Last Revised: 06/19/2023
2024 Level 1 - Equity Investments
Learning Modules
Page
Market Organization and Structure
2
Security Market Indexes
21
Market Efficiency
35
Overview of Equity Securities
45
Company Analysis: Past and Present
56
Industry and Competitive Analysis
68
Company Analysis: Forecasting
75
Equity Valuation: Concepts and Basic Tools
83
Review
101
This document should be used in conjunction with the corresponding learning modules in the 2024 Level 1 CFA® Program
curriculum. Some of the graphs, charts, tables, examples, and figures are copyright 2023, CFA Institute. Reproduced and
republished with permission from CFA Institute. All rights reserved.
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Institute.
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1
Last Revised: 06/19/2023
Market Organization and Structure
a. explain the main functions of the financial system
b. describe classifications of assets and markets
c. describe the major types of securities, currencies, contracts, commodities, and real
assets that trade in organized markets, including their distinguishing characteristics
and major subtypes
d. describe types of financial intermediaries and services that they provide
e. compare positions an investor can take in an asset
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
g. compare execution, validity, and clearing instructions
h. compare market orders with limit orders
i. define primary and secondary markets and explain how secondary markets support
primary markets
j. describe how securities, contracts, and currencies are traded in quote-driven,
order-driven, and brokered markets
k. describe characteristics of a well-functioning financial system
l. describe objectives of market regulation
2
Last Revised: 06/19/2023
Main Functions
LOS a
- explain
- of the Financial System
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
2) Price Discovery - rates of return so that I = S
3) Facilitate the efficient allocation of capital
LOS a
- explain
1) Facilitate transfers
1) Saving - move money to the future
- requires someone else willing to pay (borrow)
Sources ⇒ individuals, business, gov’t.
2) Borrowing - move money to the present
- requires someone else willing to provide (save)
Sources ⇒ individuals, business, gov’t.
3) Raise Equity Capital - indirect investing
- financial claim on assets
4) Managing Risks - hedging, insurance
3
Last Revised: 06/19/2023
1) Facilitate transfers
5) exchange assets (on the spot)
i.e. - forex
LOS a
- explain
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 ↑
2) Discovery - when supply = demand
(S = I)
⇒ equilibrium interest rate
Caution: there is not one market with one interest
rate
- each market has its own supply &
demand dynamics and its own equilibrium
3) Efficient allocation of capital
- capital seeks out the best risk-adjusted return
(liquidity)
⇒ 1, 2 & 3 require ⇒ speedy transactions
⇒ low transaction costs
⇒ access to information
⇒ regulation
4
LOS a
- explain
Last Revised: 06/19/2023
Classifications
Assets:
1) financial assets - securities, currencies
LOS b
- describe
2) physical assets - commodities, real assets
Markets can be classified on the basis of
1) the timing of delivery
- spot markets - immediate delivery
- forward/futures markets - some agreed upon
future date
2) who the seller is
- issuer - primary market
- investor/holder - secondary market
Markets can be classified on the basis of
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
5
LOS b
- describe
Last Revised: 06/19/2023
Major Types of Securities
LOS c
- describe
1) Securities a) Public - exchanges
b) Private - qualified investors only
① Fixed-Income (Debt)
Notes
Bonds
Bills
CDs
Repos
MM
② Equities (ownership claims)
Common
- voting rights
- entitled to
discretionary dividends
- last claim on
assets
Preferred
- higher priority
claim
- entitled to fixed
dividends (stated as
a yield)
Warrants
- right to purchase
stock as a prespecified price before
a pre-specified date
1) Securities
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)
3) Contracts - an agreement between 2 parties to do
something in the future
- value depends on the value of its underlying
(security, index, interest rate)
6
LOS c
- describe
Last Revised: 06/19/2023
LOS c
- describe
3) Contracts - may be cash settled or require
physical delivery
- physical vs. financial contract
- spot vs. forward/future/swap/options contracts
a) Forward (OTC, customizable)
(long)
(short)
Buyer
Seller
both have an
obligation
to buy
to sell
a specific
asset
at a
specific
price
by a
certain
date
b) Futures - a standardized, exchange-traded forward
contract
3) Contracts c) Swaps - an agreement to exchange a
series of cash flows at periodic dates over
a period of time (i.e. fixed for floating)
d) Options
Call
Put
a right
to buy
to sell
Buyers only
Sellers ➞ obligation
a specific at a specific
asset
price
by a certain
date
the
underlying
expiration
date
strike
price
e) Others - Insurance
- Credit Default Swaps
7
LOS c
- describe
Last Revised: 06/19/2023
4) Commodities - precious/industrial metals,
energy, agriculture, etc…
spot
- buyers/sellers of
the physical product
LOS c
- describe
Forward/Futures
- hedging/speculating
- usually close positions prior to
delivery date
5) Real Assets (Direct Investing)
- tangible ⇒ property, factories, equipment
- generally illiquid, high mgmt. costs
Intermediaries
- facilitate the matching of providers
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
Exchanges - provide an auction platform
- must print best bid and ask
ATS - no regulatory authority over members
dark pools ⇒ do not display orders sent to
them
typically inst. investors, large-block trades
8
LOS d
- describe
Last Revised: 06/19/2023
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
3) Securitizers - buying assets, placing them in a pool, and
selling securities against them
4) Depository Institutions and Other Financial Corporations
- banks, S&Ls, credit unions
- take deposits - pay interest, lend to borrower, charge
interest
5) Insurance Companies
- 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
Company
insurance
creditor
6) Arbitrageurs
- trade on mispricing
manages
policy holder
fraud, moral hazard, adverse selection
7) Settlement & Custodial Services (hold securities on behalf
of clients)
- clearinghouses - arrange for
final settlement
- act as counterparty for futures contracts
9
LOS d
- describe
Last Revised: 06/19/2023
Positions
LOS e
- compare
- long position - benefits from an increase
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
Forwards
long position obligated to take delivery
short position obligated to deliver
Options
right
long a call
short a put
obligation
short a call
long a put
asset or
cash
equivalent
benefit from an
increase in price of the underlying
benefit from a drop in price of
the underlying
Swaps - fixed for floating - party that benefits from a
rise in interest rates considered
‘long’
Currency - traded in pairs
Buy $100k USD CAD means
i.e. USD.CAD = 1.3250
(1)
I am long $100k USD and
short $132.5k CAD
10
LOS e
- compare
Last Revised: 06/19/2023
LOS e
- compare
Short: Contracts - must deliver the
underlying at a pre-determined date for a
pre-determined price
Securities - selling securities you don’t own
- broker arranges a borrow and lends
them to you to sell
- if the borrow cannot be maintained, seller
faces a forced buy-in
- to close a short position, seller initiates
a ‘buy-to-cover’ or ‘buy-to-close’ order
Margin
- Levered Positions
- borrowing funds from your broker
to buy securities
margin loan
⇒ interest rate ⇒ ‘call money’ rate
- minimum margin requirements
LOS f
- calculate
- interpret
Initial margin
Maintenance margin
- may be set by regulation,
the exchange, or the clearinghouse
Leverage Ratio:
𝐕𝐚𝐥𝐮𝐞 𝐨𝐟 𝐏𝐨𝐬𝐢𝐭𝐢𝐨𝐧
𝐕𝐚𝐥𝐮𝐞 𝐨𝐟 𝐄𝐪𝐮𝐢𝐭𝐲
𝐈𝐧𝐯𝐞𝐬𝐭𝐦𝐞𝐧𝐭
11
max.
leverage =
Ratio
𝟏
𝐦𝐢𝐧𝐢𝐦𝐮𝐦
𝐦𝐚𝐫𝐠𝐢𝐧
𝐫𝐞𝐪𝐮𝐢𝐫𝐞𝐦𝐞𝐧𝐭
Last Revised: 06/19/2023
LOS f
- calculate
- interpret
e.g./ 100 shares of ABC @ $30/sh. on
margin
Sell for $24 @ t1
-20%
Div. received = 30¢/sh.
-40%
Commission Paid = 10¢/sh.
Leverage Ratio = 2
Call money rate = 6%
Total ROI?
Purchase
+ Comm.
(100 × 30)
- Margin Loan
Orig. Inv.
3000
10
3010
1500
1510
Sale
(100 × 24)
- Comm.
