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2022 LI Equity
2022 LI Equity
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Market Efficiency 35
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f. calculate and interpret the leverage ratio, the rate of return on a margin
transaction, and the security price at which the investor would receive a
margin call;
i. define primary and secondary markets and explain how secondary markets
support primary markets;
Main Functions
LOS a
- of the Financial System
- explain
1) Facilitate the transfer of:
- capital between providers and users of capital
- risk between those who don’t want it to those willing
to accept it
LOS a
1) Facilitate transfers - explain
1) Saving - move money to the future
- requires someone else willing to pay (borrow)
Sources individuals, business, gov’t.
LOS a
1) Facilitate transfers - explain
5) exchange assets (on the spot)
i.e. - forex
6) Information-based trading - speculation
- investors expect to earn a return for
bearing risk
- speculators expect to earn a return in
excess of the required rate of
return
2) Discovery - capital costs money (rate of return)
- when capital supply > demand for capital , price ↓
- when capital supply < demand for capital , price ↑
LOS a
2) Discovery - when supply = demand (S = I) - explain
equilibrium interest rate
Classifications
LOS b
Assets: MBS
- describe
1) financial assets - securities, currencies
2) physical assets - commodities, real assets GLD
LOS b
Markets can be classified on the basis of
- describe
3) the maturity of the instruments traded
- money markets - debt maturity < 1 yr.
- capital markets > 1 yr.
4) Types of securities
- traditional - debt, equity, funds
- alternative - private equity, securitized
debt, hedge funds
Last Revised: 05/20/2021
LOS c
1) Securities a) Public - exchanges
- describe
b) Private - qualified investors only
Fixed-Income (Debt)
· Notes · Bonds · Bills · CDs · Repos · MM
LOS c
1) Securities - describe
Pooled Investments (i.e. mutual funds, ABS)
- shares/units represent shared ownership of the
assets held
2) Currencies
- monies issued by national monetary authorities
- trade in foreign currency market (24 hrs./day)
LOS c
3) Contracts - may be cash settled or require
- describe
physical delivery
- physical vs. financial contract
- spot vs. forward/future/swap/options contracts
LOS c
3) Contracts c) Swaps - an agreement to exchange a - describe
series of cash flows at periodic dates over
a period of time (i.e. fixed for floating)
d) Options
Call to buy
a right a specific at a specific by a certain
Put to sell
asset price date
e) Others - Insurance
- Credit Default Swaps
Last Revised: 05/20/2021
LOS c
4) Commodities - precious/industrial metals, - describe
energy, agriculture, etc…
· spot · Forward/Futures
- buyers/sellers of - hedging/speculating
the physical product - usually close positions prior to
delivery date
5) Real Assets (Direct Investing)
Intermediaries
LOS d
- facilitate the matching of providers
- describe
and users of capital and structuring products/services to
satisfy that function
LOS d
2) Dealers - will hold inventory - describe
- will become contract counterparties
- create liquidity
- can also act as a broker
- Primary Dealers can buy/sell with the Central Bank
LOS d
5) Insurance Companies
- describe
- create and sell contracts that protect
buyers from risk (auto, fire, theft, life)
- connect buyers with investors, creditors &
reinsurers
Positions
LOS e
- long position - benefits from an increase - compare
in price
- owns an asset or has purchased a contract
LOS e
Options long a call benefit from an - compare
short a put increase in price of the underlying
right obligation
short a call benefit from a drop in price of
long a put the underlying
LOS e
Short: Contracts - must deliver the - compare
underlying at a pre-determined date for a
pre-determined price
Margin
LOS f
- Levered Positions
- calculate
margin - borrowing funds from your broker
- interpret
to buy securities
me margin loan
LOS f
e.g./ 100 shares of ABC @ $30/sh. on - calculate
Sell for $24 @ t1 margin - interpret
-20%
Div. received = 30¢/sh.
-40%
Commission Paid = 10¢/sh.
Leverage Ratio = 2
Call money rate = 6% Sale (100 × 24) 2400
- Comm. (10)
Total ROI?
- Loan (1500)
Purchase (100 30) 3000
- Interest (90)
+ Comm. 10 + Dividends 30
3010 830
- Margin Loan 1500
Orig. Inv. 1510 −
= =− %
LOS f
Initial Margin - calculate
- interpret
Maintenance Margin triggers margin call back up to Initial
margin
- else ‘forced liquidation’
Max. 75%
Last Revised: 05/20/2021
Order Types
LOS g, h
prices at - compare
prices at which
which dealers Bid Ask they are willing to sell
and traders
are willing to buy spread
400 10.55 2000 × 2000
i.e. 10.55 - 10.62 100 600
100 10.53 20 × 20
200 10.51 best best 100
bid ask
1000 10.49 bid ask size size
LOS g, h
To buy - compare
10.70 · limit $ > ask
- at least partially
10.62 Ask - marketable limit order
filled
LOS g, h
Exposure Instructions - display or hide
- compare
- hidden only brokers & exchanges see them
LOS g, h
Validity Instructions - compare
stop-loss (long pos.) Buy @ $10, stop @
Stop orders
$9.50
buy-stop (short pos.)
