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2023 L1 Equity
2023 L1 Equity
Market Efficiency 35
Review 86
This document should be used in conjunction with the corresponding readings in the 2023 Level 1 CFA® Program curriculum.
Some of the graphs, charts, tables, examples, and figures are copyright 2022, CFA Institute. Reproduced and republished with
permission from CFA Institute. All rights reserved.
MM128348126.
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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
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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
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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
Caution: there is not one market with one interest
- each market has its own supply & rate
demand dynamics and its own equilibrium
3) Efficient allocation of capital
- capital seeks out the best risk-adjusted return
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Classifications
LOS b
Assets: - describe
1) financial assets - securities, currencies
2) physical assets - commodities, real assets
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
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① Fixed-Income (Debt)
Notes Bonds Bills CDs Repos MM
LOS c
1) Securities - describe
③ 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)
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LOS c
3) Contracts - may be cash settled or require - describe
physical delivery
- physical vs. financial contract
- spot vs. forward/future/swap/options contracts
a) Forward (OTC, customizable)
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
the strike expiration
Buyers only
underlying price date
Sellers ➞ obligation
e) Others - Insurance
- Credit Default Swaps
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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)
- tangible ⇒ property, factories, equipment
Intermediaries
LOS d
- facilitate the matching of providers - describe
and users of capital and structuring products/services to
satisfy that function
1) Brokers, Exchanges, Alternative Trading Systems (ATS)
Brokers - fulfill orders for clients
- more critical for large-block traders
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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
i.e. CAT bonds Insurance tornado
sells sells
creditor Company insurance
policy holder
manages
6) Arbitrageurs
fraud, moral hazard, adverse selection
- trade on mispricing
7) Settlement & Custodial Services (hold securities on behalf
- clearinghouses - arrange for of clients)
final settlement
- act as counterparty for futures contracts
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Positions
LOS e
- long position - benefits from an increase - compare
in price
- owns an asset or has purchased a contract
- short position - benefits from a decrease in price
- sold an asset they do not yet own or has
written a contract
LOS e
Options long a call benefit from an - compare
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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
- borrowing funds from your broker - interpret
to buy securities
margin loan
⇒ interest rate ⇒ ‘call money’ rate
Initial margin
- minimum margin requirements
Maintenance margin
- may be set by regulation,
the exchange, or the clearinghouse
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LOS f
e.g./ 100 shares of ABC @ $30/sh. on - calculate
margin
Sell for $24 @ t1 -20%
- interpret
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 𝟖𝟑𝟎 − 𝟏𝟓𝟏𝟎
𝐑𝐎𝐈 = = −𝟒𝟓%
𝟏𝟓𝟏𝟎
LOS f
Initial Margin - calculate
- interpret
Maintenance Margin ⇒ triggers margin call back up to Initial
margin
- else ‘forced liquidation’
(𝟏 − 𝐈𝐧𝐢𝐭𝐢𝐚𝐥 𝐌𝐚𝐫𝐠𝐢𝐧)
𝐌𝐚𝐫𝐠𝐢𝐧 𝐂𝐚𝐥𝐥 = 𝐏𝟎 ×
(𝟏 − 𝐌𝐚𝐢𝐧𝐭𝐞𝐧𝐚𝐧𝐜𝐞 𝐌𝐚𝐫𝐠𝐢𝐧)
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Order Types
prices at LOS g, h
prices at which
which dealers Bid Ask they are willing to sell
- compare
and traders
are willing to buy spread
400 10.55 i.e. 10.55 - 10.62 100 × 600
100 10.53
200 10.51 best best bid ask
1000 10.49 bid size
ask size
LOS g, h
To buy - compare
limit $ > ask - at least partially
Ask - marketable limit order filled
bid < limit $ < ask - new price prints
- creates a new market in the market
Bid limit $ = bid all buy orders at
- make the market this price placed
earlier must execute
limit $ < bid
first
- behind the market
- executes only if
(AON - all-or-none) - standing limit orders
price drops
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LOS g, h
Exposure Instructions - display or hide - compare
- hidden ⇒ only brokers & exchanges see them
- display size ⇒ lower than order
i.e. Buy 10,000 , Limit $10.55 , Display size = 500
- also called ‘Iceberg’ order
Validity Instructions - when an order may be filled
Day - expire at end of business (default)
GTC - good-til-cancelled (max. typically 6 mos.)
FOK - fill-or-kill
good-on-close (market on close) execute at the
close of trading
LOS g, h
- compare
Validity Instructions
stop-loss (long pos.) Buy @ $10, stop @
Stop orders $9.50
buy-stop (short pos.)
- Sell @ $10, buy-stop @ $10.50
Clearing Instructions - how final settlement should be
arranged
- usually the broker
- applies when using more than 1 broker
- indication of whether a sale is a
long or short sale
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LOS i
Primary Public Offering - define
- explain
Company Investment Investors
Bank
lines up subscribers (book building)
- may be done as
① Underwriting offer ② Best-efforts offer
- buys the entire issue at - acts as broker only
a negotiated offering price - works on commission
- sell on the IPO ‘bought deal’
- makes the spread
Private Placements - securities not offered to the public
- placed with qualified investors
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Trading
LOS j
Buyers must be able to find Sellers - describe
- at low cost
Q: when can they trade?
who arranges the trade?
how do they execute the trade?
how do they learn about price?