- Loan
- Interest
+ Dividends
𝐑𝐎𝐈 =
2400
(10)
(1500)
(90)
30
830
𝟖𝟑𝟎 − 𝟏𝟓𝟏𝟎
= −𝟒𝟓%
𝟏𝟓𝟏𝟎
LOS f
- calculate
- interpret
Initial Margin
Maintenance Margin ⇒ triggers margin call back up to Initial
margin
- else ‘forced liquidation’
𝐌𝐚𝐫𝐠𝐢𝐧 𝐂𝐚𝐥𝐥 = 𝐏𝟎 ×
(𝟏 − 𝐈𝐧𝐢𝐭𝐢𝐚𝐥 𝐌𝐚𝐫𝐠𝐢𝐧)
(𝟏 − 𝐌𝐚𝐢𝐧𝐭𝐞𝐧𝐚𝐧𝐜𝐞 𝐌𝐚𝐫𝐠𝐢𝐧)
e.g./ P0 = $60, margin = 50%, maintenance margin = 25%
(𝟏 − . 𝟓)
𝟔𝟎 ×
= 𝟒𝟎
(𝟏 − . 𝟐𝟓)
Loan
30
50%
Max. 75%
12
𝟑𝟎
= 𝟒𝟎
. 𝟕𝟓
𝐈𝐧𝐢𝐭. 𝐌𝐚𝐫𝐠𝐢𝐧
𝐋𝐨𝐚𝐧
(𝟏 − 𝐌𝐚𝐢𝐧. 𝐌𝐚𝐫𝐠𝐢𝐧)
Last Revised: 06/19/2023
Order Types
prices at
which dealers
Bid
Ask
and traders
are willing to buy
spread
400
100
200
1000
10.55
10.53
10.51
10.49
prices at which
they are willing to sell
i.e.
10.55 - 10.62
best
bid
best
ask
LOS g, h
- compare
100 × 600
bid
size
ask
size
Execution Instructions: how an order should be filled
1) Market orders - fill immediately at best price
- guaranteed execution, no guaranteed price
2) Limit orders - fill at a specified price or better
- guaranteed price, no guaranteed execution
LOS g, h
- compare
To buy
Ask
limit $ > ask
- marketable limit order
bid < limit $ < ask
- creates a new market
Bid
limit $ = bid
- make the market
limit $ < bid
- behind the market
(AON - all-or-none)
- standing limit orders
13
- at least partially
filled
- new price prints
in the market
all buy orders at
this price placed
earlier must execute
first
- executes only if
price drops
Last Revised: 06/19/2023
Exposure Instructions - display or hide
- hidden ⇒ only brokers & exchanges see them
LOS g, h
- compare
- 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
Validity Instructions
Stop orders
stop-loss (long pos.) Buy @ $10, stop @
$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
14
LOS g, h
- compare
Last Revised: 06/19/2023
Primary vs. Secondary
Primary
Issuer
Investor
first time ⇒ IPO
LOS i
- define
- explain
follow up ⇒ secondary offering
Secondary
Investor
Investor
- provide liquidity, ensures an efficient
primary market
- sets price for secondary offerings
Primary
Public Offering
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
15
LOS i
- define
- explain
Last Revised: 06/19/2023
Trading
Buyers
must be able to find
- at low cost
Sellers
LOS j
- describe
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
places
VS. Treasury
- all bids and asks are balanced to
determine one price (i.e. quantity bid for = quantity
offered)
- all trades occur at this price
- many continuous trading markets find their opening
price by this method
Call Market: - very liquid in session
- 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
16
LOS j
- describe
Last Revised: 06/19/2023
LOS j
- describe
Execution: ① Quote-driven markets
- customers trade with dealers (dealers trade with
dealers)
(bonds, spot commodities)
- 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
- describe
Execution: ② Order-driven markets
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./
Ask Size
Bid
Order to sell arrives:
Size 10.36 300
1400 @ Limit of $10.28
10.34 1200
300 filled at $10.30
10.32 600
900 filled at $10.28
300 10.30
new standing order of
900 10.28
200 @ 10.28
400 10.26
17
New Market
10.36
300
10.34 1200
10.32
600
10.28
200
400 10.26
Last Revised: 06/19/2023
Execution: ② Order-driven markets
3) Derivative Pricing Rule - use the
mid-point of the bid-ask from another
market
LOS j
- describe
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
- describe
Information:
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
18
Last Revised: 06/19/2023
Well-Functioning System
⇒ helps
- savers
- borrowers
- hedgers
- asset exchange
(spot)
⇒ Features
LOS k
- describe
complete markets
- all the assets/contracts
exist to satisfy all 4
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
⇒ needs intermediaries who:
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)
19
LOS k
- describe
Last Revised: 06/19/2023
LOS k
- describe
A financial system that is
Operationally efficient
is characterized by securities/assets that
have
Informationally efficient prices
which leads to an economy that is
Allocationally efficient
Regulation
Control fraud by, or deception of, market
Confidence
participants
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
20
LOS l
- describe
Last Revised: 06/19/2023
Security Market Indexes
a. describe a security market index
b. calculate and interpret the value, price return, and total return of an index
c. describe the choices and issues in index construction and management
d. compare the different weighting methods used in index construction
e. calculate and analyze the value and return of an index given its weighting method
f. describe rebalancing and reconstitution of an index
g. describe uses of security market indexes
h. describe types of equity indexes
i. describe types of fixed-income indexes
j. describe indexes representing alternative investments
k. compare types of security market indexes
LOSs will match between the video and the MM PDFs, but may be
in a different order than the CFAI readings
21
Last Revised: 06/19/2023
Market Index
LOS a
- describe
- consists of individual securities that
represent a given security market,
market segment or asset class
(most constructed as a portfolio
of marketable securities)
a.k.a.
constituent
securities
- each may have 2 versions depending on how
returns are calculated
① Price Return Index
- reflects only prices
② Total Return Index
- assumes reinvestment of
all income received since
inception
Uses:
- simple measure to capture performance and
direction of a particular market
- evaluate performance of investment managers
(active)
- construct investment portfolios (passive)
- estimate market/segment risk
22
LOS a
- describe
Last Revised: 06/19/2023
Index Return
∑𝐍𝐢'𝟏 𝐧𝐢 𝐏𝐢
𝐕𝐏𝐑𝐈 =
𝐃
VPRI - value of the
‘price return’ index
ni - # of units of security 𝒊
Pi - Price of security 𝒊
N - # of individual securities in the
index
D - value of the divisor
depends on
the type of
weighting used
- price
- equal
- market-cap
- floating-adjusted
market-cap
- fundamental weighting
a number initially chosen at
inception so that the index has a
convenient initial value
- divisor changes over time
so that changes in the index
reflect price changes only
Single Period Returns
⇒ Price Return - the %’age change in VPRI
𝑽𝑷𝑹𝑰𝟏 − 𝑽𝑷𝑹𝑰𝟎
𝐏𝐑 𝐈 =
𝑽𝑷𝑹𝑰𝟎
LOS b
- calculate
- interpret
𝟏𝟐. 𝟓𝟎 − 𝟏𝟏 𝟏. 𝟓𝟎