- Sell @ $10, buy-stop @ $10.50
LOS i
Primary Public Offering - define
Company Investment Investors - explain
Bank
· lines up subscribers (book building)
- may be done as
Trading
LOS j
Buyers must be able to find Sellers
- describe
- at low cost
LOS j
Call Market: - very liquid in session - describe
- illiquid otherwise
LOS j
Execution: Quote-driven markets - describe
- customers trade with dealers (dealers trade with
(bonds, spot commodities) dealers)
- referred to as OTC (over-the-counter)
LOS j
Execution: Order-driven markets - describe
Trade pricing rules 1) Uniform pricing rule - same
price is used for all trades (used by
Call Markets)
2) Discriminatory pricing rule
- the limit price of the order/quote that
arrived first determines the trade price
e.g./
Bid Ask Size New Market
Order to sell arrives:
Size 10.36 300 10.36 300
1400 @ Limit of $10.28
10.34 1200 10.34 1200
300 filled at $10.30
10.32 600 10.32 600
900 filled at $10.28
300 10.30 10.28 200
new standing order of
900 10.28 400 10.26
200 @ 10.28
400 10.26
Last Revised: 05/20/2021
LOS j
Execution: Order-driven markets
- describe
3) Derivative Pricing Rule - use the
mid-point of the bid-ask from another
market
e.g. POSIT
10.55 - 10.63 trades cleared at
$10.59
Brokered Markets - brokers arrange trades
among their clients
LOS j
Information: - describe
Pre-trade transparency
- publish real-time data about quotes
and orders
- all exchanges
Post-trade transparency
- publish data about trade prices
after trade occurs (most dealer markets)
Well-Functioning System
LOS k
helps - savers
- describe
- borrowers
complete markets
- hedgers
- all the assets/contracts
- asset exchange
exist to satisfy all 4
(spot)
Features · timely & accurate disclosures (supports
information efficiency)
· complete markets
LOS k
needs intermediaries who:
- describe
· match buyers & sellers by organizing exchanges,
brokerages, and ATS,
· provide liquidity on demand (make markets)
· create products to match buyers & sellers
(i.e. ABS)
· accept deposits and make loans
· provide insurance
· provide advisory services
· organize clearinghouses (settlement, counterparty)
· safeguard assets (custodial or depository services)
Last Revised: 05/20/2021
LOS k
A financial system that is - describe
Operationally efficient
Allocationally efficient
Regulation
LOS l
· Control fraud by, or deception of, market
- describe
participants Confidence
· promote fairness
b. calculate and interpret the value, price return, and total return of an index;
e. calculate and analyze the value and return of an index given its weighting
method;
Market Index
LOS a
- consists of individual securities that
- describe
represent a given security market,
market segment or asset class a.k.a.
constituent
(most constructed as a portfolio securities
of marketable securities)
LOS a
Uses: - describe
- simple measure to capture performance and
direction of a particular market
Index Return
LOS b
VPRI - value of the - calculate
‘price return’ index - interpret
ni - # of units of security
Pi - Price of security
depends on
N - # of individual securities in the
the type of
D - value of the divisor index
weighting used
- price a number initially chosen at
- equal inception so that the index has a
- market-cap convenient initial value
- floating-adjusted - divisor changes over time
market-cap so that changes in the index
- fundamental weighting reflect price changes only
LOS b
Single Period Returns - calculate
Price Return - the %’age change in VPRI . − - interpret
= .
words
each component
Last Revised: 05/20/2021
LOS b
Single Period Returns - calculate
Total Return - price change + all income - interpret
words
each component
LOS b
Multiple Period Return - calculate
- interpret
+15
e.g./
36.75
0 1000(0) 1,000
1 5.00 + 1.5% 1000(1.065) 1,065.00
2 3.00 + 2.0% 1065(1.05) 1,118.25
Last Revised: 05/20/2021
LOS b
e.g./ 2008 2009 - calculate
PRI 7.5% 8.3% - interpret
TRI 12.6% 13.4%
equity index created at beg. of 2008, VPRI = VTRI = 1000
Index Construction
LOS c
- similar to constructing and managing
- describe
a portfolio of securities
security selection
- all or just a sample
- fixed number (S&P500) or variable (TOPIX)
Index Weighting
LOS d, e
weighting determines how much of
- compare
each security to include in the index - calculate
Price Weighting (simplest) - analyze
.1 +
typically set
stocks with the highest at inception = N
price will have the
greatest impact on the
return of the index
LOS d, e
- any stock split changes all the - compare
weightings - calculate
- analyze
divisor needs to be adjusted to prevent the split
from changing the value of the index
e.g./ % 2-for-1 on A %
A $55 52.38 27.50 35.48
B 22 20.95 22 28.39
C 8 7.62 8 10.32
D 14 13.33 14 18.07
E 6 5.72 6 7.74
Σ = 105 100% 77.50 100%
D = 5
VI = 21
Last Revised: 05/20/2021
LOS d, e
Equal Weighting ($) - compare
- calculate
i.e. $10k - analyze
5 components
= $2,000 of each component
i.e.
