Equity Investments

高顿CFA研究院
Brief Introduction
Introduction of the course

Quantitative Methods 8-12%

Economics 8-12%
Financial Statement Analysis 13-17%
Corporate Issuers 8-12%
Equity Investments 10-12%
Fixed Income 10-12%
Derivatives 5-8%
Alternative Investments 5-8%
Portfolio Management 5-8%
Ethics & Professional Standards 15-20%

2
Brief Introduction
Content
 Study Session 1: Equity Investments (1)
 Module 1: Market Organization and Structure (☆☆☆)
 Module 2: Security Market Indexes (☆☆)
 Module 3: Market Efficiency (☆☆)

3
Brief Introduction
Content (Cont.)
 Study Session 2: Equity Investments (2)
 Module 4: Overview of Equity Securities (☆)
 Module 5: Introduction to Industry and Company Analysis
(☆☆)
 Module 6: Equity Valuation: Concepts and Basic Tools
(☆☆☆)

4
Equity Investments

Market Organization and Structure

Market function, classification
and assets

Financial intermediaries
Market organization and
structure
Positions and orders

Primary and secondary market

Market Function, Classification and Assets

Market function,
classification and assets

The functions of the Classification of Classification of

financial system assets market

Achieving purposes Financial Delivery date

assets
Maturity
Determining rates
Position and
Allocation efficiency Physical underlying
assets
Capital flow
Classification of Assets
Financial assets
Categories
 Fixed income
Security  Equity securities
Based on  Pooled investment vehicles (Close-
underlying ended fund, Open-ended fund and ETF)
characteristic
Derivative  Financial contracts
contracts  Physical contracts
Public  Traded on exchanges or through
Based on securities securities dealers.
whether  Not traded in public markets which are
trade publicly Private often illiquid and not subject to
securities regulation.
Classification of Market
Classification of market

Based on Categories
 Spot market
Delivery date
 Futures market
 Money market
Maturity
 Capital market
 Traditional market
Position and underlying
 Alternative market
 Primary market
Capital flow
 Secondary market
 Position and Orders

Long position

Positions Short selling

Leveraged position
Positions and
orders
Execution orders

Orders Validity orders

Clearing orders
Short Selling
Short selling

Borrow stock A

Short seller Security lender

Deposit proceeds as collateral
Sell stock A at Invest proceeds in money
spot market market instruments

Return stock A
Short seller Security lender
Return proceeds, and a portion of its
Buy back stock A investment interest.
at spot market
Leveraged Position
Leveraged position
Concepts Definitions
Buy on margin Buy securities by borrowing.
Margin loan The borrowed loan.
Call money rate Interest rate on margin loan.
Financial leverage Ratio of the value of the position to the value
ratio of the equity investment in it. (A/E)
Initial margin The fraction of the purchase price that must
requirement be buyer’s equity. (E/A)
Maintenance The minimum amount of equity in buyer’s
margin requirement position.
Leveraged Position
Leveraged position (Cont.)
 Margin call: if the value of the equity falls below the
maintenance margin requirement, the buyer will receive a
request for additional equity, or the position will be liquidated.
 Price triggering a margin call (margin call price):

1 − IM
PC = P0 ×
1 − MM
 Position and Orders

Long position

Positions Short selling

Leveraged position
Positions and
orders
Execution orders

Orders Validity orders

Clearing orders
Orders
Instructions attached to orders
Execution Validity Clearing
instructions instructions instructions
Market orders Day orders
Limit orders Good-till-cancelled
Immediate-or-cancel
All-or-nothing orders
(Fill-or-kill) /
Hidden orders Good-on-close
/ Good-on-open
/ Stop orders
Execution Instructions
Execution instructions
 Market orders instruct the broker to buy or sell immediately at
the best current price.
 Limit orders instruct the broker to obtain the best price
immediately available, but in no case accept a price higher
than a specified limit price when buying or accept a price lower
than a specified limit price when selling.
Execution Instructions
Standing limit orders
Status Description
A limit buy order placed at best bid, or a limit sell
Make the market
order placed at best ask.
A limit buy order placed at current best ask, or a
Take the market
limit sell order placed at current best bid.
Make a new A limit buy/sell order placed between the best
market bid and the best ask.
Behind the A limit buy order placed below the best bid, or a
market limit sell order placed above the best ask.
Far from the A limit buy order placed far below the best bid,
market or a limit sell order placed far above the best ask.
Validity Instructions
Validity instructions
 Stop orders cannot be filled until the stop price condition has
been satisfied.
 For a stop sell order, the execution is suspended until a
trade occurs at or below the specified stop price. Stop loss
on long position.
 For a stop buy order, the execution is suspended until a
trade occurs at or above the specified stop price. Stop loss
on short position.
 Primary and Secondary Market
IPO
Public
offering
Secondary offering
Primary
Private placement
market
Shelf registration
Other
Dividend reinvestment
Primary and
secondary market Rights offering

Call market
Trading
session
Continuous market
Secondary
market Quote-driven
Trading
Order driven
mechanism
Brokered
Equity Investments