=
(𝟏𝟏
𝟏𝟏
LOS b
- calculate
- interpret
words
𝐕𝐚𝐥𝐮𝐞 𝐚𝐭 𝐭 𝟏 − 𝐕𝐚𝐥𝐮𝐞 𝐚𝐭 𝐭 𝟎
𝐩𝐫𝐢𝐜𝐞
=
𝐫𝐞𝐭𝐮𝐫𝐧
𝐕𝐚𝐥𝐮𝐞 𝐚𝐭 𝐭 𝟎
or/ weighted average of each of the constituent components
𝑷𝒊 − 𝑷𝒊 𝟎
𝐏𝐑 𝐢 = 𝟏
𝑷𝒊 𝟎
each component
-
𝐍
𝑵
𝐢'𝟏
𝒊'𝟏
𝑷𝒊 − 𝑷𝒊𝟎
𝐏𝐑 𝐈 = N 𝐖𝐢 𝐏𝐑 𝐢 = N 𝒘𝒊 Q 𝟏
R
𝑷𝒊 𝟎
= 𝑾𝟏 𝑷𝑹𝟏 + 𝑾𝟐 𝑷𝑹𝟐 + 𝑾𝟑 𝑷𝑹𝟑 + ⋯ + 𝑾𝑵 𝑷𝑹𝑵
23
Last Revised: 06/19/2023
LOS b
- calculate
- interpret
Single Period Returns
⇒ Total Return - price change + all income
𝑽𝑷𝑹𝑰𝟏 − 𝑽𝑷𝑹𝑰𝟎 + 𝑰𝟏
𝐓𝐑 𝐈 =
𝑽𝑷𝑹𝑰𝟎
words
𝐕𝐚𝐥𝐮𝐞 𝐚𝐭 𝐭 𝟏 − 𝐕𝐚𝐥𝐮𝐞 𝐚𝐭 𝐭 𝟎
𝐭𝐨𝐭𝐚𝐥
+ 𝐈𝐧𝐜𝐨𝐦𝐞
=
𝐫𝐞𝐭𝐮𝐫𝐧
𝐕𝐚𝐥𝐮𝐞 𝐚𝐭 𝐭 𝟎
or/ weighted average of each of the constituent components
𝑷𝒊 − 𝑷𝒊𝟎 + 𝑰𝒊
𝐓𝐑 𝐢 = 𝟏
𝑷𝒊 𝟎
-
𝐍
𝑵
𝐢'𝟏
𝒊'𝟏
𝑷𝒊 − 𝑷𝒊𝟎 +𝑰𝒊
𝐓𝐑 𝐈 = N 𝐖𝐢 𝐓𝐑 𝐢 = N 𝒘𝒊 Q 𝟏
R
𝑷𝒊𝟎
each component
= 𝑾𝟏 𝑻𝑹𝟏 + 𝑾𝟐 𝑻𝑹𝟐 + 𝑾𝟑 𝑻𝑹𝟑 + ⋯ + 𝑾𝑵 𝑻𝑹𝑵
LOS b
- calculate
- interpret
Multiple Period Return
𝑽𝑷𝑹𝑰𝑻 = 𝑽𝑷𝑹𝑰𝟎 Z𝟏 + 𝑷𝑹𝑰𝟏 [Z𝟏 + 𝑷𝑹𝑰𝟐 [ … Z𝟏 + 𝑷𝑹𝑰𝑻 [
e.g./
Period
0
1
2
Return (%)
5.00
3.00
Calculation
1000(1.0)
1000(1.05)
1000(1.05)(1.03)
Ending Value
1,000
1,050
1,081.50
𝑽𝑻𝑹𝑰𝑻 = 𝑽𝑻𝑹𝑰𝟎 Z𝟏 + 𝑻𝑹𝑰𝟏 [Z𝟏 + 𝑻𝑹𝑰𝟐 [ … Z𝟏 + 𝑻𝑹𝑰𝑻 [
+15
e.g./
36.75
0
1
2
5.00 + 1.5%
3.00 + 2.0%
1000(0)
1000(1.065)
1065(1.05)
24
1,000
1,065.00
1,118.25
Last Revised: 06/19/2023
e.g./
PRI
TRI
2008
7.5%
12.6%
LOS b
- calculate
- interpret
2009
8.3%
13.4%
⇒ equity index created at beg. of 2008, VPRI = VTRI = 1000
VPRI (2008) = 1000 × (1.075) = 1075
VPRI (2009) = 1000 × 1.075 × 1.083 = 1164.225
1075(1.083)
VTRI (2008) = 1000 × (1.126) = 1126
VTRI (2009) = 1126 × (1.134) = 1276.884
Index Construction
- similar to constructing and managing
a portfolio of securities
① target market selection
⇒ asset class (equities, fixed-income, real-estate)
⇒ geographic region (Japan, Mexico, Canada)
⇒ exchange (NY, Toronto, London)
⇒ other characteristics (sector, industry, size)
② security selection
- all or just a sample
- fixed number (S&P500) or variable (TOPIX)
③ Weighting
④ Rebalancing
⑤ Reconstitution
25
LOS c
- describe
Last Revised: 06/19/2023
Index Weighting
LOS d, e
- compare
- calculate
- analyze
⇒ weighting determines how much of
each security to include in the index
① Price Weighting (simplest)
- called an Average
.9
.1
𝑾𝑷𝒊 =
𝐏𝐢
∑𝐍𝐢'𝟏 𝐏𝐢
𝟗𝟎
𝟗𝟎 + 𝟏𝟎
(i.e. DJIA)
∑𝐍𝐢'𝟏 𝐏𝐢
𝐈𝐧𝐝𝐞𝐱 𝐕𝐚𝐥𝐮𝐞 =
𝐃
typically set
at inception = N
∴ stocks with the highest
price will have the
greatest impact on the
return of the index
- any stock split changes all the
weightings
∴ divisor needs to be adjusted to prevent the split
from changing the value of the index
e.g./
A
B
C
D
E
$55
22
8
14
6
Σ = 105
D = 5
VI = 21
%
52.38
20.95
7.62
13.33
5.72
100%
2-for-1 on A
27.50
22
8
14
6
77.50
𝟐𝟏 =
𝟕𝟕. 𝟓𝟎
𝐃
26
⇒
%
35.48
28.39
10.32
18.07
7.74
100%
𝐃=
𝟕𝟕. 𝟓𝟎
= 𝟑. 𝟔𝟗
𝟐𝟏
LOS d, e
- compare
- calculate
- analyze
Last Revised: 06/19/2023
② Equal Weighting ($)
𝑾𝑬𝒊 =
i.e. $10k
5 components
= $2,000 of each component
𝟏
𝐍
LOS d, e
- compare
- calculate
- analyze
𝟐𝟎𝟎𝟎
𝟐𝟎𝟎𝟎
= shares of A ,
= shares of B, etc…
𝐏𝐀
𝐏𝐁
- select a divisor (D) to give the index a convenient
starting value
i.e. $𝟏𝟎, 𝟎𝟎𝟎
𝟏𝟎
= 𝟏𝟎𝟎𝟎 ⇒ initial value of the
index
LOS d, e
- compare
- calculate
- analyze
② Equal Weighting
+/ - simple
-/ - securities that represent the largest fraction of
the target market value are underrepresented
- those that constitute a small fraction - overrepresented
- after construction, any price change means weightings
are no longer equal
∴ frequent rebalancing required
27
Last Revised: 06/19/2023
③ Market-Capitalization Weighting
𝑾𝑴
𝒊 =
𝑸 𝒊 𝑷𝒊
∑𝑵
𝒋'𝟏 𝑸𝒋 𝑷𝒋
- divide market-cap
of the component by sum of all
market caps
LOS d, e
- compare
- calculate
- analyze
- float-adjusted Market-Cap weighting
# of shares available
to the investing public
Note: most market-cap
weighted indicies are
float adjusted
③ Market-Capitalization Weighting
+/ - components are held in proportion to
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
- leads to overweighting stocks that may
be overvalued and underweighting stocks
that may be undervalued
28
LOS d, e
- compare
- calculate
- analyze
Last Revised: 06/19/2023
④ Fundamental Weighting
- attempts to overcome market-cap
disadvantages
- uses a fundamental value as a proxy for size rather
than market cap
𝑾𝑭𝒊 =
LOS d, e
- compare
- calculate
- analyze
i.e. book value
Revenues
CFO
Earnings, etc…
𝑭𝒊
∑𝑵
𝒋'𝟏 𝑭𝒋
- results in indicies with ratios of 𝑭𝒊
Market
Value
higher than its market-cap counterpart
- weights favour securities that have decreased in
relative value
④ Fundamental Weighting
e.g./
Stock
A
B
Market-Cap
$200M
Earnings
20M
800M
20M
$ 1B
40M
Earnings Yield
𝟐𝟎g
𝟐𝟎𝟎 = 𝟏𝟎%
𝟐𝟎g
𝟖𝟎𝟎 = 𝟐. 𝟓%
𝑭𝒊 Market
Value
A
B
20%
80%
‘Momentum’
effect
<
>
50%
50%
- higher yield
- lower yield
‘Contrarian’
effect
29
LOS d, e
- compare
- calculate
- analyze
Last Revised: 06/19/2023
Rebalancing/Reconstitution
① Rebalancing
- weights assigned to constituents at inception
drift from their target weights as prices change
𝟏
𝑾𝑬𝒊 =
𝑵
𝑾𝑷𝒊 =
𝑾𝑴
𝒊 =
· equal-weighted ⇒ reduce weights of securities
that have outperformed, increase weights
of securities that have underperformed
∑𝑵
𝒋&𝟏 𝑷𝒋
· price-weighted ⇒ no need to rebalance since
the weight of each constituent is
determined by price (i.e. target weights drift
as prices change)
𝑸𝒊 𝑷𝒊
𝑵
∑𝒋&𝟏 𝑸𝒋 𝑷𝒋
· market-cap weighted ⇒ only need to be
rebalanced to reflect M&A and liquidations
𝑷𝒊
LOS f
- describe
② Reconstitution - the process of changing
the securities in the index ⇒ keeps the index
representative
LOS f
- describe
· reflect changes in the target market as a
result of bankruptcy, liquidation, M&A, delistings
· reflect judgement of the selection committee
𝑾𝑷𝒊 =
𝑷𝒊
𝑵
∑𝒋'𝟏 𝑷𝒋
𝑾𝑴
𝒊 =
𝑸 𝒊 𝑷𝒊
𝑵
∑𝒋'𝟏 𝑸𝒋 𝑷𝒋
Reconstitution results in a change in all the
weightings (price & market-cap)
⇒ usually announced prior to the reconstitution
date
30
Last Revised: 06/19/2023
Uses
· to gauge market sentiment - good
indicators of the collective option of market
participants
LOS g
- describe
⇒
· used as proxies for measuring/modeling returns, systematic
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
· as a benchmark for actively managed portfolios
· serve as the basis for the creation of investment
products (typically passive)
Index Types
1) Broad market indicies
- 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
31
LOS h
- describe
Last Revised: 06/19/2023
3) Sector Indicies
- represent a particular sector (Consumer Staples,
Utilities, etc.)