initial value of the
index
LOS d, e
Equal Weighting - compare
- calculate
+/ - simple
- analyze
-/ - securities that represent the largest fraction of
the target market value are underrepresented
LOS d, e
Market-Capitalization Weighting - compare
- calculate
- divide market-cap
- analyze
of the component by sum of all
market caps
# of shares available
to the investing public Note: most market-cap
weighted indicies are
float adjusted
LOS d, e
Market-Capitalization Weighting - compare
- calculate
+/ - components are held in proportion to
- analyze
their value in the target market Q x P
-/ - components whose price have risen the most (or fallen)
have a greater (lower) weight in the index
LOS d, e
Fundamental Weighting
- compare
- attempts to overcome market-cap - calculate
disadvantages - analyze
- uses a fundamental value as a proxy for size rather
than market cap
i.e. book value
Revenues
CFO
Earnings, etc…
Market
- results in indicies with ratios of
Value
higher than its market-cap counterpart
- weights favour securities that have decreased in
relative value
LOS d, e
Fundamental Weighting - compare
- calculate
e.g./ Stock Market-Cap Earnings Earnings Yield - analyze
A $200M 20M
B 800M 20M
$ 1B 40M Market
Value
Rebalancing/Reconstitution
LOS f
Rebalancing - describe
- weights assigned to constituents at inception
drift from their target weights as prices change
LOS f
Reconstitution - the process of changing - describe
the securities in the index keeps the index
representative
Uses
LOS g
· to gauge market sentiment - good
- describe
indicators of the collective option of market
participants
Index Types
LOS h
1) Broad market indicies
- describe
- represents more than 90% of the selected
market i.e. Russell 3000 99% of the market
cap of the US equity
market
2) Multi-market indicies
- consist of security market indicies from
different countries
- different countries/national markets/economic
development groups weighted differently
(e.g. by GDP)
a fundamental weighting of the
market-cap weighted indicies
Last Revised: 05/20/2021
LOS h
3) Sector Indicies
- describe
- represent a particular sector (Consumer Staples,
Utilities, etc.)
- helps assess manager performance (10 broad sectors)
- are returns due to stock
picking or sector allocation
4) Style Indicies
- growth vs. value
- will require more frequent rebalancing
& reconstitution
Fixed-Income Indicies
LOS i
broader universe of bonds than stocks
- describe
universe constantly changing (new issues, calls, maturities)
Duration (price volatility) is constantly changing
LOS i
can be categorized as - describe
· Aggregate or broad market indicies
· Market sector indicies
· Style indicies
· Economic sector indicies
· Specialized indicies (e.g. high-yield, inflation-linked,
emerging market)
e.g./
Investment Grade maturity credit rating
10-yr. gov’t.
Alternative Investments
LOS j
1) Commodity indicies
- describe
- consist of futures contracts on one or
more commodities
equal, fixed or price weighted (determined by a
committee)
LOS j
2) Real Estate/REIT indicies - describe
consist of shares of publicly traded
REITs
appraisal indicies
typically commercial
repeat sales indicies
property
3) Hedge Fund Indicies
broad global level
strategy level
rely on voluntary disclosure
hedge funds can choose which index to report
performance to (constituents determine the
index)
poorly performing funds don’t often report
(survivorship bias)
Last Revised: 05/20/2021
Market Efficiency
Market Efficiency
LOS a
- the extent to which market prices
- describe
incorporate available info.
inefficiency is what justifies active mgmt.
information efficiency
- assumes information is (timely, complete, correct, and
understandable)
Jobs Jobs
info. price
_
-
-
-
LOS a
- describe
- asset prices reflect new information
quickly and rationally the unanticipated element
1 min.-1 hr. consensus FRI
-
-
-
-
-
Efficient Markets
LOS a
Suppose that a speculative-grade bond issuer announces, just before bond markets - describe
open, that it will default on an upcoming interest payment. In the announcement, the
issuer confirms various reports made in the financial media in the period leading up
to the announcement. Prior to the issuer’s announcement, the financial news media
reported the following:
1) suppliers of the company were making deliveries only for cash payment, reducing
the company’s liquidity
2) the issuer’s financial condition had probably deteriorated to the point that it lacked
the cash to meet an upcoming interest payment
3) although public capital markets were closed to the company, it was negotiating
with a bank for a private loan that would permit it to meet its interest obligations and
continue operations for a least nine months. hope (hope dies last)
If the issuer defaults on the bond, the consensus opinion of analysts is that bondholders
will recover $0.36 to $0.38 per dollar value.
LOS a
1. If the market for the bond is highly efficient, the bond’s market price is most - describe
likely to fully reflect the bond’s value after default:
2. If the market for the bond is highly efficient, the piece of information that bond
investors most likely focused on in the issuer’s announcement was that the issuer:
LOS b
- describe
1. An analyst estimates that a security’s intrinsic value is lower than its market value.
The security appears to be:
IV < MV
A. undervalued
B. fairly valued
C. overvalued
2. A market in which an asset’s market values are, on average, equal to or nearly equal to
intrinsic value is best described as a market that is attractive for:
A. active investment
B. passive investment
C. both active and passive investment
3. Suppose that the future cash flows of an asset are accurately estimated. The asset
trades in a market that you believe is highly efficient based on most evidence. But
your intrinsic value estimate exceeds market value by a moderate amount. The most
likely conclusion is that you have:
Impediments
LOS c
Inefficient factors Efficient - explain
Efficiency Taxonomy
LOS d
- contrast
Market Prices Reflect
Forms of Market Past Market Public Private
Efficiency Data Information Information
Weak-form √
Semi-strong form √ √
Strong-form √ √ √
LOS d
Weak-form/ future returns should be independent of - contrast
past returns or patterns
- no serial correlations
- no trading ‘rules’
LOS d
Semi-strong form/ - encompasses weak-form - contrast
- considerable research support in developed
markets
LOS d
Strong form/ · encompasses both weak and semi-strong - contrast
forms
· research rejects the strong-form hypothesis
(i.e. fails to accept) H0
Ha - interesting
Implications
LOS e
1) Security markets are weak-form eff. - explain
technical analysis will not produce
consistent abnormal risk-adjusted returns
Market Anomalies
LOS f
Time-Series Anomalies - describe
Calendar anomalies
a) January effect - higher returns in equity
markets compared to other months
b) Turn-of-the-month effect - higher returns on the
last trading day and first 3 of next month
c) Day of week effect - avg. Mon. R < 0, and lower
than other 4
d) Holiday effect - day prior to holiday tends to
have higher returns
Last Revised: 05/20/2021
LOS f
Time-Series Anomalies - describe
Overreaction Anomalies
- investors overreact to the release of
unexpected new information
Momentum Anomalies
- securities that have outperformed in the
short-run continue to outperform (IBD) - 6pm.