When?
Call Market: trades occur only at particular times and
VS. Treasury
- all bids and asks are balanced to places
determine one price (i.e. quantity bid for = quantity
- all trades occur at this price offered)
LOS j
Call Market: - very liquid in session - describe
- illiquid otherwise
Continuous Markets: trades can be arranged and executed
anytime the market is open
Who:
Call - auction process
Continuous - auction process or dealer bid-ask quotes
(e.g. stock exchanges)
Execution: ① Quote-driven markets (price-driven or dealer
market)
- individual dealers ‘make a market’
in specific securities means they are willing
to buy and sell
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LOS j
Execution: ① Quote-driven markets - describe
- customers trade with dealers (dealers trade with
(bonds, spot commodities) dealers)
- referred to as OTC (over-the-counter)
② Order-driven markets (pure auction market)
- exchanges ⇒ buyers/sellers submit bids/offers
Order-matching rules ⇒ rank buy & sell orders based on:
Price precedence - best bid & best ask
Display precedence - display over hidden at same
price
Time precedence - first over others with same
price and display properties
LOS j
Execution: ② Order-driven markets - describe
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LOS j
Execution: ② Order-driven markets - describe
3) Derivative Pricing Rule - use the
mid-point of the bid-ask from another
market
e.g. POSIT
⇒ trades cleared at
10.55 - 10.63
$10.59
③ Brokered Markets - brokers arrange trades
among their clients
- usually for very thin markets (unique items)
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)
- wider spreads, higher transaction costs
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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)
liquidity ⇒ minimizes transaction costs
(operationally efficient)
complete markets
External/Informational efficiency (prices
respond to changes in fundamental values)
⇒ prices reflect all available information
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)
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LOS k
A financial system that is - describe
Operationally efficient
is characterized by securities/assets that
have
Informationally efficient prices
which leads to an economy that is
Allocationally efficient
Regulation
LOS l
Control fraud by, or deception of, market - describe
participants Confidence
Set minimum standards of competence for agents, define
and enforce minimum standards of practice
promote fairness
set standards for financial reporting (fair to both user
& provider)
set minimum capital requirements for financial firms
(reduce costs/disruptions of failure)
insurance/pension funds have sufficient capital
to honour their long-term commitments
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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
LOSs will match between the video and the MM PDFs, but may be
in a different order than the CFAI readings
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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
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Index Return
LOS b
∑𝐍𝐢'𝟏 𝐧𝐢 𝐏𝐢 VPRI - value of the - calculate
𝐕𝐏𝐑𝐈 = - interpret
𝐃 ‘price return’ index
ni - # of units of security 𝒊
Pi - Price of security 𝒊
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 𝟏𝟐. 𝟓𝟎 − 𝟏𝟏 𝟏. 𝟓𝟎 - interpret
= (𝟏𝟏
𝟏𝟏
words
𝑽𝑷𝑹𝑰𝟏 − 𝑽𝑷𝑹𝑰𝟎 𝐩𝐫𝐢𝐜𝐞 𝐕𝐚𝐥𝐮𝐞 𝐚𝐭 𝐭 𝟏 − 𝐕𝐚𝐥𝐮𝐞 𝐚𝐭 𝐭 𝟎
𝐏𝐑 𝐈 = =
𝑽𝑷𝑹𝑰𝟎 𝐫𝐞𝐭𝐮𝐫𝐧 𝐕𝐚𝐥𝐮𝐞 𝐚𝐭 𝐭 𝟎
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LOS b
Single Period Returns - calculate
⇒ Total Return - price change + all income - interpret
LOS b
Multiple Period Return - calculate
- interpret
𝑽𝑷𝑹𝑰𝑻 = 𝑽𝑷𝑹𝑰𝟎 Z𝟏 + 𝑷𝑹𝑰𝟏 [Z𝟏 + 𝑷𝑹𝑰𝟐 [ … Z𝟏 + 𝑷𝑹𝑰𝑻 [
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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
② security selection
- all or just a sample
- fixed number (S&P500) or variable (TOPIX)
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Index Weighting
LOS d, e
⇒ weighting determines how much of
- compare
each security to include in the index - calculate
① Price Weighting (simplest) - analyze
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 $55 52.38 27.50 35.48
B 22 20.95 22 28.39
C 8 7.62 8 10.32
D 14 13.33 14 18.07
E 6 5.72 6 7.74
Σ = 105 100% 77.50 100%
D = 5
𝟕𝟕. 𝟓𝟎 𝟕𝟕. 𝟓𝟎
VI = 21 𝟐𝟏 = ⇒ 𝐃= = 𝟑. 𝟔𝟗
𝐃 𝟐𝟏
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LOS d, e
② Equal Weighting ($) - compare
- calculate
𝟏 i.e. $10k - analyze
𝑾𝑬𝒊 =
𝐍 5 components
= $2,000 of each component
𝟐𝟎𝟎𝟎 𝟐𝟎𝟎𝟎
= shares of A , = shares of B, etc…
𝐏𝐀 𝐏𝐁
LOS d, e
② Equal Weighting - compare
- calculate
+/ - simple - analyze
-/ - securities that represent the largest fraction of
the target market value are underrepresented
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LOS d, e
③ Market-Capitalization Weighting - compare
- calculate
𝑸 𝒊 𝑷𝒊 - divide market-cap
𝑾𝑴 - analyze
𝒊 = of the component by sum of all
∑𝑵
𝒋'𝟏 𝑸𝒋 𝑷𝒋
market caps
# of shares available
to the investing public Note: most market-cap
weighted indicies are
float adjusted
LOS d, e
③ 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
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LOS d, e
④ Fundamental Weighting
- compare
- attempts to overcome market-cap - calculate
disadvantages - analyze
- uses a fundamental value as a proxy for size rather
than market cap
𝑭𝒊 i.e. book value
𝑾𝑭𝒊 = Revenues
∑𝑵
𝒋'𝟏 𝑭𝒋
CFO
Earnings, etc…
Market
- results in indicies with ratios of 𝑭𝒊
Value