Security Market Indexes

Price return
Index and index index
return Total return
index

Index weighting
Index
Security market
construction Rebalance and
indexes
reconstitution

Equity index

Index types Fixed income index

Alternative
investment index
 Index Weighting

Price weighting

Equal weighting

Index weighting Float-adjusted

Market capitalization
weighting
Free-float-adjusted
Fundamentally
weighting
Price Weighting
Weighting method, advantage and disadvantage
 The index value is the arithmetic average of security prices. It’s
simply done by buying an equal number of shares of each
security in the index.
 Advantage is its simplicity.
 Disadvantage
 Highly priced securities have a greater influence on index
value.
 When a stock split occurs, the divisor is adjusted so that the
index value is maintained unchanged.
Equal Weighting
Weighting method, advantage and disadvantage
 Each constituent security has an equal weight. The index is
matched by investing equal dollar amount in each stock.
 Index return is the arithmetic mean of HPRs on index stocks.
 Advantage is its simplicity.
 Disadvantage
 Small cap bias: small-cap stocks are over-presented because
it is over-weighted and has greater volatility.
 Requiring frequent rebalance as prices change.
Market-Capitalization Weighting
Weighting method, advantage and disadvantage
 The weight is determined by dividing a stock’s market
capitalization by the total market capitalization of the index.
 Advantage is that constituent stock’s weight equals to its
actual market fraction.
 Disadvantage
 Firms with larger market capitalizations have a greater
influence on the index’s value, which leads to momentum
tilt.
Market-Capitalization Weighting
Float-adjusted market-capitalization weighting
 The weight is determined by adjusting its market capitalization
for its market float, which is the number of shares available to
the investing public.
 E.g., Excluding shares held by controlling shareholders,
strategic investors.
Free-float-adjusted market-capitalization weighting
 Further reduce the number of shares by excluding shares not
available to foreign investors.
 Index Types
Equity index Broad universe

Fixed income
index High turnover

Appraisal Underestimate
Index Illiquidity
index volatility
types
Repeat sales Sample selection
Real estate index
index bias

REITs index Reliable

Alternative
investment index
Based on futures
Commodity index
price

Hedge fund index Survivorship bias

 Equity Investments
Market Efficiency
Number of participants
Definition
Limits
Factors affect
efficiency
Information cost
Efficient market
Trading cost

Weak
Hypothesis Semi strong
Market
Efficiency Time series Strong
Market anomaly
Cross sectional

Loss aversion vs risk aversion

Behavioral finance
Information cascade vs herding
Efficient Market Hypothesis
Three forms of efficient market

Market price reflect

Forms of Past market Public Private

efficient information information information
market

Weak form √

Semi-strong √ √
form

Strong form √ √ √
Efficient Market Hypothesis
Three forms of efficient market

Consistently earn abnormal return

Forms of Technical Fundamental Insider trading

efficient analysis analysis
market

Weak form × √ √

Semi-strong × × √
form

Strong form × × ×
Market Anomaly
Types of anomalies

Sampling of observed pricing anomalies

Time-series Cross-sectional

January effect
Day-of-the-week effect
Weekend effect Size effect
Turn-of-the-month effect
Holiday effect Value effect
Momentum anomalies
Overreaction effect
 Equity Investments

Overview of Equity Securities

Common shares

Preferred shares
Types
Private equity security

Overview of equity
securities Risk of equity Non-domestic share

Return on equity
Return and cost of
equity
Cost of equity
Common Shares
Common share voting right
 Statutory voting: each share represents one vote.
 Cumulative voting: total voting rights are based on the number
of shares owned multiplied by the number of board directors
being elected.
Common Shares
Common shares with embedded options
 Callable common shares: give the issuing company the option,
to buy back shares from investors at a predetermined call price.
 Putable common shares: give investors the option to sell their
shares back to the issuing company at a predetermined put
price.
Preference Shares
Special preference shares
 Cumulative preference shares: the unpaid dividends in the
prior periods accrue over time and must be paid in full before
dividends on common shares can be paid.
 Participating preference shares: entitle the shareholders to
receive the standard preferred dividend plus the opportunity
to receive an additional dividend if the company’s profits
exceed a pre-specified level.
 Convertible preference shares: entitle shareholders to convert
their shares into a specified number of common shares.
Non-Domestic Equity Securities
Types of non-domestic equity securities
 Depository receipts (DRs) (存托凭证): Represent ownership in
a foreign company.