- helps assess manager performance (10 broad sectors)
- are returns due to stock
picking or sector allocation
LOS h
- describe
4) Style Indicies
- growth vs. value
- will require more frequent rebalancing
& reconstitution
Fixed-Income Indicies
⇒ broader universe of bonds than stocks
⇒ universe constantly changing (new issues, calls, maturities)
⇒ Duration (price volatility) is constantly changing
Types/ · Issuer (gov’t., gov’t. agency, corporates)
· Type of financing (general obligation, collateralized)
· Currency of payment
· Maturity
· Credit quality (investment grade, high yield, ratings)
· Inflation protection?
32
LOS i
- describe
Last Revised: 06/19/2023
⇒ can be categorized as
· 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./
LOS i
- describe
Investment Grade ➞ maturity ➞ credit rating
𝐀𝐀𝐀g
𝐀𝐀
10-yr. gov’t.
Alternative Investments
1) Commodity indicies
- consist of futures contracts on one or
more commodities
⇒ equal, fixed or price weighted (determined by a
committee)
- different weightings ⇒ different exposures
⇒ different risk/return profiles
- index performance may differ from that of the
underlying commodity due to the use of derivatives
rather than the physical commodity
⇒ introduces exposure to rf, 𝚫Fp, roll yield
33
LOS j
- describe
Last Revised: 06/19/2023
2) Real Estate/REIT indicies
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)
34
LOS j
- describe
Last Revised: 06/19/2023
Market Efficiency
a. describe market efficiency and related concepts, including their importance to
investment practitioners
b. contrast market value and intrinsic value
c. explain factors that affect a market’s efficiency
d. contrast weak-form, semi-strong-form, and strong-form market efficiency
e. explain the implications of each form of market efficiency for fundamental
analysis, technical analysis, and the choice between active and passive portfolio
management
f. describe market anomalies
g. describe behavioral finance and its potential relevance to understanding market
anomalies
35
Last Revised: 06/19/2023
Market Efficiency
- the extent to which market prices
incorporate available info.
⇒ inefficiency is what justifies active mgmt.
LOS a
- describe
- price efficiency (informative prices)
⇒ ‘price signal’ determine where capital should
be allocated to earn the highest risk-adjusted
return
(avoids malinvestment)
- promotes health & sound economic growth
⇒ information efficiency
- assumes information is timely, complete, correct, and
understandable
- asset prices reflect new information
⇒
quickly and rationally
the unanticipated element
1 min. - 1 hr.
⇒ prices incorporate all past & present info.
∴ consistent, superior, risk-adjusted returns are not
achievable in an efficient market
passive R > active R
(lower costs)
36
LOS a
- describe
Last Revised: 06/19/2023
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.
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.
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:
A. in the period leading up to the announcement
B. in the first trade prices after the market opens on the announcement day
C. when the issuer actually misses the payment on the interest payment day
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:
A. had failed in its negotiations for a bank loan
B. lacked the cash to meet the upcoming interest payment
C. had been required to make cash payments for supplier deliveries
37
LOS a
- describe
Last Revised: 06/19/2023
Market vs. Intrinsic
⇒ Market Value (MV) price at which an
asset can be bought or sold (i.e. bid-ask)
LOS b
- distinguish
⇒ Intrinsic Value (IV - fundamental value) - price of an
asset if complete information & understanding
were used (typically PV - future cashflows)
- requires judgment, IV just an estimate
IV < MV - overvalued
(Sell, underweight)
IV ≃ MV - fairly valued (Hold, equal weight)
IV > MV - undervalued (Buy, overweight)
1. An analyst estimates that a security’s intrinsic value is lower than its market value.
The security appears to be:
LOS b
- describe
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:
A. overestimated the asset’s risk
B. underestimated the asset’s risk
C. identified a market inefficiency
38
Last Revised: 06/19/2023
Impediments
LOS c
- explain
Inefficient
factors
fewer, few
Market Participants
more, numerous
narrower
Information Availability
wider
less, variable
Financial Disclosure
more, standardized
Limits to Trading
speedy transactions
transparency
no restrictions
slow/lagged trans.
lack of transparency
restrictions
Transactions Costs
- mispricing would still be
efficient if within the
‘bounds of arbitrage’
Efficient
Information - Acquisition Costs
classic view return = risk assumed
∴ info. costs = waste of time
modern view
(return - info. costs) = risk assumed
Efficiency Taxonomy
LOS d
- contrast
Market Prices Reflect
Forms of Market
Efficiency
Past Market
Data
Weak-form
√
Semi-strong-form
√
√
Strong-form
√
√
(Eugene Fama, 1970)
39
Public
Information
Private
Information
√
Last Revised: 06/19/2023
Weak-form/ future returns should be independent of
past returns or patterns
- no serial correlations
- no trading ‘rules’
LOS d
- contrast
Proponents of weak-form EMH assert that abnormal
risk-adjusted returns cannot be earned by using
trading rules and technical analysis, which make
investing decisions based on historical security
market data.
Semi-strong form/ - encompasses weak-form
LOS d
- contrast
- considerable research support in developed
markets
Proponents of the hypothesis assert that investors
cannot earn abnormal risk-adjusted returns if their
investment decisions are based on important material
information after it has been made public. They
stress that security prices rapidly adjust to reflect
all public information.
Strong form/
encompasses both weak and semi-strong
forms
research rejects the strong-form hypothesis
(i.e. fails to accept)
LOS d
- contrast
Strong-form EMH assumes perfect markets where information
is cost free and available to all. Under strong-form EMH, no one
can consistently achieve abnormal risk-adjusted returns, not
even company insiders.
40
Last Revised: 06/19/2023
Implications
1) Security markets are weak-form eff.
∴ technical analysis will not produce
LOS e
- explain
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
- describe
① Time-Series Anomalies
Calendar anomalies
k
lac nce
l
l
te
a
si s
r
pe
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
41
Last Revised: 06/19/2023
LOS f
- describe
① Time-Series Anomalies
Overreaction Anomalies
- investors overreact to the release of
unexpected new information
good news inflate
prices
bad news depresses
prices
use of a contrarian strategy
Momentum Anomalies
- securities that have outperformed in the
short-run continue to outperform
(IBD)
② Cross-Sectional Anomalies
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
· BV equity
MVequity
(use of 3-factor model for valuation vs.