higher than its market-cap counterpart
- weights favour securities that have decreased in
relative value
LOS d, e
④ Fundamental Weighting - compare
- calculate
e.g./ Stock Market-Cap Earnings Earnings Yield - analyze
A $200M 20M 𝟐𝟎g
𝟐𝟎𝟎 = 𝟏𝟎%
B 800M 20M 𝟐𝟎g
𝟖𝟎𝟎 = 𝟐. 𝟓%
$ 1B 40M
𝑭𝒊 Market
Value
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Rebalancing/Reconstitution
LOS f
① Rebalancing - describe
- weights assigned to constituents at inception
drift from their target weights as prices change
LOS f
② Reconstitution - the process of changing - describe
the securities in the index ⇒ keeps the index
representative
𝑷𝒊
𝑾𝑷𝒊 = 𝑵 Reconstitution results in a change in all the
∑𝒋'𝟏 𝑷𝒋
weightings (price & market-cap)
𝑸 𝒊 𝑷𝒊
𝑾𝑴
𝒊 = 𝑵
⇒ usually announced prior to the reconstitution
∑𝒋'𝟏 𝑸𝒋 𝑷𝒋
date
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Uses
LOS g
· to gauge market sentiment - good
- describe
indicators of the collective option of market
participants
⇒
risk and risk-adjusted performance (𝛃 in CAPM)
· as proxies for asset classes in asset allocation models
- provide the historical data used to model
risk/return of different asset classes
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
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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
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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
𝐀𝐀𝐀g 10-yr. gov’t.
𝐀𝐀
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)
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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)
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Market Efficiency
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Market Efficiency
LOS a
- the extent to which market prices - describe
incorporate available info.
⇒ inefficiency is what justifies active mgmt.
LOS a
- asset prices reflect new information - describe
1 min. - 1 hr.
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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
- describe
1. If the market for the bond is highly efficient, the bond’s market price is most
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:
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LOS b
- describe
1. An analyst estimates that a security’s intrinsic value is lower than its market value.
The security appears to be:
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:
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Impediments
LOS c
Inefficient factors Efficient - explain
fewer, few Market Participants more, numerous
narrower Information Availability wider
less, variable Financial Disclosure more, standardized
slow/lagged trans. Limits to Trading speedy transactions
lack of transparency transparency
restrictions no restrictions
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 √ √ √
(Eugene Fama, 1970)
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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)
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Implications
LOS e
1) Security markets are weak-form eff. - explain
∴ technical analysis will not produce
consistent abnormal risk-adjusted returns
2) Security markets are semi-strong eff.
∴analysts must consider what is priced in
and how new info. will affect prices
- fundamental analysis facilitates semi-strong EMH
1 + 2) Portfolio Management ⇒ active managers are actually
a waste of money for investors
(The Loser’s Game)
3) Security markets are not strong-form eff.
Market Anomalies
LOS f
① Time-Series Anomalies - describe
Calendar anomalies
a) January effect - higher returns in equity
markets compared to other months
k
l lac nce b) Turn-of-the-month effect - higher returns on the
a l te
rsi s last trading day and first 3 of next month
pe
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
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LOS f
① Time-Series Anomalies - describe
Overreaction Anomalies
- investors overreact to the release of
unexpected new information
good news inflate bad news depresses
prices prices
Momentum Anomalies
- securities that have outperformed in the
short-run continue to outperform (IBD)
LOS f
② Cross-Sectional Anomalies - describe
1) Size effect
- small-cap equities tend to outperform
large-cap equities on a risk-adjusted basis
(not confirmed over time)
2) Value effect
- value stocks outperform growth stocks
· market returns
over time
· MV of equity
(use of 3-factor model for valuation vs.
· BV equity
MVequity CAPM (1-factor) eliminates this anomaly)
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LOS f
3) Other Anomalies - describe
a) Closed-end fund discounts
- to their NAVPS
not d - typically not worth the transaction
p p orte
su costs
by
ent b) Earnings Surprises
sist
con - prices may be slow to adjust
&
t
rs i sten c) IPOs - if you can get shares at the offer
pe e
enc price
evi d
d) Predictability of Returns based on prior
information i.e. economic cycle related
Behavioral Finance
LOS g
- examines investor behavior (observed) - describe
rather than relying on normative assumptions (i.e. rationality)
⇒ investors do not always make efficient
(rational & optional) decisions
- due to cognitive/behavioral biases
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LOS g
② 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
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Equity Securities
LOS a, b
- a few global facts ① 𝐄𝐪𝐮𝐢𝐭𝐲 𝐌𝐚𝐫𝐤𝐞𝐭 𝐂𝐚𝐩 - describe
~ 50%
𝐆𝐥𝐨𝐛𝐚𝐥 𝐆𝐃𝐏 - long-run
avg.