Whether foreign
Voting rights
company has a direct
remains to
involvement in issuance

Sponsored DR Yes DR investors

Unsponsored
No Depository bank
DR
Return and Risk of Equity
Equity risk
 Preference shares are less risky than common shares.
 Putable shares are less risky than callable or non-callable
shares.
 Cumulative/participating preference shares are less risky than
non-cumulative/non-participating preference shares.
Equity Investments

Introduction to Industry and Company Analysis

Product and service
provided
Industry Cyclical
Business cycle
classification sensitivity
Non-cyclical
Statistical similarity

Porter five forces

Industry and
company
analysis Industry Factors affect pricing power
analysis
External factors

Cost leadership
Company
analysis
Product differentiation
Industry Classification Approaches
Business-cycle sensitivities
 Companies are grouped on the basis of their relative sensitivity
to the business cycle.
 Cyclical company (housing, autos, etc.).
 Non-cyclical company:
 Defensive (food, health care, etc.)
 Growth (telecom, cloud computing, etc. ).
 Limitations
 Severe recessions may affect all companies.
 Different regions may experience different stages.
Porter’s Five Forces Model
Porter’s five forces model
 Rivalry among existing competitors
 Threat of new entrants
 Threat of substitute products
 Bargaining power of buyers
 Bargaining power of suppliers
Factors Affecting Pricing Power
Factors affecting pricing power
 Barriers to entry
 Industry concentration
 Market share stability
 Industry capacity
 Industry life cycle
Industry Life Cycle
Industry life cycle
Stages Characteristics
Slow growth, high price, substantial investment is
Embryonic
required, the risk of failure is high.
Rapid growth, falling price, improving profitability, low
Growth
competition, high threat from new entrants.
Slowing growth, intense competition, increasing over-
Shakeout
capacity, declining profitability, increasing failure.
Little/no growth, increasing consolidation, higher
Mature
barriers to entry, stable pricing (periodic price wars).
Negative growth, declining price (frequent price wars),
Decline
consolidation.
Industry Life Cycle
Limitations of industry life cycle analysis
 The evolution of an industry does not always follow a
predictable pattern.
 Various external factors may cause stages to be longer or
shorter, or to be skipped altogether.
 Life-cycle models tend to be most useful for analyzing
industries during periods of stability.
 Not all companies in an industry experience similar
performances.
 Equity Investments

Equity Valuation Models

Basics of dividends

DDM GGM

Discounted cash Two-stage

flow
FCFE Dividend paying capacity

Equity valuation
models Price multiples P/E ratio
Multiplier
models Enterprise value multiples

Asset based model

Dividend Discount Model

N holding periods

Gordon growth model

DDM

Preferred stock valuation

Two-stage DDM
Dividend Discount Model
N holding periods
 The intrinsic value is the present value of the expected
dividends for n periods plus the present value of the expected
price in n periods.
D1 Dn Pn
V0 = +…+ n +
(1 + r)1 (1 + r) (1 + r)n
Where,
V0 = is value of a share of stock today, at t = 0;
Dn = expected dividend in period n, assumed to be paid at
the end of the year;
r = required rate of return on the stock;
Pn = the sell price after N period (terminal value).
Dividend Discount Model
The Gordon growth model
 The Gordon Growth Model assumes dividends grow
indefinitely at a constant rate.

D1 D0 (1 + gc )
V0 = =
r − gc r − gc
Where,
g = Retention rate × ROE 
= (1 − Dividend payout ratio) × ROE
Dividend Discount Model
The Gordon growth model (Cont.)
 Assumptions of the Gordon Model:
 The dividend growth rate is forever and never change.
 The required rate of return is constant over time.
 The dividend growth rate is less than the required rate of
return.
Dividend Discount Model
Preferred stock valuation
 Preference stock valuation as a special case of Gordon growth
model if we assume zero growth (fixed dividend).
 For a non-callable, non-convertible perpetual preferred share
paying a dividend D each period, and assuming a constant
required rate of return r over time:

D
V0 =
r
Dividend Discount Model
Two-stage DDM models
 Assumes the company experiences an initial and finite period
of high growth, followed by an infinite period of sustainable
growth.
 The Gordon growth model is used to estimate the terminal
value at the end of period of high growth.
nD0 (1 + gh )t Vn
V0 = t +
t=1 (1 + r) (1 + r)n
Dn+1
Vn =
r − gl
Price Multiples
Price multiples (Cont.)
 Price multiples based on fundamentals: the stock value is
justified by fundamentals or a discount cash flow model.

P0 D1 /E1 Divdend payout ratio
= =
E1 r−g r−g
 The P/E ratio is inversely related to the required rate of
return, and positively related to the growth rate.
 The relationship between P/E and payout ratio is ambiguous
because a higher payout ratio may imply a slower growth
rate.
Enterprise Value Multiples
Enterprise value multiples
 Enterprise value = Market value of common stock + Market
value of preferred stock + Market value of debt – Cash and
cash equivalents.
 Enterprise value is often viewed as the cost of a takeover.

Enterprise value
Enterprise value multiple =
EBITDA
 Enterprise value is most useful when comparing companies
with significant differences in capital structure.
 EBITDA is usually positive.
Asset-Based Valuation
Asset-based valuation
 Market value of equity = Market value of assets – Market value
of liabilities

Appropriate Inappropriate
 Assets that do not have easily
 Primarily tangible short
determinable market values.
term assets.
 Fair values of assets and liability
 Assets with ready market
can be very different from their
values.
book values.
 Firms are held privately
 It may understate company value
 Firms cease to operate
with a “floor” value.
and are being liquidated.
 Hyper-inflationary environment.
Equity Investments

Good luck on the exam！