CAPM (1-factor) eliminates this anomaly)
42
LOS f
- describe
Last Revised: 06/19/2023
3) Other Anomalies
not
d
orte
p
p
su
by
ent
sist
con
&
t
sten
i
s
r
pe
e
enc
d
i
v
e
a) Closed-end fund discounts
- to their NAVPS
- typically not worth the transaction
costs
b) Earnings Surprises
- prices may be slow to adjust
LOS f
- describe
c) IPOs - if you can get shares at the offer
price
d) Predictability of Returns based on prior
information i.e. economic cycle related
Behavioral Finance
- examines investor behavior (observed)
rather than relying on normative assumptions (i.e. rationality)
⇒ investors do not always make efficient
(rational & optional) decisions
- due to cognitive/behavioral biases
① Loss Aversion - tendency to prefer avoiding losses to
acquiring gains
- losses are twice as powerful, psychologically
⇒ can actually lead to ‘loss persistence’
- the unwillingness to actually take a loss
43
LOS g
- describe
Last Revised: 06/19/2023
② Herding - investors ignore their own
analysis and make decisions in line with the
LOS g
- describe
direction of the market (can often be rational
to follow)
- correlated strategies, clustered trading
③ Information Cascades - the transfer of information from
those who are the first to act upon it, and
whale
watching whose decisions influence others (results in
serial correlations, perhaps overreactions to
information)
④ Overconfidence - investors have an inflated view of
their ability to process information
LOS g
- describe
- many more
Implications ⇒ for the market - unclear
- even if some investors
exhibit bias, as long as enough do not,
markets will remain efficient
⇒ for the investor
- know thyself
- if you are subject to certain
biases, develop rules to avoid the trap
e.g. Position limits, loss limits, excessive gain/loss
timeouts.
44
Last Revised: 06/19/2023
Overview of Equity Securities
a. describe characteristics of types of equity securities
b. describe differences in voting rights and other ownership characteristics among
different equity classes
c. compare and contrast public and private equity securities
d. describe methods for investing in non-domestic equity securities
e. compare the risk and return characteristics of different types of equity securities
f. explain the role of equity securities in the financing of a company’s assets
g. contrast the market value and book value of equity securities
h. compare a company’s cost of equity, its (accounting) return on equity, and
investors’ required rates of return
45
Last Revised: 06/19/2023
Equity Securities
- a few global facts ① 𝐄𝐪𝐮𝐢𝐭𝐲 𝐌𝐚𝐫𝐤𝐞𝐭 𝐂𝐚𝐩
~ 50%
𝐆𝐥𝐨𝐛𝐚𝐥 𝐆𝐃𝐏
30% ∼70% ② from 1900 - 2011
∅
70% 30%
LOS a, b
- describe
- long-run
avg.
gov’t. bonds/bills - rr ∼ 2%
equity markets - rr ∼ 4%
③ equity ownership ∼ 20% - 50% of population
(developed countries)
CPP
Company
Debt
Equity
- liability
- interest
residual claim on assets
- cap. gains + div.
Common Shares:
- ownership interest in the company (residual claim)
LOS a, b
- describe
- Share in operating performance (cap. app., dividends)
- participate in governance process (voting rights)
⇒ major corporate decisions (e.g. M&A)
⇒ election of BoD
cumulative voting
total votes = # of shares ×
# of directors
i.e. 4 directors up for re-election/election
100 shares × 4 directors = 400
100 for 1
total
400 for 1
= 100 each
or
votes
total
or
100 each
= 400
votes
100 each
Statutory voting
- each share = 1 vote
46
Last Revised: 06/19/2023
Common Shares:
- different classes each with different ownership
and voting rights, and even different claims on
net assets in liquidation event
Class A
- held by investing
public
60% voting rights
i.e.
LOS a, b
- describe
Class B
- held by insiders
(typically founding family)
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
- describe
Preference Shares: (preferreds)
- do not participate in operating performance
- no voting rights
- receive dividends before common stock
- dividend stated as a yield on par (can be fixed
or variable)
typically > common yield
- dividend still discretionary
i.e. rate - reset
- higher priority claim on net assets than common
- can be perpetual, convertible, callable, putable
- prices like debt, pays like equity (i.e. div. vs. int.)
47
Last Revised: 06/19/2023
Preference Shares: (preferreds)
Cumulative: unpaid dividends accrue over time
LOS a, b
- describe
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
Participating: ① in any increase in dividends if
company profits exceed some level OR/
if company issues special dividends
② in proceeds from a liquidity event
i.e. 2x partic. on $25 par value = $50 distribution
LOS a, b
- describe
Preference Shares: (preferreds)
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’
48
Last Revised: 06/19/2023
Public vs. Private
Public ⇒ IPO - secondary markets
LOS c
- distinguish
Private ⇒ Private Placement - no secondary market
institutional investors (PE/VC)
accredited investors
not listed on public exchanges
prices are not market-determined
highly illiquid
issuer not required (regulatory) to publish
financial statements
Note: if # of shareholders > 50, classified as a public company
LOS c
- distinguish
Types of Private Investments:
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
2) LBO/MBO - use of debt to purchase all
outstanding shares of a publicly
group of
mgmt.
traded company
investors
- usually restructured and re-issued
49
Last Revised: 06/19/2023
Types of Private Investments:
3) Private Investment in Public Equity (PIPE)
- restricted stock
- preferreds
LOS c
- distinguish
usually at a
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
⇒ Companies are able to issue shares in
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
50
LOS d
- describe
Last Revised: 06/19/2023
- reducing these restrictions tend to lead
to improved equity market performance
LOS d
- describe
⇒ Increased number of companies have issued shares in
markets outside their home country
- dual-listing
Benefits/
improves awareness about the company’s
products/services
enhances liquidity (of the shares)
increases corporate transparency
(need to meet a greater number
of filing requirements)
Methods/
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)
51
LOS d
- describe
Last Revised: 06/19/2023
LOS d
- describe
Methods/ ② Depository Receipts
- trades like an ordinary share on a local
exchange
- represents an economic interest in a
foreign company
deposits
Foreign
Co.
shares
Domestic Market
Domestic
Bank
may not be
1-for-1
issues
receipts
transfer agent
custodian
Domestic
Exchange
Buyer
dom. $
all divs. in
dom. $
Seller
dom. $
LOS d
- describe
Methods/ ② Depository Receipts
sponsored ⇒ foreign company has a direct involvement
in the issuance of receipts
- investors in DRs have the same rights as
direct owners
Level 1 1 ADR - trade OTC
Level 2 & 3 - must register with SEC
- follow regulatory guidelines
Rule 144A - QIBs (private placements)
unsponsored ⇒ foreign company has no direct involvement in
the issuance of receipts
- the depository has the rights of ownership,
not the investor
52
Last Revised: 06/19/2023
Methods/ ② Depository Receipts
GDR - global depository receipt - issued by depository
in
USD
LOS d
- describe
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)
Risk and Return
- 2 main sources of return in any one period
1) capital gains
(𝐏𝐭 − 𝐏𝐭8𝟏 ) + 𝐃𝐭
𝐑𝐭 =
2) dividends
𝐏𝐭8𝟏
- for DRs and direct foreign investments
ees
ns. f nv.
a
r
t
no
re-i
med. t. disc.
m
i
P)
mk
(DRI
3-5%
3) currency gains/losses
- over multiple periods
4) dividend (reinvestment) (compounding effect)
(does not have to be same co.)
Risk ⇒ therefore refers to the uncertainty of the
above future returns and cash flows
53
LOS e
- compare
Last Revised: 06/19/2023
⇒ Preferreds are less risky than common
- Pref. Div. known and fixed (generally)
(𝐃𝐭 )
LOS e
- compare
- dividend accounts for a large portion of the
(less uncertainty about future CFs) Pref. sh. 𝐑 𝐭
- Pref. receive div. & distributions before common
(up to par)
- rank behind all debt.
- Cumulative less risky than Non-Cumulative
⇒ Common shares - large part of 𝐑 𝐭 made up to (𝐏𝐭 − 𝐏𝐭,𝟏 )
- Putable less risky than Callable/Non-Callable
- Callable more risky than Non-Callable
⇒ Public Less risky than Private
Financing a Company
- companies issue equity to raise
(A = L + E)
capital (for many reasons/uses)
LOS f, g
- explain
- distinguish
- ultimate goal of mgmt. is to increase the
BV of the company and maximize the MV of its
equity
direct
control
indirect
control
BV = A - L
∴ increase Ret. Earn.
MV = # of shares × P0
primarily determined by investor’s
expectations about the amount,
timing and uncertainty of future
cash flows
54
Last Revised: 06/19/2023
⇒ Accounting Return on Equity
𝐑𝐎𝐄𝐭 =
𝐍𝐈𝐭
𝐍𝐈𝐭 - Pref. Div.
