and corporate paper and are well-suited for low risk investors.

High return investments

For investors with an appetite for risk, there are just as many options, all revolving around
equities. Listed over here are the more relevant ones:
 Direct equities
Equities offer risk-taking investors the best chance to achieve their financial goals. While
every asset is important in its own peculiar way, over the long-term equities have a
proven track record vis-à-vis other assets and cannot be ignored.
One way to make the most of equities is by investing directly in stockmarkets. This
requires some skill and time since studying companies, sectors, economic factors,
requires considerable resources. So direct investing is not for everyone.
For those who cannot invest directly in stockmarkets, there is always another way,
explained under the next option.
 Equity funds
If you lack the requisite time and effort, the best way to go about investing in equities is
through mutual funds. Mutual funds are managed by fund managers, who are experts and
stand a better chance of succeeding at identifying the right companies.
 ULIPs
ULIPs or unit-linked insurance plans are a variant of the endowment plan with
investments in the portfolio being linked to stockmarkets. They offer risk-taking
individuals an opportunity to select a product suited to their risk profile and investment
objectives. Since ULIPs offer many options, individuals with varying risk profiles can
consider investing in them.




 PRIMARY AND SECONDAEY MARKET
 The primary market is where securities are created, while the secondary market
is where those securities are traded by investors.
  In the primary market, companies sell new stocks and bonds to the public for the
first time, such as with an initial public offering (IPO).
 The secondary market is basically the stock market and refers to the New York
Stock Exchange, the Nasdaq, and other exchanges worldwide

OVER THE COUNTER MARKET

An over-the-counter (OTC) market is a decentralized market in
which market participants trade stocks, commodities, currencies or other instruments
directly between two parties and without a central exchange or broker. Over-the-
counter markets do not have physical locations; instead, trading is conducted
electronically

Private placement
 (or non-public offering) is a funding round of securities which are sold not through
a public offering, but rather through a private offering, mostly to a small number of
chosen investors. Generally, these investors include friends and family, accredited
investors, and institutional investors. [1]
PIPE (Private Investment in Public Equity) deals are one type of private
placement. SEDA (Standby Equity Distribution Agreement) is also a form of private
placement. They are often a cheaper source of capital than a public offering.
Since private placements are not offered to the general public, they
are prospectus exempt. Instead, they are issued through Offering Memorandum. Private
placements come with a great deal of administration and are have normally been sold
through financial institutions such as investment banks. New FinTech companies now
offer an automated, online process making it easier to reach potential investors and
reduce the administration.

Defining a Rights Issue 

A rights issue is an invitation to existing shareholders to purchase additional new shares
in the company. This type of issue gives existing shareholders securities called rights.
With the rights, the shareholder can purchase new shares at a discount to the market
price on a stated future date. The company is giving shareholders a chance to increase
their exposure to the stock at a discount price.
NSDL
National Securities Depository Limited (NSDL) is an Indian central securities
depository based in Mumbai.[3] It was established in August 1996 as the first electronic
securities depository in India with national coverage.
National Securities Depository Limited (NSDL) is a financial organization created to hold
securities such as bonds, shares etc. in the form of physical or non-physical certificates
i.e. in dematerialized format. These securities are held in depository accounts such as
funds held in bank accounts. It facilitates prompt transfer of securities as ownership is
transferred simply through book entries. This is usually done electronically thus
eliminating the extra time that was taken in following the traditional practice where
physical certificates had to be exchanged after a trade was completed.

There are two central depositories in India –

 National Security Depository Limited (NSDL) and

 Central Depository Services Limited (CDSL)

NSDL and CDSL difference lies in the following points:

 Stock Exchange: CDSL works for BSE and NSDL works for NSE

however the exchanges can use either of the two depositories for trading and

settlement of securities.

 Promoters: Another difference between the two are their promoters.

NSDL is promoted by IDBI Bank Ltd., Unit trust of India and NSE. CDSL is

promoted only by BSE as on December 2019.

Definition of 'Venture Capital'

Definition: Start up companies with a potential to grow need a certain amount of

investment. Wealthy investors like to invest their capital in such businesses with a long-
term growth perspective. This capital is known as venture capital and the investors are
called venture capitalists.

Description: Such investments are risky as they are illiquid, but are capable of giving
impressive returns if invested in the right venture. The returns to the venture capitalists
depend upon the growth of the company. Venture capitalists have the power to
influence major decisions of the companies they are investing in as it is their money at
stake

HEDGE FUND
A hedge fund is an investment fund that trades in relatively liquid assets and is able to
make extensive use of more complex trading, portfolio-construction and risk
management techniques to improve performance, such as short selling, leverage,
and derivatives.[1] Because of its use of complex techniques, financial
regulators typically do not allow hedge funds to be marketed or made available to
anyone except institutional investors, high net worth individuals and other investors who
are considered sufficiently sophisticated, such as being an accredited investor.[2]
Hedge funds are regarded as alternative investments. Their ability to make more
extensive use of leverage and more complex investment techniques distinguishes them
from regulated investment funds available to the retail market, such as US mutual funds
and UCITS. They are also considered distinct from private equity funds and other
similar closed-end funds, as hedge funds generally invest in relatively liquid assets and
are generally open-ended, meaning that they allow investors to invest and withdraw
capital periodically based on the fund's net asset value, whereas private equity
funds generally invest in illiquid assets and only return capital after a number of years.[3]
[4]
 However, other than a fund's regulatory status there are no formal or fixed definitions
of fund types, and so there are different views of what can constitute a "hedge fund".

growth stock 

In finance, a growth stock is a stock of a company that generates substantial and

sustainable positive cash flow and whose revenues and earnings are expected to
increase at a faster rate than the average company within the same industry. [1] A growth
company typically has some sort of competitive advantage (a new product, a
breakthrough patent, overseas expansion) that allows it to fend off competitors. Growth
stocks usually pay smaller dividends, as the company typically reinvests retained
earnings in capital projects.
 Value Stocks
Value stocks tend to trade at a lower price relative to their fundamentals, such as
dividends, earnings, and sales, making them appealing to investors with longer time
horizons.

Value Investing Definition

Value investors like Warren Buffett select undervalued stocks trading at less than their intrinsic
book value that have long-term potential.

What is Unlevered Free Cash Flow (FCF)

Unlevered Free Cash Flow, also known as UFCF or Free Cash Flow to Firm (FCFF), is
a measure of a company’s cash flow that includes only items that are:

 Related to or “available” to all investors in the company – Debt, Equity, Preferred,

and others (in other words, “Free Cash Flow to ALL Investors”) AND

 That are recurring for the company’s core-business operations

What Is Levered Cash Flow vs. Unlevered Free Cash Flow?

The difference between levered and unlevered free cash flow is expenses. Levered
cash flow is the amount of cash a business has after it has met its financial
obligations. Unlevered free cash flow is the money the business has before paying its
financial obligations. Operating expenses and interest payments are examples of
financial obligations that are paid from levered free cash flow.

 Levered cash flow is the amount of cash a business has after it has met its
financial obligations. 
  Unlevered free cash flow is the money the business has before paying its
financial obligations.
 It is possible for a business to have a negative levered cash flow if its expenses
exceed its earnings.

What Is a Sunk Cost?

 Sunk costs are those which have already been incurred and which are
unrecoverable.
 In business, sunk costs are typically not included in consideration when making
future decisions, as they are seen as irrelevant to current and future budgetary
concerns.
 Sunk costs are in contrast to relevant costs, which are future costs that have yet
to be incurred.

What Is a Minority Interest?

A minority interest is ownership or interest of less than 50% of an enterprise. The term
can refer to either stock ownership or a partnership interest in a company. The minority
interest of a company is held by an investor or another organization other than
the parent company. Minority interests generally come with some rights for the
stakeholder such as the participation in sales and certain audit rights.

 A minority interest is ownership or interest of less than 50% of an enterprise.

 Minority interests generally range between 20% and 30%, and stakeholders have
very little say or influence in the enterprise.
 Companies with a majority interest will list the minority interest on their balance
sheet as a noncurrent liability.

What Is Internal Rate of Return (IRR)?

The internal rate of return is a metric used in financial analysis to estimate the
profitability of potential investments. The internal rate of return is a discount rate that
makes the net present value (NPV) of all cash flows equal to zero in a discounted cash
flow analysis.

In theory, any project with an IRR greater than its cost of capital should be a profitable
one. In planning investment projects, firms will often establish a required rate of
return (RRR) to determine the minimum acceptable return percentage that the
investment in question must earn in order to be worthwhile. The RRR will be higher than
the WACC.

Any project with an IRR that exceeds the RRR will likely be deemed a profitable one,
although companies will not necessarily pursue a project on this basis alone. Rather,
they will likely pursue projects with the highest difference between IRR and RRR, as
these likely will be the most profitable.

What is a Certificate of Deposit (CD)?

A certificate of deposit (CD) is a product offered by banks and credit unions that
provides an interest rate premium in exchange for the customer agreeing to leave
a lump-sum deposit untouched for a predetermined period of time. Almost all consumer
financial institutions offer them, although it’s up to each bank which CD terms it wants to
offer, how much higher the rate will be compared to the bank’s savings and money
market products, and what penalties it applies for early withdrawal

What is Market Capitalization

Market capitalization refers to the total dollar market value of a company's
outstanding shares of stock. Commonly referred to as "market cap," it is calculated by
multiplying the total number of a company's outstanding shares by the current market
price of one share.

 Market capitalization refers to how much a company is worth as determined by

the stock market. It is defined as the total market value of all outstanding shares.
 To calculate a company's market cap, multiply the number of outstanding shares
by the current market value of one share.
 Companies are typically divided according to market capitalization: large-cap
($10 billion or more), mid-cap ($2 billion to $10 billion), and small-cap ($300
million to $2 billion).