Company
Debt Equity residual claim on assets
- liability
- interest - cap. gains + div.
LOS a, b
Common Shares: - describe
- ownership interest in the company (residual claim)
- Share in operating performance (cap. app., dividends)
- participate in governance process (voting rights)
⇒ major corporate decisions (e.g. M&A)
⇒ election of BoD
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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
i.e. Class A Class B
- held by investing - held by insiders
public (typically founding family)
60% voting rights 40% voting rights
⇒ Callable - issuer has the right to buy back shares at a
pre-determined call price
⇒ Putable - investor has the right to sell shares back to the
company at a pre-determined put-price
LOS a, b
Preference Shares: (preferreds) - describe
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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
Non-cumulative: do not accrue (forfeited permanently)
will have to offer a higher yield
LOS a, b
Preference Shares: (preferreds) - describe
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LOS c
Types of Private Investments: - distinguish
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LOS c
Types of Private Investments: - distinguish
3) Private Investment in Public Equity (PIPE)
- restricted stock usually at a
- 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
⇒ Investors gain access to foreign companies
- diversify risk away from ‘domestic only’ exposure
Restrictions still exist
- limit amount of control foreign investors have
over domestic companies
- give domestic investors the opportunity to own
the shares of foreign companies conducting business
in the domestic market
- reduce volatility of capital in/out-flows
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LOS d
- reducing these restrictions tend to lead - describe
to improved equity market performance
LOS d
Methods/ - describe
① 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)
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LOS d
Methods/ ② Depository Receipts - describe
LOS d
Methods/ ② Depository Receipts - describe
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LOS d
Methods/ ② Depository Receipts - describe
in
GDR - global depository receipt - issued by depository USD
bank outside both issuer’s home country and the U.S.
- except for
ADR - American depository receipt P.P.
- denominated in USD and trade like common shares
in the U.S.
③ Global Registered Shares - ordinary shares that are
quoted and traded in different currencies on
different stock markets
i.e. BOM on TSX in CAD + on NYSE in USD
TD
④ Basket of Listed Depository Receipts (BLDR)
(i.e. ETF)
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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. 𝐑 𝐭
- Pref. receive div. & distributions before common
- rank behind all debt. (up to par)
Financing a Company
LOS f, g
- companies issue equity to raise - explain
(A = L + E)
capital (for many reasons/uses) - distinguish
- ultimate goal of mgmt. is to increase the
BV of the company and maximize the MV of its
equity
direct BV = A - L ∴ increase Ret. Earn.
control
indirect MV = # of shares × P0
control
primarily determined by investor’s
expectations about the amount,
timing and uncertainty of future
cash flows
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LOS f, g
⇒ Accounting Return on Equity - explain
𝐍𝐈𝐭 𝐍𝐈𝐭 - Pref. Div. - distinguish
𝐑𝐎𝐄𝐭 = =
𝐀𝐯𝐠. 𝐁𝐕𝐄𝐭 (𝐁𝐕𝐄𝐭 + 𝐁𝐕𝐄𝐭8𝟏 )/𝟐
LOS h
ROE - the rate of return earned by a - compare
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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”
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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
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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)
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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)
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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