=
(𝐁𝐕𝐄𝐭 + 𝐁𝐕𝐄𝐭8𝟏 )/𝟐
𝐀𝐯𝐠. 𝐁𝐕𝐄𝐭
LOS f, g
- explain
- distinguish
Note: NI ⇒ total net income available to common shareholders
(i.e. Net Income - Preferred Dividends)
𝐑𝐎𝐄𝐭 can increase if
- Price-to-Book Ratio
𝐌𝐕𝐄𝐭 ⁄𝐬𝐡.
𝐌𝐕𝐄𝐭
=
𝐁𝐕𝐄𝐭 ⁄𝐬𝐡.
𝐁𝐕𝐄𝐭
NI rises faster than BVE
NI falls slower than BVE
- higher ratio indicates that the
market is pricing in higher
future growth opportunities
ROE - the rate of return earned by a
company on its equity capital
- uses accounting net income (s.t. estimates, methods)
- can be managed ⇒ issue debt to buyback shares
decreases equity ⇒ BVE ↓
Intrinsic Value ⇒ PV(expected future cash flows)
discounted at the ‘required rate of
return’
Cost of Equity ⇒ the discount rate needed to equate
the expected future cash flows with the
offering price
55
LOS h
- compare
Last Revised: 06/19/2023
Company Analysis: Past and Present
a. describe the elements that should be covered in a thorough company research
report
b. determine a company’s business model
c. evaluate a company’s revenue and revenue drivers, including pricing power
d. evaluate a company’s operating profitability and working capital using key
measures
e. evaluate a company’s capital investments and capital structure
56
Last Revised: 06/19/2023
Company Analysis Past and Present
Company Research Reports
Company Research Reports
57
Last Revised: 06/19/2023
Company Research Reports
Business Models
Step One in the framework is to identify the firm’s business model:
- The business model should identify the key drivers of financial results, position
- Identifies key areas that require further investigation
- Allows the analyst to set expectations
Key Elements
Products/Services
Information Sources
Issuer
Key Customers/Groups
Public Third-Party
Sales Channels
Proprietary Third-Party
Customer Acquisition
Proprietary Primary Research
Delivery Mechanisms
Price and Payment Structure
Resource, Supplier Relationships
58
Last Revised: 06/19/2023
Key Elements
Products/Services
Key Customers/Groups
Sales Channels
Customer Acquisition
Delivery Mechanisms
Price and Payment Structure
Resource, Supplier Relationships
Key Elements
Products/Services
Key Customers/Groups
Sales Channels
Customer Acquisition
Delivery Mechanisms
Price and Payment Structure
Resource, Supplier Relationships
59
Last Revised: 06/19/2023
Revenue
Revenue Analysis
Revenue Drivers
‘Causative factors’ explaining the level of, and changes in, revenue
What are they?
How have they evolved over time?
Two approaches to determining revenue drivers
- Bottom-up
- Top-down
or a combination
Bottom-Up : micro factors - look within the company
Price, Volume, Product Line, Geographic, etc.
Top-Down : macro factors - look at economy
GDP Growth, Market Size, etc.
industry and company analysis reading
60
Last Revised: 06/19/2023
Revenue Analysis
Prices are constrained by a company’s pricing power - The ability to set prices and terms
without affecting sales volume
Pricing Power is a function of : market structure, competitive positioning within the market
Highly Competitive Markets : low barriers, available substitutes, little differentiation, low
switching costs
e.g. Retail, oil & gas, fresh food, insurance, bank loans/deposits
many markets become competitive as innovation slows ➞ commoditization
Firms are price takers
Long-Run economic profit = zero (can low-cost producers maintain > zero?)
Less Competitive
: high barriers, customer loyalty, switching costs
e.g. Branded Goods, Patented Pharmaceuticals
Higher degree of Pricing Power : Value Based, Cost Based, Price Discrimination
Analysis: Price trend v. Cost trend (margins)
Revenue Analysis
Warehouse Club - Bottom Up
Sales
Membership Fees
Fresh Food Packaged Food Non Food Other
Vol.:
13%
40%
28%
Number of Members
19%
Growth : Sales Per Store (Sq. Ft.?)
Number of Stores
61
Price
Last Revised: 06/19/2023
Operating Profitability and Working Capital
Operating Costs : generate/are related to current period revenue
Acquisition, Production, Sale, Improvement, Delivery of goods and services
Management of business activities
Compliance with Laws and Regulations
[investing costs relate to acqn. and prodn of long-term assets, financing costs relate to debt
Classification Issues:
Research and Development
Depreciation/Amortization
Interest Expense
Income Taxes
Intuition
and equity]
Cashflow
Income Statement
Categorization: Behavior With Output
Nature
IFRS/US GAAP
Function
Preferred
Variable
Compensation
Cost of Goods Sold
Fixed
[Degree operating leverage]
Raw Materials
Sales and Marketing
Merchandise
General and Admin.
Office Supplies
Research and Development
Operating Profitability and Working Capital
Operating Cost and Behavior with Output:
Operating Profit = [Q × (P - VC)] - FC
Quantity Sales
Fixed Costs
(Price-Variable Costs)
Contribution Margin : Contribution margin must be positive!
Quantity Sold must be enough to cover FC
Degree of Operating Leverage (DOL) = % change operating profit
% change sales
Practical use may be limited - disclosure by nature not required by IFRS/US GAAP
- output volume not disclosed
- split of VC v. FC may vary across product lines
- useful if disclosure is typical in industry ...
62
Last Revised: 06/19/2023
Operating Profitability and Working Capital
Oil Industry Typical Disclosures :
Last 12M
Sales Volume (thousands of barrels)
Average Price
Total Revenues (millions)
154,812
$49.66
$7,688
Contribution margin per barrel?
(P - VC)
Operating Profit?
Production Costs per Barrel:
Lease Operating Expense
11.21
Production and Ad Valorem Taxes
3.40
Change in operating profit for a
Transportation
2.63
10% increase in sales volume?
Production Costs
$17.24
Other Operating Expenses (millions)
Depreciation
1,275
General and Admin.
150
Degree of operating leverage?
Operating Profitability and Working Capital
Measures of profitability using costs disclosed by function (a typical income statement)
Revenue
(Cost of Goods Sold)
mostly variable
Gross Profit
good approximation of contribution margin
(Operating Expenses)
mostly fixed (sales, R&D, general and admin.)
EBITDA
(Depreciation and Amortization)
will be fixed if straight line
EBIT or Operating Profit
Major driver of operating costs over the long run is output:
Economies of Scale
- Cost per unit decreases as output increases
- Compare size (revenues) to operating cost margin
Economies of Scope - Cost per unit decreases as number of product lines increases
- Compare profitability of integrated company with stand alone
63
Last Revised: 06/19/2023
Operating Profitability and Working Capital
Analyze trend in categories of operating costs using their drivers:
Cost
Cost of Goods Sold
Sales, General, Admin.
Depreciation and Amortization
Driver
Revenue
Revenue
Gross Fixed Assets
Metric
Gross Margin
SG&A as a % of revenue
useful economic life (gross FA/
Depn.& Amtn.)
Industry Specific (warehouse club)
Store Opening Costs
Membership Fees
Stores Opened
Cost per Store Opened
?
?
Operating Profitability and Working Capital
Gross margin (line) steady
COGS (bars) increased
SG&A margin (line)
steady
SG&A increased
Useful life (line) steady
depn. & amtn. increased
Cost per opening (line)
increasing
64
Last Revised: 06/19/2023
Operating Profitability and Working Capital
Working capital can be analyzed using activity ratios - DOH, DSO, Payables days
- cash conversion cycle
Capital Investments and Capital Structure
Long-Run Aim : Return on Capital Invested > Cost of Capital (Economic Profit)
Analyst : Compare ROIC to WACC.
Drivers: Uses of Capital
Drivers: Sources and cost of each source of capital
Cash on hand
CFO and...
Net working capital (+)
Net working capital (-)
Capital expenditure
Debt issuance
Acquisitions
Equity issuance
Debt repayment
Asset disposals
Dividends and share repurchases
65
Last Revised: 06/19/2023
Capital Investments and Capital Structure
debt issuance < increase
in cash
Returns to shareholders
no equity issued
and CAPEX very similar
no acquisitions
Capital Investments and Capital Structure
Risk : Debt finance increases financial risk.