Mezzanine financing
 is a hybrid of debt and equity financing that gives the lender the right to convert
to an equity interest in the company in case of default, generally, after venture
capital companies and other senior lenders are paid

What Is a Special Purpose Vehicle (SPV)?

A special purpose vehicle, also called a special purpose entity (SPE), is a subsidiary
created by a parent company to isolate financial risk. Its legal status as a separate
company makes its obligations secure even if the parent company goes bankrupt.

What Are Capital Markets?

  Capital markets refer to the places where savings and investments are moved
between suppliers of capital and those who are in need of capital.
 Capital markets consist of the primary market, where new securities are issued
and sold, and the secondary market, where already-issued securities are traded
between investors.
 The most common capital markets are the stock market and the bond market
Understanding Capital Markets
The term capital market broadly defines the place where various entities trade different
financial instruments. These venues may include the stock market, the bond market,
and the currency and foreign exchange markets

Primary vs. Secondary Markets

It is important to understand the distinction between the secondary market and the
primary market. When a company issues stock or bonds for the first time and sells
those securities directly to investors, that transaction occurs on the primary market.
Some of the most common and well-publicized primary market transactions are IPOs, or
initial public offerings. During an IPO, a primary market transaction occurs between the
purchasing investor and the investment bank underwriting the IPO. Any proceeds from
the sale of shares of stock on the primary market go to the company that issued the
stock, after accounting for the bank's administrative fees.

If these initial investors later decide to sell their stake in the company, they can do so on
the secondary market. Any transactions on the secondary market occur between
investors, and the proceeds of each sale go to the selling investor, not to the company
that issued the stock or to the underwriting bank.

Secondary Market Pricing

Primary market prices are often set beforehand, while prices in the secondary market
are determined by the basic forces of supply and demand. If the majority of investors
believe a stock will increase in value and rush to buy it, the stock's price will typically
rise. If a company loses favor with investors or fails to post sufficient earnings, its stock
price declines as demand for that security dwindles.

HEDGE FUND

 Hedge funds are financial partnerships that use pooled funds and employ
different strategies to earn active returns for their investors.
 These funds may be managed aggressively or make use of derivatives and
leverage to generate higher returns.
 Hedge fund strategies include long-short equity, market neutral, volatility
arbitrage, and merger arbitrage.
 They are generally only accessible to accredited investors.
Hedge Fund Partnerships
A hedge fund's purpose is to maximize investor returns and eliminate risk. If this
structure and objectives sound a lot like those of mutual funds, they are, but
that's where the similarities end. Hedge funds are generally considered to be more
aggressive, risky, and exclusive than mutual funds. In a hedge fund, limited partners
contribute funding for the assets while the general partner manages the according to its
strategy. 

 Because they are not as regulated as mutual funds or traditional financial

advisors, hedge funds are only accessible to sophisticated investors.
 These so-called accredited investors are high net-worth individuals or
organizations and are presumed to understand the unique risks associated with
hedge funds.
 For ordinary individuals, investing in the stock of a financial company that
operates hedge funds could be a way to gain indirect access.

Key Differences B/W HEDGE FUND AND PRIVATE EQUITY

1. Time Horizon: Since hedge funds are focused on primarily liquid assets, investors
can usually cash out their investments in the fund at any time. In contrast, the long-term
focus of private equity funds usually dictates a requirement that investors commit their
funds for a minimum period of time, usually at least three to five years, and often from
seven to 10 years.

2. Investment Risk: There is also a substantial difference in risk level between hedge

funds and private equity funds. While both practice risk management by combining
higher-risk investments with safer investments, the focus of hedge funds on achieving
maximum short-term profits necessarily involves accepting a higher level of risk.

3. Lock-up and Liquidity: Both hedge funds and private equity typically require large
balances, anywhere from $100,000 to upwards of a million dollars or more per investor.
Hedge funds may then lock those funds up for a period of months to a year, preventing
investors from withdrawing their money until that time has elapsed. This lock-up
period allows the fund to properly allocate those monies to investments in their strategy,
which could take some time. The lock-up period for a private equity fund will be far
longer, such as 3, 5 or 7 years. This is because a private equity investment is less liquid
and needs time for the company being invested in to turn around.
4. Investment Structure: Most hedge funds are open-ended, meaning that investors can
continually add or redeem their shares in the fund at any time. Private equity funds, on
the other hand, are closed-ended, meaning that new money cannot be invested after an
initial period has expired.

Absolute and Relative Returns

Similar to mutual fund performance analysis, hedge funds should be evaluated for both
absolute and relative return performance. However, because of the variety of hedge
fund strategies and the uniqueness of each hedge fund, a good understanding of the
different types of returns is necessary in order to identify them. 2

Absolute returns give the investor an idea of where to categorize the fund in comparison
to the more traditional types of investments. Also referred to as the total return, absolute
return measures the gain or loss experienced by a fund.

For example, a hedge fund with low and stable returns is probably a better substitute for
fixed income investments than it would be for emerging market equities, which might be
replaced by a high-return global macro fund.

Relative returns, on the other hand, allow an investor to determine a fund's

attractiveness compared to other investments. The comparables can be other hedge
funds, mutual funds or even certain indexes that an investor is trying to mimic. The key
to evaluating relative returns is to determine performance over several time periods,
such as one-, three- and five-year annualized returns. In addition, these returns should
also be considered relative to the risk inherent in each investment.

The best method to evaluate relative performance is to define a list of peers, which
could include a cross-section of traditional mutual funds, equity or fixed-income indexes
and other hedge funds with similar strategies. A good fund should perform in the
top quartiles for each period being analyzed in order to effectively prove its alpha-
generating ability.

Standard Deviation
Among the advantages of using standard deviation as a measure of risk are its ease of
calculation and the simplicity of the concept of a normal distribution of returns.
Unfortunately, that is also the reason for its weakness in describing the inherent risks in
hedge funds. Most hedge funds do not have symmetrical returns, and the standard
deviation metric can also mask the higher-than-expected probability of large losses

Value at Risk (VaR)

Value at risk is a risk metric that is based on a combination of mean and standard
deviation.5 Unlike standard deviation, however, it does not describe risk in terms of
volatility, but rather as the highest amount that is likely to be lost with a five
percent probability. In a normal distribution, it is represented by the leftmost five
percent of probable results. The drawback is that both the amount and probability can
be underestimated because of the assumption of normally distributed returns. It should
still be evaluated when performing quantitative analysis, but an investor should also
consider additional metrics when evaluating risk.

Skewness
Skewness is a measure of the asymmetry of returns, and analyzing this metric can shed
additional light on the risk of a fund.6

The figure below shows two graphs with identical means and standard deviations. The
graph on the left is positively skewed. This means the mean > median > mode. Notice
how the right tail is longer and the results on the left are bunched up towards the center.
Although these results indicate a higher probability of a result that is less than the mean,
it also indicates the probability, albeit low, of an extremely positive result as indicated by
the long tail on the right side.

Figure 1: Positive skewness and negative skewness. Image by Julie Bang © Investopedia 2020

A skewness of approximately zero indicates a normal distribution. Any skewness
measure that is positive would more likely resemble the distribution on the left, while
negative skewness resembles the distribution on the right. As you can see from the
graphs, the danger of a negatively skewed distribution is the probability of a very
negative result, even if the probability is low

Sharpe Ratio
One of the most popular measures of risk-adjusted returns used by hedge funds is
the Sharpe ratio.7 The Sharpe ratio indicates the amount of additional return obtained
for each level of risk taken. A Sharpe ratio greater than 1 is good, while ratios below 1
can be judged based on the asset class or investment strategy used. In any case, the
inputs to the calculation of the Sharpe ratio are mean, standard deviation and the risk-
free rate, so Sharpe ratios may be more attractive during periods of low-interest rates
and less attractive during periods of higher interest rates.

Kurtosis
Kurtosis is a measure of the combined weight of a distribution's tails relative to the rest
of the distribution.6

In Figure 2 below, the distribution on the left exhibits negative kurtosis, indicating a
lower probability of results around the mean, and lower probability of extreme values. A
positive kurtosis, the distribution on the right, indicates a higher probability of results
near the mean, but also a higher probability of extreme values. In this case, both
distributions also have the same mean and standard deviation, so an investor can begin
to get an idea of the importance of analyzing the additional risk metrics beyond standard
deviation and VAR.

Beta
Beta is called systematic risk and is a measure of a fund's returns relative to the returns
on an index.8 A market or index being compared is assigned a beta of 1. A fund with a
beta of 1.5, therefore, will tend to have a return of 1.5 percent for every
1 percent movement in the market/index. A fund with a beta of 0.5, on the other hand,
will have a 0.5 percent return for every 1 percent return on the market.

Beta is an excellent measure of determining how much equity exposure — to a

particular asset class — a fund has and allows an investor to determine if and/or how
large allocation to a fund is warranted. Beta can be measured relative to any benchmark
index, including equity, fixed-income or hedge fund indexes, to reveal a fund's sensitivity
to movements in the particular index. Most hedge funds calculate beta relative to
the S&P 500 index since they are selling their returns based on their relative
insensitivity/correlation to the broader equity market.

Correlation
Correlation is very similar to beta in that it measures relative changes in returns.
However, unlike beta, which assumes that the market drives the performance of a fund
to some extent, correlation measures how related the returns of two funds might
be. Diversification, for example, is based on the fact that different asset classes and
investment strategies react differently to systematic factors.

Correlation is measured on a scale of -1 to +1, where -1 indicates a perfect negative

correlation, zero indicates no apparent correlation at all, and +1 indicates a
perfect positive correlation. A perfect negative correlation can be achieved by
comparing the returns on a long S&P 500 position with a short S&P 500 position.
Obviously, for every percent increase in one position, there will be an equal
percent decrease in the other.