Top 100
LOS f
Cross-Sectional Anomalies - describe
1) Size effect
- small-cap equities tend to outperform
large-cap equities on a risk-adjusted basis
(not conformed over time)
2) Value effect
- value stocks outperform growth stocks
· market returns
over time (Fama/French)
· MV of equity
(use of 3-factor model for valuation vs.
· BV equity
MV
CAPM (1-factor) eliminates this anomaly)
equity
Last Revised: 05/20/2021
LOS f
3) Other Anomalies - describe
a) Close-end fund discounts
- to their NAVPS
- typically not worth the transaction
costs
b) Earnings Surprises
- prices may be slow to adjust
Behavioral Finance
LOS g
- examines investor behavior (observed) - describe
rather than relying on normative assumptions (i.e. rationality)
LOS g
Herding - investors ignore their own - describe
analysis and make decisions in line with the
direction of the market (can often be rational
to follow)
- correlated strategies, clustered trading
LOS g
- many more - describe
Implications for the market - unclear
- even if some investors
exhibit bias, as long as enough do not,
markets will remain efficient
Equity Securities
LOS a, b
- a few global facts
~ 50% - describe
- long-run
avg.
Company
Debt Equity - residual claim on assets
- liability - cap. gains + div.
- interest
LOS a, b
Common Shares:
- describe
- ownership interest in the company (residual claim)
- share in operating performance (cap. app., dividends)
- participate in governance proves (voting rights)
major corporate decisions (e.g. M&A)
election of BoD
LOS a, b
Common Shares: - describe
- different classes each with different ownership
and voting rights, and even different claims on
net assets in liquidation event
LOS a, b
Preference Shares: (preferreds)
- describe
- do not participate in operating performance
- no voting rights
- prices like debt, pays like equity (i.e. div. vs. int.)
Last Revised: 05/20/2021
LOS a, b
Preference Shares: (preferreds)
- describe
Cumulative: · unpaid dividends accrue over time
· must be paid in full before any
common dividends can be paid
LOS a, b
Preference Shares: (preferreds) - describe
Non-Participating - stated preferred div. only + par
value
Convertible - to common
- participate in equity participation
usually has a
while getting a higher yield
‘forced conversion’
- common in private equity (i.e. VC)
clause
(typically done so as not to re-price
the common)
forced-conversion - if the common $ > conversion price,
company may force conversion by calling
at low price
avoids ‘overhanging convertibles’
Last Revised: 05/20/2021
LOS c
Public IPO - secondary markets
- distinguish
Private Private Placement - no secondary market
LOS c
Types of Private Investments: - distinguish
1) Venture Capital - seed to growth financing
- VC firm set-up as a limited
partnership
- usually 10-year life
- 3 to 5 yr. investment phase
- YRS-10: Sell, IPO, liquidate
LOS c
Types of Private Investments: - distinguish
3) Private Investment in Public Equity (PIPE)
GM - $5B - 10% - restricted stock usually at a
GS - $5B - 10%
- preferreds discount
Advantages of Private Equity:
- management focused more on long-term value
creation
- inefficient markets higher risk-adjusted
returns
- lower company costs due to lack of - filing requirements
- listing fees
- regulatory costs
Non-Domestic Equity
LOS d
Companies are able to issue shares in
- describe
international markets
- wider shareholder base
- lower cost of capital
LOS d
- reducing these restrictions tend to lead - describe
to improved equity market performance
LOS d
Methods/ - describe
Direct Investing
- buy/sell directly in foreign market
· purchase price, sale price, gains/losses
& dividends in foreign currency
(exchange rate risk)
· must be familiar with trading,
clearing & settlement regulations of
the foreign market
· may lead to less transparency & more
volatility (or vice versa)
Last Revised: 05/20/2021
LOS d
Methods/ - describe
Depository Receipts
- trades like an ordinary share on a local
exchange
- represents an economic interest in a
foreign company
Domestic Market
Buyer
deposits may not be
dom. $
1-for-1
shares
Domestic
Foreign Domestic
issues Exchange
Co. Bank
receipts
Seller
· transfer agent · all divs. in dom. $
· custodian dom. $
LOS d
Methods/ - describe
Depository Receipts
LOS d
Methods/ - describe
Depository Receipts
LOS e
Preferreds are less risky than common - compare
- Pref. Div. known and fixed (generally) (Dt)
- dividend accounts for a large portion of the
(less uncertainty about future CFs) Pref. sh. Rt
Financing a Company
LOS f, g
- companies issue equity to raise - explain
(A = L + E)
capital (for many reasons/uses) - distinguish
LOS f, g
Accounting Return on Equity - explain
- Pref. Div. - distinguish
- Price-to-Book Ratio
P0 - higher ratio indicates that the
market is pricing in higher
future growth opportunities
LOS h
ROE - the rate of return earned by a - compare
company on its equity capital
- uses accounting net income (s.t. estimates, methods)
c. explain the factors that affect the sensitivity of a company to the business
cycle and the uses and limitations of industry and company descriptors such
as “growth”, “defensive”, and “cyclical”;
i. describe industry life cycle models, classify an industry as to life cycle stage,
and describe limitations of the life-cycle concept in forecasting industry
