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Part 4 Chapter 10 11 12 Fmi
Part 4 Chapter 10 11 12 Fmi
Private equity (private firm) is a business that is privately held and the
equity is not traded in public stock exchange.
Some business owners hope to go public so that:
❖ They can obtain financing to support the firm’s growth
❖ They can “cash out” by selling their original equity investment to others.
A public offering is feasible if:
➔ The owners want to sell at least $50 million in stock.
➔ The shareholder base will be large enough to support an active secondary
market.
FINANCING BY VENTURE CAPITAL FUNDS
Private firms that need a large equity investment but are not yet in a position to go public may attempt to obtain
funding from a venture capital (VC) fund. Such funds receive money from:
These investors are not allowed to withdraw their money before a specified deadline.
Venture capital funds have participated in a number of businesses that ultimately went public and became
very successful, including
1. Apple,
2. Microsoft, and
3. Oracle Corporation.
Private Equity Financing by Venture Capital
Funds (cont.)
● Venture Capital Market
➔ Brings together the private businesses that need equity funding and
the VC funds that can provide funding.
Terms of a Venture Capital Deal
When a VC fund decides to invest in a business, it will negotiate the terms of its investment,
including the amount of funds it is willing to invest.
➢ The VC fund will set out requirements for the business and VC fund managers
may serve as advisers to the business.
Financing by Private Equity Funds Private equity funds pool money provided by institutional
investors (such as pension funds and insurance companies) and invest in businesses.
Financing by Private Equity Funds
❏ Private equity funds pool money provided by institutional investors (such
as pension funds and insurance companies) and invest in businesses.
❏ They also rely heavily on debt to finance their investments.
❏ Unlike VC, private equity funds take over businesses and manage them.
Their target are overvalued and mismanaged.
❏ They sell their stake in the business after several years.
PUBLIC EQUITY….
When a firm goes public, it issues stock in the primary market in exchange for cash.
➔ The secondary market allows investors to sell the stock they previously
purchased to other investors.
Ownership and Voting Rights
. Normally, only the owners of common stock are permitted to vote on certain key
matters concerning the firm, such as the
buy ✅ undervalued.
sell ✅ overvalued.
Facebook’s IPO
On May 18, 2012, Facebook engaged in an IPO that generated $16 billion.
Facebook’s opening price was $38/share. The price fluctuated throughout the day with a high of
about $43 and ended at $38.23.
Organized Exchanges
❏ Each organized exchange has a trading floor where floor traders
execute transactions in the secondary market for their clients.
❏ New York Stock Exchange (NYSE)
❏ Floor brokers [commision / independent broker ]
❏ Specialists
Over-the-Counter Market
❖ Stocks not listed on the organized exchanges are traded in the over-
the-counter (OTC) market.
❖ Nasdaq - National Association of Securities Dealers Automatic
Quotations (Nasdaq), which is an electronic quotation system that
provides immediate price quotations.
❖ OTC Bulletin Board - lists stocks that have a price below $1 per share,
which are sometimes referred to as penny stocks.
❖ Pink Sheets - The OTC market has where even smaller stocks are
traded. Some of the stocks have very little trading volume and may not
be traded at all for several weeks.
Stock Exchanges Extended Trading
Sessions
-The NYSE and Nasdaq market offer extended trading sessions beyond
normal trading hours.
● FUNDAMENTAL ANALYSIS -
○ relies on fundamental financial characteristics (such as earnings) of the firm and its
corresponding industry that are expected to influence stock values.
● TECHNICAL ANALYSIS -
=$2X14=$28
Stock Valuation Methods (cont’d)
★ Dividend discount model John Williams (1931)
● stated that the price of a stock should reflect the present value of the
stock’s future dividends:
t = period
Dt = dividend in period t
k = discount rate
Stock Valuation Methods (cont’d)
➔ Dividend discount model (cont’d)
◆ For a constant dividend, the cash flow is a perpetuity:
Example 1: A firm is expected to pay a dividend of $2.10 per share every year in
the foreseeable future. Investors require a return of 15% on the firm’s stock.
According to the dividend discount model, what is a fair price for the firm’s
stock?
k= discount rate
Using the Dividend Discount Model
◆ For a constantly growing dividend, the cash flow is a growing
perpetuity:
Example 2: A firm is expected to pay a dividend of $2.10 per share in one year.
In every subsequent year, the dividend is expected to grow by 3 percent
annually. Investors require a return of 15% on the firm’s stock. According to the
dividend discount model, what is a fair price for the firm’s stock?
dt= dividend in period t
k= discount rate
expected to grow
Relationship between dividend discount model and PE
ratio
The forecasted earnings per share can be multiplied by the PE ratio of the firms industry
If the mean PE ratio of all other firms in the same industry is 6 , the stock price in 3 years can be
forecast as follows:
1 2 3 3
= $ 60.84
FREE CASH FLOW MODEL
1st = estimate the free cash flows that will result from operations
2nd= subtract existing liabilities to determine the value of the firm
3rd= divide the value of the firm by the # of shares to derive a value per share
LIMITATIONS
- Difficulty of obtaining an accurate estimate of free cash flow per period.