The best use of correlation is to compare the correlation of each fund in a portfolio with
each of the other funds in that portfolio. The lower the correlation these funds have to
each other, the more likely the portfolio is well diversified. However, an investor should
be wary of too much diversification, as returns may be dramatically reduced.
  Hedge funds that invest in distressed debt purchase the bonds of firms that have
filed for bankruptcy or are likely to do so in the near future.
 Hedge funds purchase these bonds at a steep discount of their face value in the
anticipation that the company will successfully emerge from bankruptcy as a
viable enterprise.
 If the failing company turns its fortunes around, the value of its bonds will
increase, giving the hedge fund an opportunity to reap substantial profits.
 Because owning distressed debt is risky, hedge funds can limit their risks by
taking relatively small positions in distressed companies

What Is Real Estate?

Real estate is the land along with any permanent improvements attached to the land,
whether natural or man-made—including water, trees, minerals, buildings, homes,
fences, and bridges. Real estate is a form of real property. It differs from personal
property, which are things not permanently attached to the land, such as vehicles,
boats, jewelry, furniture, and farm equipment.

 Real estate is a class of "real property" that includes land and anything
permanently attached to it, whether natural or man-made.
 There are five main categories of real estate: residential; commercial; industrial;
raw land; and special use.
 You can invest in real estate directly by purchasing a home, rental property or
other property, or indirectly through a real estate investment trust (REIT).
Understanding Real Estate
People often use the terms land, real estate,and real property interchangeably, but
there are some subtle distinctions.

 Land refers to the earth's surface down to the center of the earth and upward to
the airspace above, including the trees, minerals, and water.
 Real estate is the land, plus any permanent man-made additions, such as
houses and other buildings

Physical Characteristics of Real Estate

Land has three physical characteristics that differentiate it from other assets in the
economy:
 1. Immobility. While some parts of land are removable and the topography can be
altered, the geographic location of any parcel of land can never be changed.
2. Indestructibility. Land is durable and indestructible (permanent).
3. Uniqueness. No two parcels of land can be exactly the same. Even though they
may share similarities, every parcel differs geographically

Types of Real Estate

There are five main types of real estate:

1. Residential real estate. Any property used for residential purposes. Examples

include single-family homes, condos, cooperatives, duplexes, townhouses, and
multifamily residences with fewer than five individual units.
2. Commercial real estate. Any property used exclusively for business purposes,
such as apartment complexes, gas stations, grocery stores, hospitals, hotels,
offices, parking facilities, restaurants, shopping centers, stores, and theaters.
3. Industrial real estate. Any property used for manufacturing, production,
distribution, storage, and research and development. Examples include factories,
power plants, and warehouses.
4. Land. Includes undeveloped property, vacant land, and agricultural land (farms,
orchards, ranches, and timberland).
5. Special purpose. Property used by the public, such as cemeteries, government
buildings, libraries, parks, places of worship, and schools.

How To Invest in Real Estate

There are a number of ways to invest in real estate. Some of the most common ways to
invest directly include:

 Homeownership
 Rental properties
 House flipping

If you buy physical property (e.g., rental properties, house flipping), you can make
money two different ways: Revenue from rent or leases, and appreciation of the real
estate's value. Unlike other investments, real estate is dramatically affected by its
location. Factors such as employment rates, the local economy, crime rates,
transportation facilities, school quality, municipal services and property taxes can drive
real estate prices up or down.

Mortgage-Backed Securities
Another option for investing in real estate is via mortgage-backed securities (MBS).
These received a lot of bad press due to the role they played in the mortgage meltdown
that triggered a global financial crisis in 2007-08. 3 However, MBS are still in existence
and traded.

The most accessible way for the average investor to buy into these products is
via ETFs. Like all investments, these products carry a degree of risk. However, they
may also offer portfolio diversification. Investors must investigate the holdings to ensure
the funds specialize in investment-grade mortgage-backed securities, not the subprime
variety that figured in the crisis.

How to Make Money in Real Estate

Property value increases and rental income are just two ways to profit

 The most common way to make money in real estate is through appreciation—an
increase in the property's value that is realized when you sell.
 Location, development, and improvements are the primary ways that residential
and commercial real estate can appreciate in value.
 Inflation can also play a role in increasing a property's value over time.
 You can also make money in the form of income from rents for both residential
and commercial properties, and companies may pay you royalties on raw land,
for example, for any discoveries, such as minerals or oil.
 Real estate investment trusts (REITs), mortgage-backed securities (MBSs),
mortgage investment corporations (MICs), and real estate investment groups
(REIGs) are investment alternatives within the real estate sector.
What Is a Real Estate Investment Trust (REIT)?
A real estate investment trust (REIT) is a company that owns, operates, or finances
income-generating real estate. Modeled after mutual funds, REITs pool the capital of
numerous investors. This makes it possible for individual investors to earn dividends
from real estate investments—without having to buy, manage, or finance any properties
themselves.

ypes of REITs
There are three types of REITs:

 Equity REITs. Most REITs are equity REITs, which own and manage income-
producing real estate. Revenues are generated primarily through rents (not by
reselling properties).
 Mortgage REITs. Mortgage REITs lend money to real estate owners and
operators either directly through mortgages and loans, or indirectly through the
acquisition of mortgage-backed securities. Their earnings are generated primarily
by the net interest margin—the spread between the interest they earn on
mortgage loans and the cost of funding these loans. This model makes them
potentially sensitive to interest rate increases.
 Hybrid REITs. These REITs use the investment strategies of both equity and
mortgage REITs.3  

 
Owns and operates income-producing real
Equity
estate
 
 
Mortgag
Holds mortgages on real property
e
    
Hybrid Owns properties and holds mortgages
REITs can be further classified based on how their shares are bought and held:

 Publicly Traded REITs. Shares of publicly traded REITs are listed on a national

securities exchange, where they are bought and sold by individual investors.
They are regulated by the U.S. Securities and Exchange Commission (SEC).
 Public Non-Traded REITs. These REITs are also registered with the SEC but
don’t trade on national securities exchanges. As a result, they are less liquid than
publicly traded REITs. Still, they tend to be more stable because they’re not
subject to market fluctuations.
 Private REITs. These REITs aren’t registered with the SEC and don’t trade on
national securities exchanges. In general, private REITs can be sold only to
institutional investors.

Pros
 Liquidity
 Diversification
 Transparency
 Stable cash flow through dividends
 Attractive risk-adjusted returns

Cons
 Low growth
 Dividends are taxed as regular income
 Subject to market risk
 Potential for high management and transaction fees

REIT vs. Real Estate Fund: What's the Difference?

REITS pay out dividends; real estate funds can appreciate in value

A REIT is a corporation, trust, or association that invests directly in income-producing

real estate and is traded like a stock. A real estate fund is a type of mutual fund that
primarily focuses on investing in securities offered by public real estate companies.
While you can use either to diversify your investment portfolio, there are key differences
to know.

KEY TAKEAWAYS

 A real estate investment trust (REIT) is a corporation that invests in income-

producing real estate and is bought and sold like a stock.
 A real estate fund is a type of mutual fund that invests in securities offered by
public real estate companies, including REITs.
  REITs pay out regular dividends, while real estate funds provide value through
appreciation.

 REITs are companies that own, operate, or finance income-producing properties.

 Equity REITs own and operate properties and generate revenue primarily
through rental income.
 Mortgage REITs invest in mortgages, mortgage-backed securities, and related
assets and generate revenue through interest income.
 REITs are generally required to have at least 100 investors, and regulations
prevent what would otherwise be a potentially nefarious workaround: having a
small number of investors own a majority of the interest in the REIT.

 At least 75% of a REIT’s assets must be in real estate, and at least 75% of its
gross income must be derived from rents, mortgage interest, or gains from the
sale of the property.

 Also, REITs are required by law to pay out at least 90% of annual taxable income
(excluding capital gains) to their shareholders in the form of dividends. This
restriction, however, limits a REIT’s ability to use internal cash flow for growth
purposes.

How to Assess a Real Estate Investment Trust (REIT)

 Traditional metrics such as earnings per share (EPS) and P/E ratio are not a
reliable way to estimate the value of a REIT.
 A better metric to use is funds from operations (FFO), which makes adjustments
for depreciation, preferred dividends, and distributions.
 It's best to use FFO in conjunction with other metrics like growth rates, dividend
history, and debt ratios

What Is a Captive Real Estate Investment Trust?

A captive real estate investment trust is simply a real estate investment trust (REIT) with
controlling ownership by a single company. A company that owns real estate associated
with its business may find it advantageous to bundle the properties into a REIT for the
special tax breaks. This tax mitigation strategy can be used by retailers and banks with
many stores or branches.

 A captive REIT is any REIT with greater than 50% ownership stake by a single
company.
  Captive REITs are usually subsidiaries.
 As REITs, captive REITs enjoy all of the tax advantages of a standard REIT.
 Comprehensively, captive REIT accounting can be complex for a parent
company and the captive REIT subsidiary.
 Accounting and tax professionals should ensure they are fully compliant with all
federal and state laws encompassing captive REITs
Understanding Captive Real Estate Investment Trusts
A captive real estate investment trust can be created to take advantage of the tax
breaks offered by a real estate investment trust (REIT). Companies may choose to
develop or take controlling ownership in a REIT for captive status. Controlling or captive
status is defined as more than 50% of the voting ownership stake of a REIT.