Measure : Degree of financial leverage =
% change net income
% change operating income
Interest coverage
=
EBIT
‘interest’
66
Last Revised: 06/19/2023
Capital Investments and Capital Structure
Positive ROIC - WACC spread
Degree of financial leverage ≃ 1.0
67
Last Revised: 06/19/2023
Industry and Competitive Analysis
a. describe the purposes of, and steps involved in, industry and competitive analysis
b. describe industry classification methods and compare methods by which companies
can be grouped
c. determine an industry’s size, growth characteristics, profitability, and market share
trends
d. analyze an industry’s structure and external influences using Porter’s Five Forces
and PESTLE frameworks
e. evaluate the competitive strategy and position of a company
68
Last Revised: 06/19/2023
Industry and Competitive Analysis
LOS B: Classification methods
LOS C: Industry survey
LOS D: Porter’s 5 Forces
PESTLE
LOS E: Apply it!
Purpose and Steps
same business models, product markets, factor markets
same supply and demand opportunities and risks
Median Industry Profitability
Business Model variation, Competitive Strategy, Size, Execution
variation around the mean
Relative importance of industry v. company specific factors RE: Economic Profit
(ROIC - WACC)
Industry most important factor in sustainability of economic profits
Company specific effects much larger for low performing firms than high
no floor
ceiling
Aim of Industry and Competitive Analysis:
1. Estimate industry ‘base rate’ and its drivers
2. Form forward-looking opinion on potential structural changes
3. Analyze firm’s strengths/weaknesses to determine their position v. base rate
69
Last Revised: 06/19/2023
Industry Classification
The Simple Definition: Companies that sell similar products or services
The Problems
: include substitutes? Companies in multiple industries, geography,
updates...
Third Party Schemes
Early gov’t. agency methods: country specific, grouped by production characteristics, not
updated
More recent commercial methods: GICS (Global Industry Classification Scheme)
ICB (Industry Classification Benchmark)
public companies
TRBC (The Refinitiv Business Classification) + private, non-profit,
gov’t.
Global, grouped using demand approach, undated frequently
Industry Classification
Limitations
1. Groupings of companies with business model variations or that sell substitutes
e.g. Application Software: Shopify: e-commerce payment processing
Check Point Software: security software
2. Multi-Product Companies
e.g. Amazon: Consumer discretionary
- Most of its profits are generated by Amazon Web Services (AWS)
3. Geography
e.g. Healthcare: companies do not compete globally
4. Changes in groupings affecting comparability
e.g. Fintech: Payment Processors: Information Technology or Financial Sector?
Alternative Methods: Geography - country of incorporation, groups: developed, emerging,
frontier
Business Cycle - defensive, cyclical: By sector
Statistical Similarities - clustering analysis
ESG characteristics
70
Last Revised: 06/19/2023
Industry Survey
Size and Historical Growth Rate
Size = Total Annual Sales from product or customer perspective
may not be all sales from every constituent e.g. Retail: Amazon Retail Sales √
AWS X
Growth Rate = Year over year each year
or Compound growth rate for multi years
Breakdown into contributions from volume and price/mix useful
Estimate contribution of private companies using gov’t. / 3rd party data
Industry Survey
Growth Characteristics
Use historical growth pattern to characterize industry growth - magnitude
- sensitivity to business
cycle
Limitations: High correlation in severe downturn, life cycle can impact growth
Style Box
defensive
Utilities
Biotech
cyclical
Crude oil
Mature
Fintech
Growth
sensitivity
Driven by business model
Are products discretionary?
Interest Rate Exposure
Subscription?
magnitude
Full saturation
Not yet reached full saturation
Growth in line with
Idiosyncratic drivers separate
economy or declining
from GDP
71
Last Revised: 06/19/2023
Industry Survey
Industry Profitability Measures
Return on Invested Capital - after-tax operating profits
- not distorted by capital structure
- data not readily available unless publicly traded
Use time series to assess trends
Use percentiles (e.g. Quartiles) to assess distribution
Market Share Trends
Measured using Annual Revenue v. Industry Size
- trends are key, as is organic growth v. acquisition
An industry with many small firms may be highly competitive, consolidation decreases
!
competition
Herfindahl-Hirschman Index (HHI): - 𝐬𝐢 𝟐 = sum of squared market shares
𝐢#𝟏
Monopoly HHI = 10,000 (1002)
High Concentration
Moderate Concentration
2,500+
1,500 - 2,500
(Acquisition causing 200 + increase may face regulatory
challenge)
Structure and External Influences
Porter’s Five Forces
Threat of
Threat of
Bargaining Power
Bargaining Power
Rivalry Amongst
New Entrants
Substitutes
of Customers
of Suppliers
Existing Competitors
Historic
# substitutes
Number/size
Number/size
History
Network effects
Easy to switch?
Are products
Easy to switch
Concentration
Economies of Scale
Innovation of
critical for customer
Differentiated?
Differentiated Products?
Economies of Scope
substitutes
% of customer
# substitutes
Exit barriers?
Customer Loyalty
budget
Switching Costs
Can customers
Slow growth?
Preferential Access
‘backward integrate’
Gov’t. Policies
72
Last Revised: 06/19/2023
Structure and External Influences
PESTLE
External Influences :
Political
Economic
Social
Technological
Legal
Environmental
Fiscal Policy
GDP
Trends
Sustaining
Laws
Low Carbon
Monetary Policy
Inflation
Demographics
Disruptive
Regulations
Transition Risk
Regulation
Interest Rates
[External?]
Gov’t. Purchasing
Cycle
Competitive Strategy
An effective strategy is evidenced by a track record of economic profit
But how to assess it on a forward-looking basis?
Three Questions
1. Does it create a defense against the five industry forces?
2. Does it benefit from, or at least not clash with, external industry forces? (PESTLE)
3. Does the company have the resources and capabilities to make it work?
Three Strategies
Cost Leadership
Differentiation
Lowest Cost Producer
Superior Product
Strategy 4 : Stuck in the middle.
73
Focus
Focus on specific
customer group
Last Revised: 06/19/2023
Competitive Strategy
74
Last Revised: 06/19/2023
Company Analysis: Forecasting
a. explain principles and approaches to forecasting a company’s financial results and
position
b. explain approaches to forecasting a company’s revenues
c. explain approaches to forecasting a company’s operating expenses and working
capital
d. explain approaches to forecasting a company’s capital investments and capital
structure
e. describe the use of scenario analysis in forecasting
75
Last Revised: 06/19/2023
Company Analysis: Forecasting
Principles and Approach
Perspective in this module: longer-term-oriented forecast for straightforward public
issuer
What to Forecast (forecast objects)
1. Drivers of Financial Statement Lines
e.g. Sales : Stores opened, sales per store
operating expenses : % of sales
2. Individual Financial Statement Lines - less material lines, those without clear drivers
e.g. depreciation expense
3. Summary Measures e.g. Free Cash Flow, EPS, Total Assets ➞ efficient but less transparent
(typically used when measure is stable, predictable, disclosures are
minimal)
4. Ad Hoc Objects - items not yet reported in financial statements
e.g. Forecast Result of legal proceedings
Use forecast objects that are disclosed regularly: gross margin √ by product line?
Avoid overly complex models
Principles and Approach
Forecast Approaches
Historical Results
Assume past is precedent
simple, default
Historical Base Rates
Management Guidance
Analyst’s Discretion
and Convergence
Assume convergence to Public company published All other methods
peer group average
management guidance
discretion required in
check track record
surveys
industry structure not
choosing object, sample,
sensitivity to business
quantitative models
expected to change
time frame
cycle (no informational
low sensitivity to
suited to mature, stable
probability
distribution
used when change
business cycle
industries - Tesla?
non-material items
not for cyclical or
advantage for mgmt.)
is likely
climate change
dominant companies
alphabet and meta
Forecast Horizon: Determined by investment strategy, cyclicality, company factors, employer
76
Last Revised: 06/19/2023
Forecasting Revenues
Forecast Objects : Top-Down
Growth Relative to GDP: 1. Forecast growth rate of nominal GDP - Real GDP growth (volume)
- inflation forecast
2. Adjust for company specifics - +/- bps for life cycle, bus. cycle
Market Growth and Market Share: 1. Forecast growth rate for company’s product market - v.
GDP?