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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
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LOS e
Peer group ➞ a group of companies engaged in similar - explain
business activities whose economics and valuations
are influenced by closely related factors
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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
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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)
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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
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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
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Page 14
Life-Cycle Models/ LOS i
Growth: new customers enter the market increasing - describe
demand, profitability improves, sales grow - classify
Page 15
Life-Cycle Models/ LOS i
Maturity: focus on incremental innovations, industry at - describe
risk from radical innovation (usually from outside) - classify
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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
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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
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Page 20
Company analysis: LOS L
- describe
Corporate Profile
- governance arrangements
Industry characteristics
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a. evaluate whether a security, given its current market price and a value estimate, is
overvalued, fairly valued, or undervalued by the market
c. describe regular cash dividends, extra dividends, stock dividends, stock splits,
reverse stock splits, and share repurchases
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
l. describe asset-based valuation models and their use in estimating equity value
LOSs will match between the video and the MM PDFs, but may be
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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)
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· 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
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-
May 29 Sept 28 Sept 29 Oct 21
Holder of Payment
Record Date Date
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9 LOS e
𝐃𝐭 - explain
𝐕𝟎 = N ⇒ why use ∞
(𝟏 + 𝐫)𝐭 - describe
𝐭'𝟏
- holding period, t = 1
𝐃𝐭 𝐏𝐭 𝐃𝐭<𝟏 𝐏𝐭<𝟏
𝐕𝟎 = + where 𝐏𝐭 = +
(𝟏 + 𝐫) (𝟏 + 𝐫)
𝐭 (𝟏 + 𝐫) (𝟏 + 𝐫)
so at t = 2
𝐃𝐭 𝐃𝐭<𝟏 𝐏𝐭<𝟏 𝐃𝐭<𝟐 𝐏𝐭<𝟐
𝐕𝟎 = + + where 𝐏𝐭<𝟏 = +
(𝟏 + 𝐫) (𝟏 + 𝐫)𝟐 (𝟏 + 𝐫)𝟐 (𝟏 + 𝐫) (𝟏 + 𝐫)
and at t = 3
𝐃𝐭 𝐃𝐭<𝟏 𝐃𝐭<𝟐 𝐏𝐭<𝟐 and so on…
𝐕𝟎 = z + + {+
(𝟏 + 𝐫) (𝟏 + 𝐫)𝟐 (𝟏 + 𝐫)𝟑 (𝟏 + 𝐫)𝟑
t = n
𝐧
𝐃𝐭 𝐏𝐧
𝐕𝟎 = |N }+~ • ⇒ terminal stock value
(𝟏 + 𝐫)𝐭 (𝟏 + 𝐫)𝐧
𝐭'𝟏
LOS e
e.g./ YR1 YR2 YR3 - explain
Div. 2.00 2.10 2.20 - describe
P3 = 20
r=10% 𝟐. 𝟎𝟎 𝟐. 𝟏𝟎 𝟐. 𝟐𝟎 𝟐𝟎
𝐕𝟎 = + + +
Find V0 (𝟏. 𝟏𝟎) (𝟏. 𝟏𝟎)𝟐 (𝟏. 𝟏𝟎)𝟑 (𝟏. 𝟏𝟎)𝟑
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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?
𝒕=𝟏
𝛃 = 1.2 𝐃𝐭 𝐏𝐭 Dt = D0(1 + g)
𝐕𝟎 = +
est. P1 = $15.40 (𝟏 + 𝐫) (𝟏 + 𝐫) = 4(1.2)
𝟒. 𝟖𝟎 𝟏𝟓. 𝟒𝟎 = 4.80
= +
(𝟏. 𝟏𝟐) (𝟏. 𝟏𝟐)
r = rf + 𝛃(rE - rf)
= 𝟒. 𝟐𝟗 + 𝟏𝟑. 𝟕𝟓 = .06 + 1.2(.11 - .06)
= 𝟏𝟖. 𝟎𝟒 = .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
Usually CAPM
9 Recall 𝐫 = 𝐫𝐟 + 𝛃(𝐫𝐄 − 𝐫𝐟 )
𝐅𝐂𝐅𝐄𝐭 economic
𝐕𝟎 = N
(𝟏 + 𝐫)𝐭 or/ r = rf + risk premium judgement
𝐭'𝟏
gov’t. company’s
Dt bond yield
bond
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Preferred Shares
LOS f
- non-callable, non-convertible
- calculate
(perpetual)
𝐃𝟎 Recall: dividend
𝐕𝟎 = PV of a perpetuity stated as a fixed
𝐫
yield
𝟓. 𝟓𝟎
e.g./ $100 par value @ 5.5% , r = 6% 𝐕𝟎 = = 𝟗𝟏. 𝟔𝟕
. 𝟎𝟔
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%
𝐃𝟎 𝟒. 𝟕𝟓 What if the
IV = ? 𝐕𝟎 = = = $𝟔𝟑. 𝟑𝟑
𝐫 . 𝟎𝟕𝟓 shares were
callable?
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LOS g
e.g./ D0 = $5
𝐃𝟎 (𝟏 + 𝐠) 𝟓(𝟏. 𝟎𝟒) - calculate
g = 4% 𝐕𝟎 = = = $𝟏𝟑𝟎/𝐬𝐡. - interpret
𝐫−𝐠 . 𝟎𝟖 − . 𝟎𝟒
r = 8%
PV of a growing perpetuity
𝐃𝟎
- if g = 0 , 𝐕𝟎 = PV of a perpetuity
𝐫
how do we get g?