Companies that build a captive REIT to manage their own real estate properties will
typically characterize them as either rental or mortgage REITs. Mortgage REITs
(mREITs) provide mortgage capital for the promise of reciprocal income, which is often
the basis for a REIT’s revenue. Companies may also use captive real estate investment
trusts by transferring real estate into a REIT, and then renting the properties from those
REITs

a company must meet the following requirements t qualify as a REIT:

 Taxable as a corporation
 Pay at least 90% of taxable income in the form of shareholder dividends each
year
 Derive at least 75% of gross income from rents, interest on mortgages that
finance real property, or real estate sales
 Invest at least 75% of total assets in real estate, cash, or U.S. Treasuries
 Have at least 100 shareholders (controlling companies may name executives as
shareholders in order to meet this requirement)

 Flipping properties and buying and holding real estate represent two different
investment strategies.
 Owning real estate offers investors the opportunity to accumulate wealth over
time and avoid the stock market's ups and downs.
 Flipping can provide a quick turnaround on your investment and avoids the
ongoing hassles of finding tenants and maintaining a property, but costs and
taxes can be high.
 Buy-and-hold properties provide passive monthly income and tax advantages,
but not everyone is prepared for the management and legal responsibilities of
being a landlord.
Why Invest in Real Estate?
That's a good question. Residential real estate ownership is gaining ever-increasing
interest from retail investors for many of the following reasons:

 Real estate can provide more predictable returns than stocks and bonds.
 Real estate provides an inflation hedge because rental rates and investment
cash flow usually rise by at least as much as the inflation rate.
 Real estate provides an excellent place for capital in times when you're unsure of
the prospects for stocks and bonds.
 The equity created in a real estate investment provides an excellent base for
financing other investment opportunities. Instead of borrowing to get the capital
to invest (i.e., buying stocks on margin), investors can borrow against their equity
to finance other projects.
 The tax-deductibility of mortgage interest makes borrowing against a home
attractive.
 In addition to providing cash flow for owners, residential real estate can also be
used for a home or other purposes.

 Return on investment (ROI) measures how much money, or profit, is made on an

investment as a percentage of the cost of that investment.
 To calculate the percentage ROI for a cash purchase, take the net profit or net
gain on the investment and divide it by the original cost.
 If you have a mortgage, you'll need to factor in your downpayment and mortgage
payment.
 Other variables can affect your ROI including repair and maintenance costs, as
well as your regular expenses.
What Is Return on Investment (ROI)?
Return on investment measures how much money, or profit, is made on an investment
as a percentage of the cost of that investment. It shows how effectively and efficiently
investment dollars are being used to generate profits. Knowing ROI allows investors to
assess whether putting money into a particular investment is a wise choice or not.

ROI can be used for any investment—stocks, bonds, a savings account, and a piece of
real estate. Calculating a meaningful ROI for a residential property can be challenging
because calculations can be easily manipulated—certain variables can be included or
excluded in the calculation. It can become especially difficult when investors have the
option of paying cash or taking out a mortgage on the property.

Here, we'll review two examples for calculating ROI on residential rental property: a

cash purchase and one that's financed with a mortgage.

To calculate the percentage ROI, we take the net profit, or net gain, on the investment
and divide it by the original cost.
ROI = Cost of InvestmentGain on Investment − Cost of Investment

For instance, if you buy ABC stock for $1,000 and sell it two years later for $1,600, the
net profit is $600 ($1,600 – $1,000). ROI on the stock is 60% [$600 (net profit) ÷ $1,000
(cost) = 0.60].

ROI for Cash Transactions

Calculating a property's ROI is fairly straightforward if you buy a property with cash.
Here's an example of a rental property purchased with cash:

 You paid $100,000 in cash for the rental property.

 The closing costs were $1,000 and remodeling costs totaled $9,000, bringing
your total investment to $110,000 for the property. 
 You collected $1,000 in rent every month.

A year later:

 You earned $12,000 in rental income for those 12 months.

 Expenses including the water bill, property taxes, and insurance, totaled $2,400
for the year. or $200 per month.
 Your annual return was $9,600 ($12,000 – $2,400).

To calculate the property’s ROI:

 Divide the annual return ($9,600) by the amount of the total investment or
$110,000.
 ROI = $9,600 ÷ $110,000 = 0.087 or 8.7%.
 Your ROI was 8.7%.

ROI for Financed Transactions

Calculating the ROI on financed transactions is more involved.

For example, assume you bought the same $100,000 rental property as above, but
instead of paying cash, you took out a mortgage. 

 The downpayment needed for the mortgage was 20% of the purchase price,

or $20,000 ($100,000 sales price x 20%).
 Closing costs were higher, which is typical for a mortgage, totaling $2,500 up
front.
 You paid $9,000 for remodeling.
 Your total out-of-pocket expenses were $31,500 ($20,000 + $2,500 + $9,000).

There are also ongoing costs with a mortgage:

  Let's assume you took out a 30-year loan with a fixed 4% interest rate. On the
borrowed $80,000, the monthly principal and interest payment would be $381.93.
 We’ll add the same $200 per month to cover water, taxes, and insurance, making
your total monthly payment $581.93.
 Rental income of $1,000 per month totals $12,000 for the year.
 Monthly cash flow is $418.07 ($1,000 rent - $581.93 mortgage payment).

One year later:

 You earned $12,000 in total rental income for the year at $1,000 per month.
 Your annual return was $5,016.84 ($418.07 x 12 months).

To calculate the property's ROI:

 Divide the annual return by your original out-of-pocket expenses (the

downpayment of $20,000, closing costs of $2,500, and remodeling for $9,000) to
determine ROI.
 ROI = $5,016.84 ÷ $31,500 = 0.159.
 Your ROI is 15.9%.

INVESTMENTS WAYS

Understanding the Investment Risk Ladder

Here are the major asset classes, in ascending order of risk, on the investment risk
ladder.

Cash
A cash bank deposit is the simplest, most easily understandable investment asset—and
the safest. Not only does it give investors precise knowledge of the interest they'll earn,
but it also guarantees they'll get their capital back.

On the downside, the interest earned from cash socked away in a savings account
seldom beats inflation. Certificates of deposit (CDs) are highly liquid instruments, very
similar to cash that are instruments that typically provide higher interest rates than those
in savings accounts. However, money is locked up for a period of time and there are
potential early withdrawal penalties involved. 1

Bonds
A bond is a debt instrument representing a loan made by an investor to a borrower. A
typical bond will involve either a corporation or a government agency, where the
borrower will issue a fixed interest rate to the lender in exchange for using their capital.
Bonds are commonplace in organizations that use them in order to finance operations,
purchases, or other projects.2
Bond rates are essentially determined by the interest rates. Due to this, they are heavily
traded during periods of quantitative easing or when the Federal Reserve—or other
central banks—raise interest rates.3

Mutual Funds
A mutual fund is a type of investment where more than one investor pools their money
together in order to purchase securities. Mutual funds are not necessarily passive, as
they are managed by portfolio managers who allocate and distribute the pooled
investment into stocks, bonds, and other securities. Individuals may invest in mutual
funds for as little as $1,000 per share, letting them diversify into as many as 100
different stocks contained within a given portfolio.

Mutual funds are sometimes designed to mimic underlying indexes such as the S&P
500 or DOW Industrial Index. There are also many mutual funds that are actively
managed, meaning they are updated by portfolio managers who carefully track and
adjust their allocations within the fund. However, these funds generally have greater
costs—such as yearly management fees and front-end charges—which can cut into an
investor's returns.

Mutual funds are valued at the end of the trading day, and all buy and sell transactions
are likewise executed after the market closes.4

Exchange Traded Funds (ETFs)

Exchange traded funds (ETFs) have become quite popular since their introduction back
in the mid-1990s. ETFs are similar to mutual funds, but they trade throughout the day,
on a stock exchange. In this way, they mirror the buy-and-sell behavior of stocks. This
also means their value can change drastically during the course of a trading day.

ETFs can track an underlying index such as the S&P 500 or any other "basket" of
stocks the issuer of the ETF wants to underline a specific ETF with. This can include
anything from emerging markets, commodities, individual business sectors such as
biotechnology or agriculture, and more. Due to the ease of trading and broad coverage,
ETFs are extremely popular with investors. 5

Stocks
Shares of stock let investors participate in the company’s success via increases in the
stock’s price and through dividends. Shareholders have a claim on the company’s
assets in the event of liquidation (that is, the company going bankrupt) but do not own
the assets.

Holders of common stock enjoy voting rights at shareholders’ meetings. Holders of

preferred stock don’t have voting rights but do receive preference over common
shareholders in terms of the dividend payments.6

Alternative Investments
There is a vast universe of alternative investments, including the following sectors:
  Real estate: Investors can acquire real estate by directly buying commercial or
residential properties. Alternatively, they can purchase shares in real estate
investment trusts (REITs). REITs act like mutual funds wherein a group of
investors pool their money together to purchase properties. They trade like
stocks on the same exchange.7
 Hedge funds and private equity funds: Hedge funds, which may invest in a
spectrum of assets designed to deliver beyond market returns, called "alpha."
However, performance is not guaranteed, and hedge funds can see incredible
shifts in returns, sometimes underperforming the market by a significant margin.
Typically only available to accredited investors, these vehicles often require high
initial investments of $1 million or more. They also tend to impose net worth
requirements. Both investment types may tie up an investor's money for
substantial time periods.8
 Commodities: Commodities refer to tangible resources such as gold, silver,
crude oil, as well as agricultural products

What is the Stock Market?

The stock market refers to the collection of markets and exchanges where regular
activities of buying, selling, and issuance of shares of publicly-held companies take
place. Such financial activities are conducted through institutionalized formal exchanges
or over-the-counter (OTC) marketplaces which operate under a defined set of
regulations

How Stock Exchanges Make Money

Stock exchanges operate as for-profit institutes and charge a fee for their services. The
primary source of income for these stock exchanges are the revenues from the
transaction fees that are charged for each trade carried out on its platform. Additionally,
exchanges earn revenue from the listing fee charged to companies during the IPO
process and other follow-on offerings.