performance;
Page 1
LOS a
1/ Understand a company’s business environment - explain
- provides context for a company analysis growth opportunities
and threats, competitive dynamics, business risks
Page 2
1) By product/service supplied/ (GICS, ICB) LOS b, c
- compare
- companies placed in industries based on their
- explain
principal business activity (source of the majority of
its revenues/earnings)
- sector - a group of related industries
cyclical non-cyclical
correlated with overall economy relatively independent of the
high demand in expansions business cycle
low demand in contractions relatively stable demand over the
typically have high operating business cycle
leverage (high FC, low VC) non-discretionary goods/services
durable/discretionary goods (Utilities, food/beverage, Health Care)
(auto, industrials, housing)
Page 3
2) By business cycle sensitivity LOS b, c
- compare
growth cyclical companies growing rapidly but still very
- explain
business cycle sensitive
non-cyclical
defensive growth
- revenues/profits least affected - specific demand drivers that
by fluctuations in economic override broad economic factors
activity - generate growth regardless of phase
(staple consumer goods, basic of the business cycle
services, rates of return determined (e.g. Netflix)
by regulation)
Page 4
2) By business cycle sensitivity LOS b, c
cyclical - compare
non-cyclical - explain
- also, different countries and regions progress through the various stages
of the business cycle at different times
Page 5
3) By statistical similarities LOS b, c
- produce non-stable groups across time - compare
- relies on historical data may not be representative - explain
of future relationships
- subject to Type I/II errors
LOS d
Commercial Industry Classification Systems/
- describe
GICS - global industry classification standard - identify
- classified based on principal business activity
Page 6
both GICS and ICB recognize the same top-level LOS d
broad groupings - describe
- identify
1. Materials - building materials, chemicals, forest products
2. Consumer Discretionary - auto, apparel, hotel
3. Consumer Staples - food/beverage, personal care products
4. Energy - exploration, production, refining, services to
5. Financials - banking, insurance, asset mgmt.
6. Health Care - biotech, pharma, medical devices
7. Industrials - heavy machinery, aerospace/defense
8. Real Estate - REITs, REOCs
9. Information Technology - electronic entertainment, internet services, tech.
consulting
10. Communication Services/Telecom - fixed line/wireless, video gaming
11. Utilities - electric, gas, water
Page 7
LOS e
Peer group a group of companies engaged in similar - explain
business activities whose economics and valuations
are influenced by closely related factors
Page 8
Peer group companies with limited lines of business can LOS e
be categorized easily - explain
companies with multiple divisions may be included in
more than 1 category
LOS f, g
- describe
macro
industry
variables
structure
affecting
the industry Porter’s
5-forces
Page 9
Principles of Strategic Analysis/ LOS f, g
- describe
analysis of the competitive environment must be
informed by the structural attributes of an industry
Page 10
barriers to entry: higher/stronger barriers reduce competition LOS h
- low barriers reduce pricing power and drive - explain
return on invested capital to its required return (economic
profit = 0)
- disruptive technologies are a threat
- fintech vs. traditional payment clearing
- high barriers to entry often create high barriers to exit - can make
industries prone to overcapacity (retail malls)
Page 11
Industry concentration: fragmented, tend to be highly price LOS h
competitive - explain
- capacity is fixed in the short term but variable in the long term
- capacity cycles in waves tight to loose
Last Revised: 05/20/2021
Page 12
Industry capacity: LOS h
- if new capacity is physical, longer lead times for - explain
capacity to come online - market will be tight for sometime
Page 13
Price Competition: industries for which price is a large LOS h
factor in customer purchase decisions tend to - explain
LOS i
Life-Cycle Models/
- describe
Mature
Decline - classify
Shakeout
Embryonic Growth
Page 14
Life-Cycle Models/ LOS i
Growth: new customers enter the market increasing - describe
demand, profitability improves, sales grow - classify
rapidly, lower prices as a result of scale, low levels
of competition (market share gains come from industry
growth vs. each other), high threat of new entrants
- focus on top-line revenue growth + reinvestment
Shakeout: demand growth slows, competitive pressures begin to grow
as market share gains begin to come at the expense of
others, capacity outweigh demand which puts downward
pressure on price
- focus on cost reduction and building brand loyalty
Maturity: little/no growth in demand, industry in consolidation,
companies become more price strategic, high barriers to
entry, efficient cost structures, positive cash flows, dividends
present
Page 15
Life-Cycle Models/ LOS i
Maturity: focus on incremental innovations, industry at - describe
risk from radical innovation (usually from outside) - classify
Page 16
Limitations/ LOS i
social changes/demographics (growth decline) - describe