g = div. growth rate
g = b × ROE
b = earnings retention rate
(1 - DPR)
ROE = return on equity
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LOS g
- calculate
- interpret
IV = ? with
r = 19%
𝐃𝟎 (𝟏 + 𝐠)
𝐕𝟎 =
D0 = 2.28 r = .19 g = ? 2.28 = 1.35(1 + g)4 𝐫−𝐠
LOS g
- calculate
- interpret
strictly
15.8
15.9
19%
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assumptions: LOS g
- 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%
𝐃𝟓 (𝟏 + 𝐠) 𝟒. 𝟎𝟎(𝟏. 𝟎𝟔)
𝐕𝟓 = = = $𝟏𝟎𝟔
𝐫−𝐠 . 𝟏 − . 𝟎𝟔
𝟒. 𝟎𝟎
(𝟏. 𝟏)𝟓 𝟒
𝐕𝟒 …. 𝟏 − . 𝟎𝟔†
𝟏𝟎𝟔 𝐕𝟎 = =
(𝟏 + 𝐫)𝟒 (𝟏 + 𝐫)𝟒
(𝟏. 𝟏)𝟓
= 𝟐. 𝟒𝟖𝟒 + 𝟔𝟓. 𝟖𝟏𝟖 = 𝟔𝟖. 𝟑𝟎 = 𝟔𝟖. 𝟑𝟎
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LOS g
- Multistage DDM - calculate
- interpret
2-stage: makes use of 2 growth rates
high g low g
𝐠𝐬 𝐠𝐋
2 - initial finite - perpetuity
1 period
Vn use Gordon Growth
use DDM + terminal
V0 value
model to estimate Vn
𝐧
𝐃𝟎 (𝟏 + 𝐠 𝐬 )𝐭 𝐕𝐧 𝐃𝐧<𝟏
𝐕𝟎 = N + 𝐕𝐧 =
(𝟏 + 𝐫) 𝐭 (𝟏 + 𝐫)𝐧 𝐫 − 𝐠𝐋
𝐭'𝟏
𝐃𝐧<𝟏 − 𝐃𝟎 (𝟏 + 𝐠 𝐬 )𝐧 (𝟏 + 𝐠 𝐋 )
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
𝟓(𝟏. 𝟏) 𝟓(𝟏. 𝟏)𝟐 r = 15%
𝐕𝟎 = +
𝟏. 𝟏𝟓 (𝟏. 𝟏𝟓)𝟐
𝟑
𝐃𝟑 (𝟏 + . 𝟎𝟓) 𝟓. 𝟎𝟎(𝟏. 𝟏)𝟑 (𝟏. 𝟎𝟓)
𝟓(𝟏. 𝟏) 𝟔𝟗. 𝟖𝟕𝟕𝟓 𝐕𝟑 = =
+ + . 𝟏𝟓 − . 𝟎𝟓 . 𝟏𝟓 − . 𝟎𝟓
(𝟏. 𝟏𝟓) 𝟑 (𝟏. 𝟏𝟓)𝟑
= 𝟔𝟗. 𝟖𝟕𝟕𝟓
= $𝟓𝟗. 𝟔𝟖 (90 Sec)
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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
𝐏𝟎 𝐏g = 𝐏𝟎 𝐏g = 𝐏𝟎 𝐏g = 𝐏𝟎
𝐏𝐄 = 𝐁 𝐁𝐕g 𝐒 𝐒𝐚𝐥𝐞𝐬g 𝐂𝐅 𝐅𝐂𝐅g
𝐄𝐏𝐒
𝐬𝐡. 𝐬𝐡. 𝐬𝐡.
(or OCF/sh.)
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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
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LOS i, j
< undervalued - explain
Ratio = specified fairly valued - calculate
> value overvalued - interpret
EPS
.96
.84 𝟑𝟔
.72 Σ = 3.12 𝐏𝐄𝐭𝐭𝐦 = = 𝟑𝟎𝐱
𝟏. 𝟐𝟎 (overvalued)
.60
.48
.36 𝟑𝟔
Σ = 1.20 𝐏𝐄𝐟 = = 𝟏𝟏. 𝟓𝟑𝐱
.24 𝟑. 𝟏𝟐
.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
𝐃𝟏
Recall 𝐕𝟎 = - explain
𝐫−𝐠 - calculate
- interpret
𝐃𝟏
Let’s assume that V0 = P0 , then 𝐏𝟎 =
𝐫−𝐠
𝐃𝟏g
Divide P0 & D1 by EPS 𝐏𝟎g 𝐄𝐏𝐒 DPR
𝐄𝐏𝐒 = 𝐫 − 𝐠
𝐃𝐏𝐑
justified = 𝐏g =
𝐄 𝐫−𝐠
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LOS i, j
𝐏g = 𝐃𝐏𝐑 So, P/E is positively related - explain
𝐄 𝐫−𝐠
to - calculate
① 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)
② 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.…
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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
cost of a takeover
· most useful when
comparing companies with
significant differences in capital structure
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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 𝐃𝟏
𝐕𝟎 = 𝐃𝟎 = (𝟏 + 𝐠)
E 𝐫−𝐠
E
E
𝟑. 𝟏𝟎 = 𝟐. 𝟒𝟑(𝟏 + 𝐠)𝟓
‰𝟑. 𝟏𝟎g𝟐. 𝟒𝟑 − 𝟏 = 𝐠
𝟓
= 𝟒. 𝟗𝟗𝟎𝟕%
~𝟓%
𝐃𝟎 (𝟏 + 𝐠)
= 𝟐. 𝟒𝟑(𝟏. 𝟎𝟓) = 𝟐. 𝟓𝟓
② Find IV assuming avg. PEttm is
appropriate. 𝐏 (𝟏𝟑. 𝟐 + 𝟏𝟔. 𝟒 + 𝟏𝟓. 𝟐 + 𝟏𝟒)g
g𝐄 = 𝟒 = 𝟏𝟒. 𝟕 𝟐. 𝟓𝟓
𝐈𝐕 = 𝟒. 𝟎𝟎 × 𝟏𝟒. 𝟕 = $𝟓𝟖. 𝟖𝟎 (U) 𝐕𝟎 = = $𝟓𝟏. 𝟎𝟎
. 𝟏 − . 𝟎𝟓
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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 𝟔𝟎, 𝟎𝟎𝟎
𝐕𝟎 = = $𝟔𝟎
𝟏𝟎𝟎𝟎
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REVIEW
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Review - 1
Functions of Financial System/ saving
capital
1) Facilitate transfer of borrowing
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
- requires/ speedy transactions
low transaction costs
access to information
regulation
Review - 2
Assets/ - financial assets - stock, bonds, currencies
- physical assets - commodities, real estate
Markets classified by/
spot
1) timing of delivery forward/futures
2) who the seller is primary
secondary
money mkt.