The exchange also earns from selling market data generated on its platform - like real-
time data, historical data, summary data, and reference data – which is vital for equity
research and other uses. Many exchanges will also sell technology products, like a
trading terminal and dedicated network connection to the exchange, to the interested
parties for a suitable fee.

The exchange may offer privileged services like high-frequency trading to larger clients
like mutual funds and asset management companies (AMC), and earn money
accordingly. There are provisions for regulatory fee and registration fee for different
profiles of market participants, like the market maker and broker, which form other
sources of income for the stock exchanges.
The exchange also makes profits by licensing their indexes (and their methodology)
which are commonly used as a benchmark for launching various products like mutual
funds and ETFs by AMCs.

Many exchanges also provide courses and certification on various financial topics to
industry participants and earn revenues from such subscriptions.

 When deciding between investing in individual stocks in an industry or buying an

exchange-traded fund (ETF) that offers exposure to that industry, consider
opportunities for how to best reduce your risk and generate a return that beats
the market.
 Stock-picking offers an advantage over exchange-traded funds (ETFs) when
there is a wide dispersion of returns from the mean.
 Exchange-traded funds (ETFs) offer advantages over stocks when the return
from stocks in the sector has a narrow dispersion around the mean.
 Exchange-traded funds (ETFs) may also be advantageous if you are unable to
gain an advantage through knowledge of the company.
What Is a Bond?
A bond is a fixed income instrument that represents a loan made by an investor to a
borrower (typically corporate or governmental). A bond could be thought of as
an I.O.U. between the lender and borrower that includes the details of the loan and its
payments. Bonds are used by companies, municipalities, states, and sovereign
governments to finance projects and operations. Owners of bonds are debtholders, or
creditors, of the issuer. Bond details include the end date when the principal of the loan
is due to be paid to the bond owner and usually includes the terms for variable or fixed
interest payments made by the borrower.

The Issuers of Bonds

Governments (at all levels) and corporations commonly use bonds in order to borrow
money. Governments need to fund roads, schools, dams or other infrastructure. The
sudden expense of war may also demand the need to raise funds.

Similarly, corporations will often borrow to grow their business, to buy property and
equipment, to undertake profitable projects, for research and development or to hire
employees. The problem that large organizations run into is that they typically need far
more money than the average bank can provide. Bonds provide a solution by allowing
many individual investors to assume the role of the lender. Indeed, public debt markets
let thousands of investors each lend a portion of the capital needed. Moreover, markets
allow lenders to sell their bonds to other investors or to buy bonds from other individuals
—long after the original issuing organization raised capital.

Characteristics of Bonds
Most bonds share some common basic characteristics including:
  Face value is the money amount the bond will be worth at maturity; it is also the
reference amount the bond issuer uses when calculating interest payments. For
example, say an investor purchases a bond at a premium $1,090 and another
investor buys the same bond later when it is trading at a discount for $980. When
the bond matures, both investors will receive the $1,000 face value of the bond.
 The coupon rate is the rate of interest the bond issuer will pay on the face value
of the bond, expressed as a percentage. For example, a 5% coupon rate means
that bondholders will receive 5% x $1000 face value = $50 every year.
 Coupon dates are the dates on which the bond issuer will make interest
payments. Payments can be made in any interval, but the standard is
semiannual payments.
 The maturity date is the date on which the bond will mature and the bond issuer
will pay the bondholder the face value of the bond.
 The issue price is the price at which the bond issuer originally sells the bonds.

Categories of Bonds
There are four primary categories of bonds sold in the markets. However, you may also
see foreign bonds issued by corporations and governments on some platforms.

 Corporate bonds are issued by companies. Companies issue bonds rather than

seek bank loans for debt financing in many cases because bond markets offer
more favorable terms and lower interest rates.
 Municipal bonds are issued by states and municipalities. Some municipal bonds
offer tax-free coupon income for investors.
 Government bonds such as those issued by the U.S. Treasury. Bonds issued
by the Treasury with a year or less to maturity are called “Bills”; bonds issued
with 1–10 years to maturity are called “notes”; and bonds issued with more than
10 years to maturity are called “bonds”. The entire category of bonds issued by a
government treasury is often collectively referred to as "treasuries." Government
bonds issued by national governments may be referred to as sovereign debt.
 Agency bonds are those issued by government-affiliated organizations such as
Fannie Mae or Freddie Mac.

Varieties of Bonds
The bonds available for investors come in many different varieties. They can be
separated by the rate or type of interest or coupon payment, being recalled by the
issuer, or have other attributes.

Zero-coupon bonds do not pay coupon payments and instead are issued at a discount
to their par value that will generate a return once the bondholder is paid the full face
value when the bond matures. U.S. Treasury bills are a zero-coupon bond.

Convertible bonds are debt instruments with an embedded option that allows

bondholders to convert their debt into stock (equity) at some point, depending on certain
conditions like the share price. For example, imagine a company that needs to borrow
$1 million to fund a new project. They could borrow by issuing bonds with a 12%
coupon that matures in 10 years. However, if they knew that there were some investors
willing to buy bonds with an 8% coupon that allowed them to convert the bond into stock
if the stock’s price rose above a certain value, they might prefer to issue those.

The convertible bond may the best solution for the company because they would have
lower interest payments while the project was in its early stages. If the investors
converted their bonds, the other shareholders would be diluted, but the company would
not have to pay any more interest or the principal of the bond.

The investors who purchased a convertible bond may think this is a great solution
because they can profit from the upside in the stock if the project is successful. They
are taking more risk by accepting a lower coupon payment, but the potential reward if
the bonds are converted could make that trade-off acceptable.

Callable bonds also have an embedded option but it is different than what is found in a

convertible bond. A callable bond is one that can be “called” back by the company
before it matures. Assume that a company has borrowed $1 million by issuing bonds
with a 10% coupon that mature in 10 years. If interest rates decline (or the company’s
credit rating improves) in year 5 when the company could borrow for 8%, they will call or
buy the bonds back from the bondholders for the principal amount and reissue new
bonds at a lower coupon rate.

A callable bond is riskier for the bond buyer because the bond is more likely to be called
when it is rising in value. Remember, when interest rates are falling, bond prices rise.
Because of this, callable bonds are not as valuable as bonds that aren’t callable with the
same maturity, credit rating, and coupon rate.

A Puttable bond allows the bondholders to put or sell the bond back to the company
before it has matured. This is valuable for investors who are worried that a bond may
fall in value, or if they think interest rates will rise and they want to get their principal
back before the bond falls in value.

The bond issuer may include a put option in the bond that benefits the bondholders in
return for a lower coupon rate or just to induce the bond sellers to make the initial loan.
A puttable bond usually trades at a higher value than a bond without a put option but
with the same credit rating, maturity, and coupon rate because it is more valuable to the
bondholders.

The possible combinations of embedded puts, calls, and convertibility rights in a bond
are endless and each one is unique. There isn’t a strict standard for each of these rights
and some bonds will contain more than one kind of “option” which can make
comparisons difficult. Generally, individual investors rely on bond professionals to select
individual bonds or bond funds that meet their investing goals.
Yield-to-Maturity (YTM)
The yield-to-maturity (YTM) of a bond is another way of considering a bond’s price.
YTM is the total return anticipated on a bond if the bond is held until the end of its
lifetime. Yield to maturity is considered a long-term bond yield but is expressed as
an annual rate. In other words, it is the internal rate of return of an investment in a bond
if the investor holds the bond until maturity and if all payments are made as scheduled.
YTM is a complex calculation but is quite useful as a concept evaluating the
attractiveness of one bond relative to other bonds of different coupon and maturity in the
market. The formula for YTM involves solving for the interest rate in the following
equation, which is no easy task, and therefore most bond investors interested in YTM
will use a computer:

YTM=n ROOT(Face Value/ Present Value) −1

We can also measure the anticipated changes in bond prices given a change in interest
rates with a measure knows as the duration of a bond. Duration is expressed in units of
the number of years since it originally referred to zero-coupon bonds, whose
duration is its maturity.

or practical purposes, however, duration represents the price change in a bond given a
1% change in interest rates. We call this second, more practical definition the modified
duration of a bond.

The duration can be calculated to determine the price sensitivity to interest rate changes
of a single bond, or for a portfolio of many bonds. In general, bonds with long maturities,
and also bonds with low coupons have the greatest sensitivity to interest rate changes.
A bond’s duration is not a linear risk measure, meaning that as prices and rates change,
the duration itself changes, and convexity measures this relationship.

Imagine a bond that was issued with a coupon rate of 5% and a $1,000 par value. The
bondholder will be paid $50 in interest income annually (most bond coupons are split in
half and paid semiannually). As long as nothing else changes in the interest rate
environment, the price of the bond should remain at its par value.

However, if interest rates begin to decline and similar bonds are now issued with a 4%
coupon, the original bond has become more valuable. Investors who want a higher
coupon rate will have to pay extra for the bond in order to entice the original owner to
sell. The increased price will bring the bond’s total yield down to 4% for new investors
because they will have to pay an amount above par value to purchase the bond.

On the other hand, if interest rates rise and the coupon rate for bonds like this one rise
to 6%, the 5% coupon is no longer attractive. The bond’s price will decrease and begin
selling at a discount compared to the par value until its effective return is 6%.
The bond market tends to move inversely with interest rates because bonds will trade at
a discount when interest rates are rising and at a premium when interest rates are
falling.

In particular, there are six important features to look for when considering a bond.