Determining the Required Rate of Return to Value Stocks
➢ The capital asset pricing model:
-Used to estimate the required rate of return for any firm with publicly
traded stock
i. Beta reflects the sensitivity of the stock’s return to the market’s overall return
ii. Beta is typically measured with monthly or quarterly data over the last four years or so
Using the CAPM
The beta of the stock for vaxon, inc is estimated as 1.2 according to the
regression analysis just explained. The prevailing risk-free rate is 6 percent, and
the market risk premium is estimated to be 7 percent based on historical data. A
stock’s risk premium is computed as the market risk premium multiplied by the
stock’s beta, so vaxon stock’s risk premium (above the risk-free rate
) is 0.07 x 1.2 = 8.4 percent. Therefore, the required rate of return on vaxon
stock is
= 6%+1.2(7%)
= 14.4%
Factors That Affect Stock Prices
A. Economic factors
❖ Impact of economic growth
➢ An increase in economic growth increases expected cash flows
and value
➢ Indicators such as employment, GDP, retail sales, and personal
income are monitored by market participants
❖ Impact of interest rates
➢ Given a choice of risk-free Treasury securities or stocks, stocks
should only be purchased if they offer a sufficiently high expected
return
Factors That Affect Stock Prices (cont’d)
❖ Impact of the dollar’s exchange rate value
■ The value of the dollar affects U.S. stocks because:
● Foreign investors purchase U.S. stocks when the dollar is
weak
● Stock prices are affected by the impact of the dollar’s changing
value on cash flows
● Some U.S. firms are involved in exporting U.S.-based MNCs
have some earnings in foreign currencies
● Exchange rates may affect expectations of other economic
factors
Factors That Affect Stock Prices (cont’d)
A. Market-related factors
a. Investor sentiment
i. In some periods, stock market performance is not highly correlated with existing
economic conditions
ii. Stocks can exhibit excessive volatility because their prices are partially driven by fads
and fashions
iii. A study by Roll found that only one-third of the variation in stocks returns can be
explained by systematic economic forces
b. January effect
i. Many portfolio managers invest in riskier small stocks at the beginning of the year and
shift to larger companies near the end of the year
■ When a firm’s announced earnings are higher than expected, investors may raise their
estimates of the firm’s future cash flows
■ Expected acquisitions typically result in an increased demand for the target’s stock
and raise the stock price The effect on the acquiring firm is less clear
○ Expectations
■ Investors attempt to anticipate new policies so they can make their move before other
investors
Integration of factors affecting stock prices
❏ The main source of uncertainty is the price at which the stock can be sold
❏ Dividends tend to be much more stable than stock price
Stock Risk (cont’d)
● Measures of risk
○ The volatility of a stock:
■ May indicate the degree of uncertainty surrounding the stock’s
future returns
■ Reflects total risk because it reflects movements in stock prices for
any reason
Stock Risk (cont’d)
Measures of risk (cont’d) The volatility of a stock portfolio depends on: The
volatility of the individual stocks in the portfolio
● The risk of a high-beta portfolio can be reduced by replacing some of the high-
beta stocks with low-beta stocks
Forecasting Stock Price Volatility and Beta
(cont’d)
● Forecasting a stock portfolio’s volatility
○ Portfolio volatility can be forecast by first deriving forecasts of
individual volatility levels
○ Next, the correlation coefficient for each pair of stock in the portfolio is
forecast by estimating the correlation in recent periods
● Forecasting a stock portfolio’s beta
○ First forecast the betas of the individual stocks and then take a
weighted average
Stock Market Efficiency
➔ Forms of efficiency
◆ Weak-form efficiency suggests that security prices reflect all trade-
related information
◆ Semistrong-form efficiency suggests that security prices fully reflect all
public information
● Includes announcements by firms, economic news or events, and
political news or events
● If semistrong-form efficiency holds, weak-form efficiency holds as
well
◆ Strong-form efficiency suggests that security prices fully reflect all
information, including private or insider information
Stock Market Efficiency (cont’d)
● Tests of the efficient market hypothesis
○ Test of weak-form efficiency
■ Tested by searching for a nonrandom pattern in security prices
■ Studies have generally found that historical price changes are
independent over time
■ There is some evidence that stocks:
● Have performed better in January (January effect)
● Have performed better on Fridays than on Mondays (weekend
effect)
● Have performed well on the trading days just before holidays
(holiday effect)
Foreign Stock Valuation, Performance, and
Efficiency (cont’d)
❖ Measuring performance from investing in foreign stocks
➢ The performance measurement should control for general market
movements and exchange rate movements in the region where the
portfolio managers has been assigned to invest funds
Foreign Stock Valuation, Performance, and
Efficiency (cont’d)
★ Performance from global diversification
○ Stock investors can benefit by diversifying internationally
■ Economies do not move in tandem
■ Stock markets across countries may respond to some of the same
expectations
■ In general, correlations between stock indexes have been higher in
recent years than they were several years ago
Foreign Stock Valuation, Performance, and
Efficiency (cont’d)
➢ Performance from global diversification (cont’d)
○ Integration of markets during the 1987 crash
■ There was a high correlation among country stock markets during the crash
■ This suggests that the underlying cause of the crash systematically affected all markets
○ Integration of markets during mini-crashes
■ On August 27, 1998 (“Bloody Thursday”) most stock markets around the world experienced
losses
■ Illustrates that even a well-diversified international portfolio is not insulated from some
events
○ Diversification among emerging stock markets
■ These markets have lower correlations with developed countries, but also higher risk
Foreign Stock Valuation, Performance, and
Efficiency (cont’d)
● International market efficiency
○ Some foreign markets are inefficient because of the small number of
analysts and portfolio managers
○ Market inefficiencies are more common in small foreign stock markets
○ Insider trading is more prevalent in many foreign markets
○ Political and exchange rate risk may be high in some foreign markets
Chapter 12:
Market Microstructure and
Strategies
Chapter 12: Market Microstructure and Strategies
❏ A process by which securities such as stocks are traded.
A Margin Call - from brokerage firm and will have to deposit cash to
the account i n order to boost the equity.
Impact on Returns
R = SP - INV- LOAN +D
INV
Where: o
SP - selling price of the stock
INV - initial investment by investor, not including borrowed funds
LOAN - bOrrowed funds D - Dividend payments
Short Selling
❏ Investors place an order to sell a stock that they do not own.