3) the maturity of the instruments traded
capital mkt.
4) types of securities traditional (debt, equity)
alternative (private equity, securitized
Securities/ debt)
① Fixed-Income (notes, bills, bonds, CDs, Repos, MM)
② Equities (common, preferred, warrants)
③ Pooled Investments (mutual funds, ABS)
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Currencies - forex
Contracts - a financial contract between 2 parties
underlying financial asset
physical asset
- some cash settled, some physical settlement
a) Forwards
Buyer both have an to buy a specific at a specific by a
Seller obligation to sell asset price certain
b) Futures - exchange-traded forwards (standardized) date
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
4) Depository Institutions/Other Financial Corporations
- banks, credit unions (deposit taking)
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⇒ Intermediaries/
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
forward/future long - takes delivery
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
Currencies - traded in pairs, long one, short the other
⇒ Levered Positions/ margin = me , loan = broker
- interest rate on loan = ‘call money’ rate
Review - 6
⇒ Levered Positions/
Initial margin
- margin requirements
maintenance margin
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Review - 7
⇒ Order Types/ market - guaranteed execution, but not price
limit - guaranteed price, but not execution
x x x x x
Bid Ask
behind the marketable
to Buy: make the create a
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
Review - 8
⇒ Validity Instructions/
stop loss (stop a long pos.)
Stop orders
buy stop (stop a short pos.)
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Review - 9
⇒ Continuous Market/ anytime trading when mkt. is open
- auction market or dealer market
⇒ Quote Driven Markets/ dealer markets (dealer supplies both
(OTC) bid & ask)
⇒ Order-Driven Markets/ pure action markets
(exchanges)
order matching rules/
price precedence - best bid & best ask
display precedence - displayed over hidden at same
price
time precedence - first over others w/ same
price & display
trade pricing rules/ uniform pricing - Call Mkt.
Review - 10
derivative pricing rule/ mid point of bid-ask from
another market
⇒ Brokered Markets/ brokers arrange trades (unique items)
⇒ Trade Information/ pre-trade transparency - bid/ask known before
trade
post-trade transparency - prices known after
trades executed
⇒ Well-functioning financial system/
timely & accurate disclosures (information efficiency)
liquidity (operational efficiency)
complete markets - assets/contracts exist to
satisfy savers, borrowers, hedgers, asset
external information efficiency exchanges
- prices reflect all information
+ financial intermediaries + regulation
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Index ⇒ constituent securities representing a given
security market (or asset class)
- 2 versions ① Price Return - reflects only prices
② Total Return - reinvestment of all income
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Review - 3
⇒ Index Construction/ ① target market selection
asset class, geography, sector, industry, size?
② security selection - all or a sample?
- fixed or variable
③ weightings ④ Rebalancing ⑤ Reconstitution
Review - 4
⇒ Index Construction/ ③ market-cap weighted Index
𝑸 𝒊 𝑷𝒊
④ float-adjusted 𝑾𝑴
𝒊 = 𝑵
∑𝒊'𝟏 𝑸𝒊 𝑷𝒊
# of shares - most market-cap indicies
available to the are float adjusted
investing public
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⇒ Rebalancing/ weights drift over time
𝐖𝐢𝐄 = 𝟏g𝐍 · equal weighting - reduce weights of components
that have outperformed, increase ones that
𝑷𝒊
𝑾𝑷𝒊 = have underperformed
∑𝑵
𝒊'𝟏 𝑷𝒊 · price weighting - no need to rebalance
𝑸 𝒊 𝑷𝒊 · market cap weighting - only need rebalancing
𝑾𝑴
𝒊 = 𝑵
∑𝒊'𝟏 𝑸𝒊 𝑷𝒊 to reflect M&A and liquidations
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
disclosure
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Market Efficiency
Review - 1
- the process by which the markets incorporates info.
- price efficiency - informative prices (avoids malinvestment)
- prices incorporate all past & present info.
- general conclusion/ consistent superior risk-adjusted returns
are not achievable passive R > active R
IV ≃ MV - fairly valued
+⁄− 10%
Review - 2
⇒ Impediments to efficiency/
- few market participants
characteristics - lack of information availability
of private - less financial disclosure
markets - trading is limited
- lack of transparency
- restrictions risk
classic view (return = assumed
⇒ Information Acquisition Costs/
modern view (return - Info. = risk
⇒ Forms of Efficiency/ costs assumed
Past data public info. private info.