or (mature growth) - classify
Page 17
2/ Technological Influences/ LOS j
- new products may replace older products - describe
- new products may also change the way other industries
operate
new ways of organizing, new way of producing
Page 18
6/ Environmental Influences/ LOS j
consumer perception climate, animal rights, - describe
government regulation sustainability, biological infection
floods
resource shortages, supply chain disruptions fire
weather
products/services
offensive - growth
competitive strategy
defensive - maintaining share
1) low-cost strategy - low cost producer/provider
- gain market share with lower prices
Page 19
Company analysis: LOS L
competitive strategy - describe
Page 20
Company analysis: LOS L
- describe
Corporate Profile
- governance arrangements
Industry characteristics
a. evaluate whether a security, given its current market price and a value
estimate, is overvalued, fairly valued, or undervalued by the market;
e. explain the rationale for using present value models to value equity and
describe the dividend discount and free-cash-flow-to-equity models;
g. calculate and interpret the intrinsic value of an equity security based on the
Gordon (constant) growth dividend discount model or a two-stage dividend
discount model, as appropriate;
i. explain the rationale for using price multiples to value equity, how the price
to earnings multiple relates to fundamentals, and the use of multiples based
on comparables;
k. describe enterprise value multiples and their use in estimating equity value;
IV versus MV
LOS a
- goal is to identify mispriced securities - evaluate
(i.e. IV ≠ MV)
· also depends
on the confidence of the inputs more confidence
Valuation Models
Page 2
- 3 major categories of valuation model LOS b
1) Present Value Models (discounted cash flow) - describe
- present value of the future benefits to be
received from the security
- either future dividends paid (dividend discount model)
or future cash available to pay dividends (FCFF/FCFE)
Page 4
· Share Repurchase - an alternative to cash LOS c
dividends - describe
- company uses cash to buy back its own stock
Transaction:
Treasury Stock $ a contra-equity account
PPE
Cash $ - Accum.Dep.
Reasons for:
a) signaling a belief that their shares are undervalued
b) flexibility on amounts and timing
c) tax efficiency (deliver capital gains vs. dividends)
d) nullify the effect of employee stock options
Last Revised: 05/20/2021
-
May 29 Sept 28 Sept 29
Holder of Payment
Record Date Date
LOS e
- explain
why use ∞
- describe
- holding period, t = 1
where
so at t = 2
where
and at t = 3
and so on…
t = n
LOS e
e.g./ YR1 YR2 YR3 - explain
Div. 2.00 2.10 2.20 - describe
P3 = 20
r=10% . . .
= + + +
Find V0 ( . ) ( . ) ( . ) ( . )
= . + . + . + .
=$ .
LOS e
e.g./ D0 = $4
- explain
g = 20% (expected growth rate in the
- describe
dividend for one year)
rf = 6%
rE = 11% What is V0?
=
= 1.2 Dt = D0(1 + g)
est. P1 = $15.40 = 4(1.2)
= 4.80
r = rf + (rE - rf)
= .06 + 1.2(.11 - .06)
= .06 + 1.2(.05)
= .06 + .06
= .12
LOS e
- FCFE free cash flow to equity - explain
- describe
reflects dividend paying capacity
(useful for non-dividend paying stocks)
CAPEX
CAPM
Recall
economic
or/ r = rf + risk premium judgement
gov’t. company’s
Dt bond yield
bond
Last Revised: 05/20/2021
Preferred Shares
LOS f
- non-callable, non-convertible
- calculate
(perpetual)
Recall: dividend
PV of a perpetuity
stated as a fixed
yield
LOS f
e.g./ Non-Callable, Non-Convertible, Perpetual - calculate
Par value = $100 @ 4.75%
Credit Rating = Ba1/BB, required return on BB = 7.5%
What if the
IV = ?
shares were
callable?
LOS g
e.g./ D0 = $5
- calculate
g = 4% - interpret
r = 8%
PV of a growing perpetuity
- if g = 0 , PV of a perpetuity
how do we get g?
g = div. growth rate
g = b ROE
b = earnings retention rate
(1 - DPR)
ROE = return on equity
Last Revised: 05/20/2021
LOS g
- calculate
- interpret
IV = ? with
r = 19%
( + )
=
D0 = 2.28 r = .19 g = ? 2.28 = 1.35(1 + g) 4 −
= g = .14
share price of $38.91 undervalued
if g = 13%
if g = 0
g adds $39.98 to V0 if g = 13%
r = 20%
LOS g
- calculate
- interpret
strictly
15.8
15.9
19%
LOS g
assumptions:
- calculate
1) Dividends are the correct
- interpret
metric for valuation purposes
- alternatives
a) modify the model (for varying patterns of
growth)
b) use a cash flow measure
other than dividends (for non-dividend
paying stocks)
c) use some other approach
LOS g
e.g./ D5 = 4.00 (expected) - calculate
g = 6% (t5 onwards) - interpret
r = 10%
4.00 4.00(1.06)....
0 5 6 7 g = 6%
r = 10%
Last Revised: 05/20/2021
LOS g
- Multistage DDM - calculate
- interpret
2-stage: makes use of 2 growth rates
high g low g
2 - initial finite - perpetuity
1 period
Vn use Gordon Growth
use DDM + terminal
V0 value
model to estimate Vn
LOS g
e.g./ D0 = $5.00 - calculate
gs = 10%/a for 3 years - interpret
gL = 5%/a subsequent
r = 15% D3 = 5.00(1.1)3
g = 10%
g = 5%
-
0 1 2 3 4 5
5.00
r = 15%
(90 Sec)
Last Revised: 05/20/2021
Model Appropriateness
LOS h
- constant growth - stable growth
- identify
- maturity phase
g < (1 - DPR)ROE
- non-cyclical
- dividend paying company
Price Multiples
LOS i, j
- ratios that compare the share price - explain
with some sort of monetary flow or value - calculate
earnings book value - interpret
sales
cash flow
(or OCF/sh.)