Maturity
This is the date when the principal or par amount of the bond is paid to investors and
the company’s bond obligation ends. Therefore, it defines the lifetime of the bond. 2 A
bond's maturity is one of the primary considerations an investor weighs against their
investment goals and horizon. Maturity is often classified in three ways:

 Short-term: Bonds that fall into this category tend to mature within one to three
years
 Medium-term: Maturity dates for these types of bonds are normally over ten
years
 Long-term: These bonds generally mature over longer periods of time

Secured/Unsecured
A bond can be secured or unsecured. A secured bond pledges specific assets to
bondholders if the company cannot repay the obligation. This asset is also called
collateral on the loan. So if the bond issuer defaults, the asset is then transferred to the
investor. A mortgage-backed security (MBS) is one type of secured bond—backed by
titles to the homes of the borrowers.3

Unsecured bonds, on the other hand, are not backed by any collateral. That means the
interest and principal are only guaranteed by the issuing company. Also
called debentures, these bonds return little of your investment if the company fails. 4 As
such, they are much riskier than secured bonds.

Liquidation Preference
When a firm goes bankrupt, it repays investors in a particular order as it liquidates. After
a firm sells off all its assets, it begins to pay out its investors. Senior debt is debt that
must be paid first, followed by junior (subordinated) debt. Stockholders get whatever is
left.5

Coupon
The coupon amount represents interest paid to bondholders, normally annually or
semiannually.6 The coupon is also called the coupon rate or nominal yield. To calculate
the coupon rate, divide the annual payments by the face value of the bond.

Tax Status
While the majority of corporate bonds are taxable investments, some government
and municipal bonds are tax-exempt, so income and capital gains are not subject to
taxation.7  Tax-exempt bonds normally have lower interest than equivalent taxable
bonds. An investor must calculate the tax-equivalent yield to compare the return with
that of taxable instruments.

Callability
Some bonds can be paid off by an issuer before maturity. 8 If a bond has a call provision,
it may be paid off at earlier dates, at the option of the company, usually at a slight
premium to par. A company may choose to call its bonds if interest rates allow them to
borrow at a better rate. Callable bonds also appeal to investors as they offer better
coupon rates.

Risks of Bonds
Bonds are a great way to earn income because they tend to be relatively safe
investments. But, just like any other investment, they do come with certain risks. Here
are some of the most common risks with these investments.

Interest Rate Risk

Interest rates share an inverse relationship with bonds, so when rates rise, bonds tend
to fall and vice versa.9 Interest rate risk comes when rates change significantly from
what the investor expected. If interest rates decline significantly, the investor faces the
possibility of prepayment. If interest rates rise, the investor will be stuck with an
instrument yielding below market rates. The greater the time to maturity, the greater the
interest rate risk an investor bears, because it is harder to predict market developments
farther out into the future.

Credit/Default Risk
Credit or default risk is the risk that interest and principal payments due on the
obligation will not be made as required. When an investor buys a bond, they expect that
the issuer will make good on the interest and principal payments—just like any other
creditor.

When an investor looks into corporate bonds, they should weigh out the possibility that
the company may default on the debt. Safety usually means the company has greater
operating income and cash flow compared to its debt. If the inverse is true and the debt
outweighs available cash, the investor may want to stay away.

Prepayment Risk
Prepayment risk is the risk that a given bond issue will be paid off earlier than expected,
normally through a call provision. This can be bad news for investors because the
company only has an incentive to repay the obligation early when interest rates have
declined substantially. Instead of continuing to hold a high-interest investment, investors
are left to reinvest funds in a lower interest rate environment.
Agencies
The most commonly cited bond rating agencies are Standard & Poor’s, Moody’s,
and Fitch.1 0 They rate a company’s ability to repay its obligations. Ratings range from
AAA to Aaa for high-grade issues very likely to be repaid to D for issues that are
currently in default.1 1

Bonds rated BBB to Baa or above are called investment grade. This means they are
unlikely to default and tend to remain stable investments. Bonds rated BB to Ba or
below are called junk bonds—default is more likely, and they are more speculative and
subject to price volatility.

Firms will not have their bonds rated, in which case it is solely up to the investor to
judge a firm’s repayment ability. Because the rating systems differ for each agency and
change from time to time, research the rating definition for the bond issue you are
considering. 

What Is a Corporate Bond?

 Corporate bonds are issued by companies that want to raise additional cash.
 You can buy corporate bonds on the primary market through a brokerage firm,
bank, bond trader, or a broker.
 Some corporate bonds are traded on the over-the-counter market and offer good
liquidity.
 Before investing, learn some of the basics of corporate bonds including how
they're priced, the risks associated with them, and how much interest they pay.
Basic Characteristics of Treasury Securities
Treasury securities are divided into three categories according to their lengths of
maturities. These three types of bonds share many common characteristics, but also
have some key differences. The categories and key features of treasury securities
include:

 T-Bills – These have the shortest range of maturities of all government bonds.

Among bills auctioned on a regular schedule, there are five terms: 4 weeks, 8
weeks, 13 weeks, 26 weeks, and 52 weeks. Another bill, the cash management
bill, isn't auctioned on a regular schedule. It is issued in variable terms, usually of
only a matter of days.2 These are the only type of treasury security found in both
the capital and money markets, as three of the maturity terms fall under the 270-
day dividing line between them.3  4 T-Bills are issued at a discount and mature at
par value, with the difference between the purchase and sale prices constituting
the interest paid on the bill.5
 T-Notes – These notes represent the middle range of maturities in the treasury
family, with maturity terms of 2, 3, 5, 7 and 10 years currently available. The
Treasury auctions 2-year notes, 3-year notes, 5-year notes, and 7-year notes
 every month. The agency auctions 10-year notes at original issue in February,
May, August, and November, and as reopenings in the other eight months.
Treasury notes are issued at a $1,000 par value and mature at the same price.
They pay interest semiannually.6
 T-Bonds – Commonly referred to in the investment community as the “long
bond”, T-Bonds are essentially identical to T-Notes except that they mature in 30
years. T-Bonds are also issued at and mature at a $1,000 par value and pay
interest semiannually. Treasury bonds are auctioned monthly. Bonds are
auctioned at original issue in February, May, August, and November, and then as
reopenings in the other eight months. 7

Auction Purchase of Treasury Securities

All three types of Treasury securities can be purchased online at auction in
$100 increments. However, not every maturity term for each type of security is available
at every auction.7  5 For example, the 2, 3, 5 and 7-year T-Notes are available each
month at auction, but the 10-year T-Note is only offered quarterly. 6

All maturities of T-Bills are offered weekly except for the 52-week maturity, which is
auctioned once each month.5 Employees who wish to purchase Treasury securities may
do so through the TreasuryDirect Payroll Savings Plan. This program allows investors to
automatically defer a portion of their paychecks into a TreasuryDirect account. The
employee then uses these funds to purchase treasury securities electronically. 8

Taxpayers can also funnel their income tax refunds directly into a TreasuryDirect

account for the same purpose.9 Paper certificates are no longer issued for Treasury
securities, and all accounts and purchases are now recorded in an electronic book-entry
system

How Municipal Bonds Work

 Municipal bonds are good for people who want to hold on to capital while
creating a tax-free income source.
 General obligation bonds are issued to raise funds right away to cover costs,
while revenue bonds are issued to finance infrastructure projects.
 Both general obligation bonds and revenue bonds are tax-exempt and low-risk,
with issuers very likely to pay back their debts.
 Buying municipal bonds is low-risk, but not risk-free, as the issuer could fail to
make agreed-upon interest payments or be unable to repay the principal upon
maturity.
Basics of Bond Investing
Bonds are a form of debt issued by a company or government that wants to raise some
cash. In essence, when an entity issues a bond, it asks the buyer or investor for a loan.
So when you buy a bond, you're lending the bond issuer money. In exchange, the
issuer promises to pay back the principal amount to you by a certain date and sweetens
the pot by paying you interest at regular intervals—usually semi-annually.
 
Although bonds are considered safe investments, they do come with their own risks.

While stocks are traded on exchanges, bonds are traded over the counter. This means
you have to buy them—especially corporate bonds— through a broker. Keep in mind,
you may have to pay a premium depending on the broker you choose. If you're looking
to buy federal government bonds like U.S. Treasury Securities, you can do so directly
through the government. You can also invest in a bond fund which is a debt fund that
invests primarily in different types of debts including corporate, government and
municipal bonds, as well as other debt instruments.

Interest Rate Risk

The most well-known risk in the bond market is interest rate risk. Interest rates have an
inverse relationship with bond prices. So when you buy a bond, you commit to receiving
a fixed rate of return (ROR) for a set period. Should the market rate rise from the date of
the bond's purchase, its price will fall accordingly. The bond will then trade at
a discount to reflect the lower return that an investor will make on the bond.

The inverse relationship between market interest rates and bond prices holds true under
falling interest-rate environments as well. The originally issued bond would sell at
a premium above par value because the coupon payments associated with this bond
would be greater than the coupon payments offered on newly issued bonds. As you can
infer, the relationship between the price of a bond and market interest rates is simply
explained by the supply and demand for a bond in a changing interest-rate environment.

Market interest rates are a function of several factors including the supply and demand
for money in the economy, the inflation rate, the stage that the business cycle is in, and
the government's monetary and fiscal policies.

Example of Interest Rate Risk

If you bought a 5% coupon, a 10-year corporate bond that is selling at par value,
the present value of the $1,000 par value bond would be $614. This amount represents
the amount of money needed today to be invested at an annual rate of 5% per year
over a 10-year period, in order to have $1,000 when the bond reaches maturity.

If interest rates jump to 6%, the present value of the bond would be $558 because it
would only take $558 invested today at an annual rate of 6% for 10 years to accumulate
$1,000. But if interest rates decreased to 4%, the present value of the bond would be
$676.