weak √
semi-strong √ √
strong √ √ √
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⇒ Weak form/ future returns independent of past returns
- technical analysis useless
- no abnormal risk-adjusted returns based on past prices
⇒ Semi-strong form/ no abnormal risk-adjusted returns based
on public information
- both technical & fundamental analysis useless
- must consider what is priced in (only unanticipated
information affects prices)
⇒ Strong/ research rejects strong-form hypothesis
⇒ Time-Series Anomalies/
January
Calendar
- 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
⇒ Cross Sectional Anomalies/
1) size effect - small cap tend to outperform large cap
equities on a risk-adjusted basis
2) Value effect/ value stocks outperform growth
stocks over time
(3-factor model eliminates this effect)
Other Anomalies/ closed-end fund discount
none supported by earnings surprises
persistent & IPOs
economic
consistent evidence Predictability of Returns based on prior info. cycle
related
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⇒ Behavioral Finance/ investors do not always act
rationally due to cognitive/behavioral biases (+ emotional)
① Loss Aversion/ tendency to avoid taking losses
- leads to ‘loss persistence’
② Herding/ ignore personal analysis and make decisions
in line with the direction of the market
③ Information Cascades/ serial correlation - acting on
actions of someone who acted on information
④ Overconfidence/ inflated view of your ability
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⇒ Preferred Shares/ in increases in divs. if profit
participating over some level
proceeds of a liquidity event
convertible - typically ‘forced conversion’ clause
⇒ Public/ - secondary market
⇒ Private/ not listed, private placement, prices not market determined
highly illiquid (inefficient market)
1) Venture Capital
2) LBO/MBO - leveraged/mgmt. buyout
3) PIPE - private investment in public equity
restricted stock
Adv./ focus on long-term value creation
higher risk-adjusted return
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Review - 3
companies can list in international markets
- more filing requirements
investors can buy in international markets
- typically limits on foreign ownership
Direct Investing ⇒ price + Divs. forex risk
Depository Receipts - foreign company deposits shares
with Domestic Bank
issues receipts in domestic
currency on exchange
L1 - OTC Sponsored foreign company directly involved
L2 & 3 - exch. investors have ownership rights
Unsponsored foreign company not involved
depository has rights of ownership
Review - 4
GDR - global depository receipt - issued outside
home country of company and outside U.S.
ADR - American depository receipt - issued in U.S.
⇒ Global Registered Shares/ ordinary shares traded on different
exchanges in different currencies
⇒ Risk & Return/ 1) capital gains (𝐏𝐭 − 𝐏𝐭8𝟏 ) + 𝐃𝐭
𝐑𝐭 =
2) dividends 𝐏𝐭8𝟏
3) currency gains/losses
4) reinvestment of dividends (Total Return)
Book Value = A - L 𝐍𝐈𝐭 𝐍𝐈𝐭
𝐑𝐎𝐄𝐭 = =
Market Value = # shares × P 𝐀𝐯𝐠. 𝐁𝐕𝐄𝐭 (𝐁𝐕𝐄𝐭 + 𝐁𝐕𝐄𝐭8𝟏 )g
𝟐
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Price-to-Book 𝐌𝐕𝐄𝐭g higher ratio
𝐬𝐡. = 𝐌𝐕𝐄𝐭
𝐁𝐕𝐄𝐭g 𝐁𝐕𝐄𝐭 overvalued
𝐬𝐡. or/ higher growth
opps. priced in
Intrinsic Value (IV)
PV (expected future cash flows)
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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
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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
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Shakeout Decline
Embryonic
Growth
time
Review - 6
LOS i - describe, classify/
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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
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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/ 9
𝐃𝐭
1) Dividend Discount Model ⇒ 𝐕𝟎 = N
(𝟏 + 𝐫)𝐭
𝐧 𝐭'𝟏
𝐃𝐭 𝐏𝐧
𝐕𝟎 = N + 𝒓𝒆 = 𝐫𝐟 + 𝛃(𝐑 𝐦 − 𝐫𝐟 )
(𝟏 + 𝐫)𝐭 (𝟏 + 𝐫)𝐧
𝐭'𝟏
(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
0
𝐅𝐂𝐅𝐄𝐭 CAPEX judgement
𝐕𝟎 = F
(𝟏 + 𝐫)𝐭 𝐫 = 𝐫𝐟 + 𝛃(𝐑 𝐌 − 𝐫𝐟 ) or r = rf + risk premium
𝐭&𝟏
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⇒ 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 𝐏
𝐏𝐄 = 𝟎g𝐄𝐏𝐒
- useless if E < 0
⇒ P/S - not influenced by actg. measures 𝐏g = 𝐏𝟎
𝐒 Œ𝐒𝐚𝐥𝐞𝐬
- ignores cost structure g𝐬𝐡.
⇒ P/CF - less volatile than EPS 𝐏g = 𝐏𝟎
𝐂𝐅 Œ𝐅𝐂𝐅g
- ignores non-cash revenues 𝐬𝐡.
⇒ P/BV - more stable, appropriate for 𝐏g 𝐏
𝐁𝐕 = 𝟎Œ𝐁𝐕
firms in distress g𝐬𝐡.
⇒ Justified P/E/ - denominator may be
𝐃𝟏
- assume V0 = P0, then 𝐏𝟎 = based on trailing values or
𝐫−𝐠
forward values
𝐏𝟎g 𝐃𝟏 /𝐄𝐏𝐒 𝐃𝐏𝐑
𝐄𝐏𝐒 = 𝐫 − 𝐠 𝐏𝐄 =
𝐫−𝐠
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Review - 5
⇒ Justified P/E/ 𝐃𝐏𝐑 P/E positively related to:
=
𝐫−𝐠 ① DPR
· higher DPR, lower RR, ② 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
107