LOS i, j
Price-to-Earnings (P/E)
+ - explain
- - calculate
- easy to use · useless if EPS < 0, - interpret
+ Price-to-Sales (P/s)
-
- not influenced by actg. choices - rev. recognition issues
- better metric if EPS < 0 still apply
- ignores cost structure
LOS i, j
Price-to-Cash Flow (P/CF)
+ - explain
- - calculate
· more of an economic measure - interpret
- ignores non-cash
· more difficult to manipulate
revenues
· tends to be less volatile than EPS
· more reliable over long-term
LOS i, j
< undervalued - explain
Ratio = specified fairly valued - calculate
> value overvalued - interpret
EPS
.96
.84
.72 Σ = 3.12
.60 (overvalued)
.48
.36
.24 Σ = 1.20
.12 (undervalued)
actual estimated Q
YR1
Target Price = 15 3.12 = $46.80
industry P/E = 15 Strong - ‘Buy’
P0 = $36.00
LOS i, j
Recall - explain
- calculate
- interpret
justified =
Last Revised: 05/20/2021
LOS i, j
So, P/E is positively related - explain
to - calculate
DPR - questionable however
- interpret
called the - higher DPR, lower retention
‘justified P/E’ rate, lower re-investment
(i.e. justified by the (dividend displacement of
fundamentals) earnings)
g (1 - DPR)ROE
P/E is positively
related to ROE
LOS i, j
- Based on comparables - explain
multiple 1 - calculate
Company multiple 2 versus Benchmark value - interpret
multiple 3 (i.e. compared to) of the multiple(s)
etc.…
LOS i, j
e.g./ Company P/S - explain
A .14 A appears - calculate
B .26 undervalued ‘Relative’ to its - interpret
C .32 peers
or/
D .48
E .64 E appears overvalued
‘Relative’ to its peers
e.g./ Year
2016 2015 2014 2013 2012
P/E 11.2 13.6 15.2 16.1 15.8
MV(equity)
cost of a takeover
· most useful when
comparing companies with
significant differences in capital structure
Asset-Based Valuation
LOS L
- uses MVs of a company’s A & L to
- describe
determine the value of the company as a whole
1. Using DDM,
E find V0 (r = 10%)
E = ( + )
E
E
E
(U)
Last Revised: 05/20/2021
Asset-Based Valuation
= MV MV(A) = 5000 +
= MV 15000 + 30000
+ 55000 = 105,000
x 1.1 = MV
= MV
1000 shares
MV(A) - MV(L) = 105,000
20% - 45,000
DDM $51 P0 = $50.80 60,000
P/E $58.80
Last Revised: 05/20/2021
Last Revised: 05/20/2021
saving Review - 1
Functions of Financial System/ capital
borrowing
1) Facilitate transfer of risk
- providers/users of capital indiv., bus., gov’t.
- information-based trading (speculator return > req. r)
2) Price Discovery - what is the price of risk
3) Facilitate the efficient allocation of capital
- hedging, insurance
- capital seeks out best risk-adjusted return
Review - 2
Assets/ - financial assets - stock, bonds, currencies
- physical assets - commodities, real estate
d) Options
Call to buy a specific at a specific by a certain
a right
Put to sell asset price date
Sellers an obligation
e) Others - Insurance, Credit Default Swaps
Review - 4
· Commodities - spot
hedging
- forward/futures
speculation
generally illiquid
· Real Assets - property, factories, equipment
high mgmt. costs
Intermediaries/
1) Brokers, Exchanges, ATS (Alternative Trading Systems)
best bid and ask dark pools - do not display
order sent to them
2) Dealers - hold inventory
- act as market makers (create liquidity)
- Primary Dealers (can buy/sell w/ Central Bank)
3) Securitizers
5) Insurance Companies
Last Revised: 05/20/2021
Intermediaries/ Review - 5
6) Arbitrageurs
7) Settlement & Custodial Services - hold securities on
behalf of clients
Positions/ long - benefits from an increase in price
short - benefits from a drop in prices
long - takes delivery
· forward/future
short - delivers
· options long - buy a call or put
short - sell a call or put
· swaps - party that benefits from a rise in rates = long
Review - 7
Order Types/ market - guaranteed execution, but not price
limit - guaranteed price, but not execution
x x x x x
Bid Ask
make the create a marketable
to Buy: behind the
market limit order
market new market
standing limit all earlier orders
order at the bid executed
first
Exposure Instructions/ display or hide, or display a certain size
Validity Instructions/ when an order is to be filled
Day = default
GTC = good-til-cancelled
FOK = fill-or-kill
good-on-close = market order on close
Review - 8
Validity Instructions/
stop loss (stop a long pos.)
Stop orders
buy stop (stop a short pos.)