Supply and Demand

Interest rate risk is also fairly easy to understand in terms of supply and demand. If you
purchased a 5% coupon for a 10-year corporate bond that sells at par value, the
investor would expect to receive $50 per year, plus the repayment of the $1,000
principal investment when the bond reaches maturity. Now, let's determine what would
happen if market interest rates increased by one percentage point. Under this scenario,
a newly issued bond with similar characteristics as the originally issued bond would pay
a coupon amount of 6%, assuming it is offered at par value.

For this reason, the issuer of the original bond would find it difficult to find a buyer willing
to pay par value for their bond under a rising interest rate environment because a buyer
could purchase a newly issued bond in the market that pays a higher coupon amount.

As a result, the bond issuer would have to sell it at a discount from par value in order to
attract a buyer. The discount on the price of the bond would be the amount that would
make a buyer indifferent in terms of purchasing the original bond with a 5% coupon
amount, or the newly issued bond with a more favorable coupon rate.

Reinvestment Risk
Another risk associated with the bond market is called reinvestment risk. In essence, a
bond poses a reinvestment risk to investors if the proceeds from the bond or future cash
flows will need to be reinvested in a security with a lower yield than the bond originally
provided. Reinvestment risk can also come with callable bonds—investments that can
be called by the issuer before the maturity rate.

For example, imagine an investor buys a $1,000 bond with an annual coupon of 12%.
Each year, the investor receives $120 (12% x $1,000), which can be reinvested back
into another bond. But imagine that, over time, the market rate falls to 1%. Suddenly,
that $120 received from the bond can only be reinvested at 1%, instead of the 12% rate
of the original bond.

Call Risk for Bond Investors

Another risk is that a bond will be called by its issuer. Callable bonds have call
provisions that allow the bond issuer to purchase the bond back from the bondholders
and retire the issue. This is usually done when interest rates fall substantially since the
issue date. Call provisions allow the issuer to retire the old, high-rate bonds and sell
low-rate bonds in a bid to lower debt costs.

Default Risk
Default risk occurs when the bond's issuer is unable to pay the contractual interest or
principal on the bond in a timely manner or at all. Credit rating services such
as Moody's, Standard & Poor's, and Fitch give credit ratings to bond issues. 1 This gives
investors an idea of how likely it is that a payment default will occur. If the bond issuer
defaults, the investor loses part or all of their original investment plus any interest they
may have earned.

For example, most federal governments have very high credit ratings (AAA). They have
the means to pay their debts by raising taxes or printing, making default unlikely.
However, small emerging companies have some of the worst credit—BB and lower—
and are more likely to default on their bond payments. 2 In these cases, bondholders will
likely lose all or most of their investments.
 Inflation Risk
This risk refers to situations when the rate of price increases in
the economy deteriorates the returns associated with the bond. This has the greatest
effect on fixed bonds, which have a set interest rate from inception.

For example, if an investor purchases a 5% fixed bond, and inflation rises to 10% per
year, the bondholder will lose money on the investment because the purchasing
power of the proceeds has been greatly diminished. The interest rates of floating-rate
bonds or floaters are adjusted periodically to match inflation rates, limiting investors'
exposure to inflation risk.

Options vs. Futures: What’s the Difference?

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By MARY HALL
 Updated May 19, 2019
An options contract gives an investor the right, but not the obligation, to buy (or sell)
shares at a specific price at any time, as long as the contract is in effect. By contrast,
a futures contract requires a buyer to purchase shares—and a seller to sell them—on a
specific future date, unless the holder's position is closed before the expiration date.

Options and futures are both financial products investors can use to make money or
to hedge current investments. Both an option and a future allow an investor to buy an
investment at a specific price by a specific date. But the markets for these two products
are very different in how they work and how risky they are to the investor.

KEY TAKEAWAYS

 Options and futures are similar trading products that provide investors with the
chance to make money and hedge current investments.
 An option gives the buyer the right, but not the obligation, to buy (or sell) an asset
at a specific price at any time during the life of the contract.
 A futures contract gives the buyer the obligation to purchase a specific asset, and
the seller to sell and deliver that asset at a specific future date unless the holder's
position is closed prior to expiration.

Options Trading Strategies: A Guide for Beginners

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By ELVIN MIRZAYEV
 Updated Oct 14, 2019
Options are conditional derivative contracts that allow buyers of the contracts (option
holders) to buy or sell a security at a chosen price. Option buyers are charged an
amount called a "premium" by the sellers for such a right. Should market prices be
unfavorable for option holders, they will let the option expire worthless, thus ensuring
the losses are not higher than the premium. In contrast, option sellers (option writers)
assume greater risk than the option buyers, which is why they demand this premium.

Options are divided into "call" and "put" options. With a call option, the buyer of the
contract purchases the right to buy the underlying asset in the future at a predetermined
price, called exercise price or strike price. With a put option, the buyer acquires the right
to sell the underlying asset in the future at the predetermined price. 

Why Trade Options Rather Than a Direct Asset?

There are some advantages to trading options. The Chicago Board of Options
Exchange (CBOE) is the largest such exchange in the world, offering options on a wide
variety of single stocks, ETFs and indexes. 1  Traders can construct option strategies
ranging from buying or selling a single option to very complex ones that involve multiple
simultaneous option positions.

The following are basic option strategies for beginners. 

Buying Calls (Long Call)

This is the preferred strategy for traders who:

 Are "bullish" or confident on a particular stock, ETF or index and want to limit risk
 Want to utilize leverage to take advantage of rising prices

Options are leveraged instruments, i.e., they allow traders to amplify the benefit by
risking smaller amounts than would otherwise be required if trading the underlying
asset itself. A standard option contract on a stock controls 100 shares of the underlying
security.

Suppose a trader wants to invest $5,000 in Apple (AAPL), trading around $165 per

share. With this amount, he or she can purchase 30 shares for $4,950. Suppose then
that the price of the stock increases by 10% to $181.50 over the next month. Ignoring
any brokerage, commission or transaction fees, the trader’s portfolio will rise to $5,445,
leaving the trader with a net dollar return of $495, or 10% on the capital invested.

Now, let's say a call option on the stock with a strike price of $165 that expires about a
month from now costs $5.50 per share or $550 per contract. Given the trader's available
investment budget, he or she can buy nine options for a cost of $4,950. Because the
option contract controls 100 shares, the trader is effectively making a deal on 900
shares. If the stock price increases 10% to $181.50 at expiration, the option will
expire in the money and be worth $16.50 per share ($181.50-$165 strike), or $14,850
on 900 shares. That's a net dollar return of $9,990, or 200% on the capital invested, a
much larger return compared to trading the underlying asset directly. (For related
reading, see "Should an Investor Hold or Exercise an Option?")

Risk/Reward: The trader's potential loss from a long call is limited to the premium paid.
Potential profit is unlimited, as the option payoff will increase along with the underlying
asset price until expiration, and there is theoretically no limit to how high it can go. 

Image by Julie Bang © Investopedia 2019

Buying Puts (Long Put)
This is the preferred strategy for traders who:

 Are bearish on a particular stock, ETF or index, but want to take on less risk than
with a short-selling strategy
 Want to utilize leverage to take advantage of falling prices

A put option works the exact opposite way a call option does, with the put option gaining
value as the price of the underlying decreases. While short-selling also allows a trader
to profit from falling prices, the risk with a short position is unlimited, as there
is theoretically no limit on how high a price can rise. With a put option, if the underlying
rises past the option's strike price, the option will simply expire worthlessly. 

Risk/Reward: Potential loss is limited to the premium paid for the options. The
maximum profit from the position is capped since the underlying price cannot drop
below zero, but as with a long call option, the put option leverages the trader's return.

Image by Julie Bang © Investopedia 2019

Covered Call
This is the preferred position for traders who:

 Expect no change or a slight increase in the underlying's price

 Are willing to limit upside potential in exchange for some downside protection

A covered call strategy involves buying 100 shares of the underlying asset and selling a
call option against those shares. When the trader sells the call, he or she collects the
option's premium, thus lowering the cost basis on the shares and providing some
downside protection. In return, by selling the option, the trader is agreeing to sell shares
of the underlying at the option's strike price, thereby capping the trader's upside
potential. 
Suppose a trader buys 1,000 shares of BP (BP) at $44 per share and simultaneously
writes 10 call options (one contract for every 100 shares) with a strike price
of $46 expiring in one month, at a cost of $0.25 per share, or $25 per contract and $250
total for the 10 contracts. The $0.25 premium reduces the cost basis on the shares to
$43.75, so any drop in the underlying down to this point will be offset by the premium
received from the option position, thus offering limited downside protection.

If the share price rises above $46 before expiration, the short call option will be

exercised (or "called away"), meaning the trader will have to deliver the stock at the
option's strike price. In this case, the trader will make a profit of $2.25 per share ($46
strike price - $43.75 cost basis).

However, this example implies the trader does not expect BP to move above $46 or
significantly below $44 over the next month. As long as the shares do not rise above
$46 and get called away before the options expire, the trader will keep the premium free
and clear and can continue selling calls against the shares if he or she chooses.

Risk/Reward: If the share price rises above the strike price before expiration, the short
call option can be exercised and the trader will have to deliver shares of the
underlying at the option's strike price, even if it is below the market price. In exchange
for this risk, a covered call strategy provides limited downside protection in the form of
premium received when selling the call option. 

Image by Julie Bang © Investopedia 2019

Protective Put
This is the preferred strategy for traders who:

 Own the underlying asset and want downside protection.

A protective put is a long put, like the strategy we discussed above; however, the goal,
as the name implies, is downside protection versus attempting to profit from a downside
move. If a trader owns shares that he or she is bullish on in the long run but wants to
protect against a decline in the short run, they may purchase a protective put. 