Review - 10
· derivative pricing rule/ · mid point of bid-ask from
another market
Review - 1
Index constituent securities representing a given
security market (or asset class)
- 2 versions Price Return - reflects only prices
Total Return - reinvestment of all income
Review - 2
Returns/ · Single Period
or weighted average of
each component :
each component
Total Return/ or
· if no
income
Last Revised: 05/20/2021
Review - 3
Index Construction/ target market selection
asset class, geography, sector, industry, size?
security selection - all or a sample?
- fixed or variable
weightings Rebalancing Reconstitution
Review - 4
Index Construction/ market-cap weighted Index
float-adjusted
# of shares - most market-cap indicies
available to the are float adjusted
investing public
Review - 5
Rebalancing/ weights drift over time
Review - 6
Types/ 1) Broad market Index
2) Multi-market Index - indicies from different
countries (e.g. countries by GDP)
3) Sector Indicies
growth
4) Style Indicies
value
Market Efficiency
IV MV - fairly valued
+/- 10%
Review - 2
Impediments to efficiency/
Review - 3
Weak form/ future returns independent of past returns
- technical analysis useless
- no abnormal risk-adjusted returns based on past prices
Time-Series Anomalies/
Calendar January
- all lack turn-of-the month (last day + first 3)
persistence Day of the week (avg. M. r. < 0)
Holiday effect (day prior)
Review - 4
Time-Series Anomalies/
Overreaction/ investors overreact to unexpected info.
(use of a contrarian strategy)
Momentum/ securities that have outperformed in
the short-run continue to outperform
Review - 5
Behavioral Finance/ investors do not always act
rationally due to cognitive/behavioral biases (+ emotional)
Review - 2
Preferred Shares/ in increases in divs. if profit
· participating over some level
proceeds of a liquidity event
· convertible - typically ‘forced conversion’ clause
1) Venture Capital
2) LBO/MBO - leveraged/mgmt. buyout
3) PIPE - private investment in public equity
· restricted stock
Review - 3
· companies can list in international markets
- more filing requirements
· investors can buy in international markets
- typically limits on foreign ownership
Review - 4
· GDR - global depository receipt - issued outside
home country of company and outside U.S.
· Book Value = A - L
· Market Value = # of shares P
Last Revised: 05/20/2021
Review - 5
· Price-to-Book · higher ratio
· overvalued
or/ higher growth
opps. priced in
· Intrinsic Value (IV)
PV (expected future cash flows)
· Cost of Equity
Last Revised: 05/20/2021
identified by GICS/ICB
LOS b, c - compare/explain/
Groupings: 1/ By product/service supplied - principal business activity
Review - 2
LOS b, c - compare/explain/
Groupings: 2/ By business cycle sensitivity
LOS d - describe/identify/
GICS - Global Industry Classification Standard
Sector - Industry group - Industry - Sub-Industry
- classified based on principal business activity
ICB - Industry Classification Benchmark
Industry - Super sector - Sector - Sub-sector
- classified based on primary revenue source
Last Revised: 05/20/2021
Review - 3
LOS d - describe/identify/
11 Broad sectors Materials Consumer Discretionary Utilities
Consumer Staples Energy Health Care
Financials Real Estate Industrials IT
Communication Services/Telecom
Review - 4
LOS f, g - describe
external influences: Porter’s 5 forces
Demographic Bargaining power of buyers low = attractive
Government Bargaining power of suppliers
Macroeconomic Threat of new entrants high
Technology Threat of substitutes =
Social Industry Rivalry unattractive
Environmental
LOS h - explain/
low - little pricing power (highly competitive)
Barriers tendencies, not
high - greater pricing power laws
- often create high exit barriers
Shakeout Decline
Embryonic
Growth
time
Review - 6
LOS i - describe, classify/
Review - 7
LOS j - describe/ External Influences
cyclical - business cycle related
1/ Macroeconomic
structural - permanent changes
5/ Social - values
Review - 8
LOS L - describe/ Company analysis
Equity Valuation
Review - 1
IV - Intrinsic Value MV - Market Value
< - overvalued
IV = MV + 10 - 20%
fairly valued
> undervalued
- 10 - 20%
3) Asset-based valuation
Present Value Models/
1) Dividend Discount Model
= + ( − )
(usually)
explicit forecast terminal
period value
Review - 2
Present Value Models/
2) FCFE · free cash flow to equity
(useful for non-dividend paying stocks)
CFO - FCInv + Net Borrowings
CAPEX judgement
=
( + ) or r = rf + risk premium
gov’t. company’s bond
bond yield
Preferred Shares/
(perpetuity)
- div. stated as a yield (stable)
Gordon Growth Model/ - assumes divs. grow indefinitely at a
constant rate
(g < r)
- a growing perpetuity
Review - 3
Gordon Growth DDM/ 1) Divs. are correct metric for
assumes valuation
2) g is forever
3) r is constant
Review - 4
Price Multiples/
P/E - easy to use, most common
- useless if E < 0
P/S - not influenced by actg. measures
- ignores cost structure
P/CF - less volatile than EPS
- ignores non-cash revenues
P/BV - more stable, appropriate for
firms in distress
Justified P/E/ - denominator may be
- assume V0 = P0, then based on trailing values or
forward values
Last Revised: 05/20/2021
Review - 5
Justified P/E/ P/E positively related to:
DPR
· higher DPR, lower RR, g = RR(ROE)
lower reinvestment …and negatively related to r
(dividend displacement of earnings)
Review - 6
Asset Based Valuation/
- use MV of A & L to determine value of company
· financial companies