If the price of the underlying increases and is above the put's strike price at maturity, the
option expires worthless and the trader loses the premium but still has the benefit of the
increased underlying price. On the other hand, if the underlying price decreases, the
trader’s portfolio position loses value, but this loss is largely covered by the gain from
the put option position. Hence, the position can effectively be thought of as an insurance
strategy.

The trader can set the strike price below the current price to reduce premium payment
at the expense of decreasing downside protection. This can be thought of as deductible
insurance. Suppose, for example, that an investor buys 1,000 shares of Coca-Cola (KO)
at a price of $44 and wants to protect the investment from adverse price movements
over the next two months. The following put options are available:

June 2018
Premium
options

$44 put $1.23

$42 put $0.47

$40 put $0.20

The table shows that the cost of protection increases with the level thereof. For
example, if the trader wants to protect the investment against any drop in price, he or
she can buy 10 at-the-money put options at a strike price of $44 for $1.23 per share, or
$123 per contract, for a total cost of $1,230. However, if the trader is willing to tolerate
some level of downside risk, he or she can choose less costly out-of-the-money options
such as a $40 put. In this case, the cost of the option position will be much lower at only
$200.

Risk/Reward: If the price of the underlying stays the same or rises, the potential loss
will be limited to the option premium, which is paid as insurance. If, however, the price
of the underlying drops, the loss in capital will be offset by an increase in the option's
price and is limited to the difference between the initial stock price and strike price plus
the premium paid for the option. In the example above, at the strike price of $40, the
loss is limited to $4.20 per share ($44 - $40 + $0.20).
Other Options Strategies
These strategies may be a little more complex than simply buying calls or puts, but they
are designed to help you better manage the risk of options trading:

 Covered call strategy or buy-write strategy: Stocks are bought, and the

investor sells call options on the same stock. The number of shares you bought
should be identical to the number of call options contracts you sold.
 Married Put Strategy: After buying a stock, the investor buys put options for an
equivalent number of shares. The married put works like an insurance policy
against short-term losses call options with a specific strike price. At the same
time, you'll sell the same number of call options at a higher strike price.
 Protective Collar Strategy: An investor buys an out-of-the-money put option,
while at the same time writing an out-of-the-money call option for the same stock.
 Long Straddle Strategy: Investor buys a call option and a put option at the
same time. Both options should have the same strike price and expiration date.
 Long Strangle Strategy: Investor buys an out-of-the-money call option and a
put option at the same time. They have the same expiration date but they have
different strike prices. The put strike price should be below the call strike price.

How to Calculate Your Portfolio's Investment Returns

 To calculate your investment returns, gather the total cost of your investments
and the average historical return, and define the time period for which you want
to calculate your returns.
 You can use the holding period return to compare returns on investments held for
different periods of time.
 You'll have to adjust for cash flows if money was deposited or withdrawn from
your portfolio(s).
 Annualizing returns can make multi-period returns more comparable across other
portfolios or potential investments.
Holding Period Return
Once you define your time periods and sum up the portfolio NAV, you can start making
your calculations. The simplest way to calculate a basic return is called the holding
period return.

Here's the formula to calculate the holding period return:

 HPR = Income + (End of Period Value - Initial Value) ÷ Initial Value

This return/yield is a useful tool to compare returns on investments held for different
periods of time. It simply calculates the percentage difference from period to period of
the total portfolio NAV and includes income from dividends or interest. In essence, it's
the total return from holding a portfolio of assets—or a singular asset—over a specific
period of time.
Adjusting for Cash Flows
You will need to adjust for the timing and amount of cash flows if money was deposited
or withdrawn from your portfolio(s). So if you deposited $100 in your account mid-
month, the portfolio end-of-month NAV has an additional $100 that was not due to
investment returns when you calculate a monthly return. This can be adjusted using
various calculations, depending on the circumstances.

The modified Dietz method is a popular formula to adjust for cash flows. Using
an internal rate of return (IRR) calculation with a financial calculator is also an effective
way to adjust returns for cash flows. IRR is a discount rate that makes the net present
value zero. It is used to measure the potential profitability of an investment.

Annualizing Returns
A common practice is to annualize returns for multi-period returns. This is done to make
the returns more comparable across other portfolios or potential investments. It allows
for a common denominator when comparing returns.

An annualized return is a geometric average of the amount of money an investment

earns each year. It shows what could have been earned over a period of time if the
returns had been compounded. The annualized return does not give an indication
of volatility experienced during the corresponding time period. That volatility can be
better measured using standard deviation, which measures how data is dispersed
relative to its mean.

An Example of Calculating Portfolio Returns

The sum total of the positions in a brokerage account is $1,000 at the beginning of the
year and $1,350 at the end of the year. There was a dividend paid on June 30. The
account owner deposited $100 on March 31. The return for the year is 16.3% after
adjusting for the $100 cash flow into the portfolio one-quarter of the way through the
year.

CORPORATE ACTIONS

The Stock Split

A stock split, sometimes called a bonus share, divides the value of each of
the outstanding shares of a company. A two-for-one stock split is most common. An
investor who holds one share will automatically own two shares, each worth exactly half
the price of the original share.

So, the company has just cut its own stock price in half. Inevitably, the market will adjust
the price upwards the day the split is implemented.
The effects: Current shareholders are rewarded, and potential buyers are more
interested.

Notably, there are twice as many common stock shares out there than there were
before the split. Nevertheless, a stock split is a non-event, because it does not affect a
company's equity or its market capitalization. Only the number of shares outstanding
changes.

Stock splits are gratifying to shareholders, both immediately and in the longer term.
Even after that initial pop, they often drive the price of the stock higher. Cautious
investors may worry that repeated stock splits will result in too many shares being
created.

The Reverse Split

A reverse split would be implemented by a company that wants to force up the price of
its shares.

For example, a shareholder who owns 10 shares of stock valued at $1 each will have
only one share after a reverse split of 10 for one, but that one share will be valued at
$10.

A reverse split can be a sign that the company's stock has sunk so low that its
executives want to shore up the price, or at least make it appear that the stock is
stronger. The company may even need to avoid getting categorized as a penny stock.

In other cases, a company may be using a reverse split to drive out small investors.

Volume 75%
 
1:58
What Are Corporate Actions?
Dividends
A company can issue dividends in either cash or stock. Typically, they are paid out at
specific periods, usually quarterly or annually. Essentially, these are a share of the
company profits that are being paid to owners of the stock.

Dividend payments affect the equity of a company. The distributable equity (retained
earnings and/or paid-in capital) is reduced.

A cash dividend is straightforward. Each shareholder is paid a certain amount of money

for each share. If an investor owns 100 shares and the cash dividend is $0.50 per
share, the owner will be paid $50.
A stock dividend also comes from distributable equity but in the form of stock instead of
cash. If the stock dividend is 10%, for example, the shareholder will receive one
additional share for every 10 owned.

If the company has a million shares outstanding, the stock dividend would increase its
outstanding shares to a total of 1.1 million. Notably, the increase in shares dilutes
the earnings per share, so the stock price would decrease.

The distribution of a cash dividend signals to an investor that the company has
substantial retained earnings from which shareholders can directly benefit. By using its
retained capital or paid-in capital account, a company is indicating that it expects to
have little trouble replacing those funds in the future.

However, when a growth stock starts to issue dividends, many investors conclude that a
company that was rapidly growing is settling down for a stable but unspectacular rate of
growth.

Rights Issues
A company implementing a rights issue is offering additional or new shares only to
current shareholders. The existing shareholders are given the right to purchase or
receive these shares before they are offered to the public.

A rights issue regularly takes place in the form of a stock split, and in any case can
indicate that existing shareholders are being offered a chance to take advantage of a
promising new development.

Mergers and Acquisitions

A merger occurs when two or more companies combine into one with all parties
involved agreeing to the terms. Usually, one company surrenders its stock to the other.

When a company undertakes a merger, shareholders may welcome it as an expansion.

On the other hand, they could conclude that the industry is shrinking, forcing the
company to gobble up the competition to keep growing.

In an acquisition, a company buys a majority stake of a target company's shares. The

shares are not swapped or merged. Acquisitions can be friendly or hostile.

A reverse merger is also possible. In this scenario, a private company acquires a public

company, usually one that is not thriving. The private company has just transformed
itself into a publicly-traded company without going through the tedious process of
an initial public offering. It may change its name and issue new shares.

The Spin-Off
A spin-off occurs when an existing public company sells a part of its assets or
distributes new shares in order to create a new independent company.

Often the new shares will be offered through a rights issue to existing shareholders
before they are offered to new investors. A spin-off could indicate a company ready to
take on a new challenge or one that is refocusing the activities of the main business.

What Is Compound Annual Growth Rate – CAGR?

Compound annual growth rate (CAGR) is the rate of return that would be required for an
investment to grow from its beginning balance to its ending balance, assuming the
profits were reinvested at the end of each year of the investment’s lifespan.

Formula and Calculation of CAGR

CAGR=[(EV / /BV)^1/n ] −1

EV=Ending value

BV=Beginning value

n=Number of years

 CAGR is one of the most accurate ways to calculate and determine returns for
anything that can rise or fall in value over time.
 Investors can compare the CAGR of two alternatives in order to evaluate how
well one stock performed against other stocks in a peer group or against a
market index.
 CAGR does not reflect investment risk.

HURDLE RATE

 A hurdle rate is the minimum rate of return required on a project or investment.

 Hurdle rates give companies insight into whether they should pursue a specific
project.
 Riskier projects generally have a higher hurdle rate, while those with lower rates
come with lower risk.
 Investors use a hurdle rate in a discounted cash flow analysis to arrive at the net
present value of an investment to deem its worth.
 Companies often use their weighted average cost of capital (WACC) as the
hurdle rate.