2. Forecast market share e.g. Product market today = 250 bn
Forecast growth
= 10%
Market share today
= 5%
Expected market share growth = 0%
Forecast Objects: Bottom-Up
Volumes and Average Selling Prices - useful for industries that disclose (airlines, asset
managers)
Product-Line or Segment Revenues - if disclosed and segments have different economic
exposures
Capacity-Based Measures - Retail e.g. number stores and sales per store
Return or Yield Based Measures - e.g. net interest income for banks
Forecasting Revenues
Non-Recurring Items (exclude!)
Disclosed (easy) : changes in exchange rates
extra days/weeks in a period
acquisitions/divestitures
other (unusual/infrequent)
may use proprietary forecasts
Financial Reporting Quality?
Not Quantified (not as easy) : Require Judgment
e.g. COVID-19: large increase in e-commerce sales as a % of retail sales
will this recur, is it a ‘new normal’?
[it did not]
Forecast Approaches
Any of the four!
77
[no]
Last Revised: 06/19/2023
Forecasting Revenues
Forecasting Expenses
Disclosures RE: expenses are less detailed than revenue - Analyst likely to use aggregated
data
Cost of Goods Sold (COGS)
Revenue is the key driver ➞ use % sales or gross margin
Typically large/largest cost ➞ be accurate! considerations - Price Shocks ➞ Hedging?
- Growth Substitutes
- New Products
- Differing Business Models
e.g. owned stores v. franchised
Understand impact of changing input prices:
e.g. : Year 1: Sales
100
COGS (25)
increase is fully passed on
Sales
125
input costs double
COGS
(50)
Gross Profit
75
Gross Profit
75
COGS as % sales
75%
COGS as % sales
40%
Gross Margin
25%
Gross Margin
60%
78
Last Revised: 06/19/2023
Forecasting Expenses
SG&A Expenses
Relationship with sales not as direct as COGS
selling and distribution may be modeled using sales
general more fixed - driver may be wage inflation
Company’s presenting segmental disclosures will disclose segmental EBITDA, operating
margins
Analyst may use these summary measures rather than COGS and S,G&A
Forecasting Expenses
1. Assuming total sales growth of 2% and
5 yrs.
constant overall underlying profit margin,
29,308
15,203
15,077
calculate sales, OP cost and OP profit margin
in 5 years.
Sales (51,990 × 1.025)
OP Profit Margin
57,390
19.1%
Operating Costs
46,428
Operating Profit
10,962
6,648
2. Assuming segmental growth rates (6%, -5%,
2,666
7%) and constant segmental operating profit
2,235
margin:
Sales (29,308 + 15,203 + 15,077)
59,588
Operating Profit (6,648 + 2,666 + 2,235) 11,549
OP Profit Margin
79
19.38%
Last Revised: 06/19/2023
Forecasting Working Capital
Efficiency Ratios! (Note: example uses year-end balances)
Year 3: DSO = 10,161 × 365 = 15.08
Year 6: Acc. Receivable = 15 × 380,292 = 15,716
365
245,866
DOH = 41,671 × 365 = 73
Inventory
= 73 × 319,445 = 63,657
209,114
365
DPO = 72,199 × 365 = 126
Acc. Payable
= 126 × 319,445 = 110,292
209,114
365
Forecasting Capital Structure
Forecasted long-term assets are based on cash flow statements and income statements
PPE increases due to
capital expenditure
maintenance CAPEX
growth CAPEX
historic depn. plus
more discretionary
inflation adjustment
Forecasted capital structure ➞ use leverage ratios
80
decreases due to
depreciation
useful lives
Last Revised: 06/19/2023
Forecasting Capital Structure
Assume
PPE CAPEX = % of Revenue (Year 3 level)
Intangible CAPEX = % of Revenue (Year 1 level)
Goodwill remains at Year 3 level
Depn. & Amtzn. % of Beginning net PPE, net
intangibles
(Year 3 level)
Total Fixed Assets in Year 4:
12,326
PPE (net) at end Yr. 3 : 6,306
CAPEX (1.2% × 290,122): 3,481
Dep’n. (7% × 6,306)
:
(441)
9,346
9,346
Intangibles (net) end Yr. 3: 4,013
CAPEX (0.2% × 290,122):
580
AMTZN (47% × 4,013) : (1,866)
Year 4 Forecast Revenue 290,122
Goodwill (= Year 3)
2,727
2,727
253
253
Forecasting Capital Structure
Assume : EBITDA margin of 6%
Gross debt to EBITDA Ratio of 1.25
Forecasted gross debt year 4:
EBITDA = 6% × 290,122 =
17,407
Gross debt = 1.25 × 17,407 = 21,759
81
Last Revised: 06/19/2023
Other Approaches
Scenario Analysis
Final Step in Forecasting - incorporate risk factors - Business Cycle
- Inflation/Deflation
- Competition
- Technology
Analyst should forecast a range of scenarios, not a point estimate
Assessing impact of tablet sales on PC sales
Assume cannibalization factors: 40% for Consumers
15% for Non-Consumers
Average Selling Price : Consumer
USD 85
Non-Consumer USD 155
82
Last Revised: 06/19/2023
Equity Valuation: Concepts and Basic Tools
a. evaluate whether a security, given its current market price and a value estimate, is
overvalued, fairly valued, or undervalued by the market
b. describe major categories of equity valuation models
c. describe regular cash dividends, extra dividends, stock dividends, stock splits,
reverse stock splits, and share repurchases
d. describe dividend payment chronology
e. explain the rationale for using present value models to value equity and describe
the dividend discount and free-cash-flow-to-equity models
f. calculate the intrinsic value of a non-callable, non-convertible preferred stock
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
h. identify characteristics of companies for which the constant growth or a multistage
dividend discount model is 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
j. calculate and interpret the following multiples: price to earnings, price to an
estimate of operating cash flow, price to sales, and price to book value
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
m. explain advantages and disadvantages of each category of valuation model
LOSs will match between the video and the MM PDFs, but may be
in a different order than the CFAI readings
83
Last Revised: 06/19/2023
IV versus MV
LOS a
- evaluate
- goal is to identify mispriced securities
(i.e. IV ≠ MV)
IV - intrinsic value/fundamental value
MV - market value
- overvalued
<
IV =
MV - fairly valued
>
- undervalued
+ 10% - 20%
- 10% - 20%
tighter
bands
· also depends
on the confidence of the inputs ⇒ more confidence
· also depends on the expected time frame of
convergence of IV and MV
Valuation Models
- 3 major categories of valuation model
1) Present Value Models (discounted cash flow)
- 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)
2) Multiplier Models - market value or Enterprise Value
multiples
- price is some multiple of some fundamental variable
e.g./ P/E or P/S (stated on a forward basis based on an
estimate, or on a trailing basis based on observed values)
3) Asset based valuation models
(estimated value of Assets) - (estimated value of
Liabilities + est. value
of Pref. shares)
84
Page 2
LOS b
- describe
Last Revised: 06/19/2023
Dividends & Repurchases
· Dividend - a distribution paid to shareholders
based on the number of shares owned
- regular cash dividend - paid at regular intervals
- extra or special dividend - paid by a company that does
not pay at regular intervals or as a supplement
Page 3
LOS c
- describe
➞ not a legal obligation ➞ they are discretionary
➞ declared/authorized by the BoD
· Stock Dividend - bonus issue of shares - additional shares
issued (typically 2% - 4%) instead of cash
- not relevant for valuation
· Stock Splits/Reverse Stock Splits - no economic effect
↓
↓
increase # of shares
e.g. 2-for-1 (P0/sh. ↓)
decrease # of shares
e.g. 1-for-10 (P0/sh. ↑)
· Share Repurchase - an alternative to cash
dividends
- company uses cash to buy back its own stock
Transaction:
Treasury Stock
Cash
$
➞ a contra-equity account
Page 4
LOS c
- describe
PPE
- Accum.Dep.
$
these shares are not considered for dividends, voting or
computing EPS
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
85
Last Revised: 06/19/2023
Dividend Payment Chronology
dividends are
now contractual
Page 5
LOS d
- describe
stock begins trading
without the dividend
Sept 29
Holder of
Record Date
-
-
-
Sept 28
May 29
-
Ex-Dividend
Date
Declaration
Date
Oct 21
Payment
Date
- settlement = T + 2 ∴ to be a shareholder of record on
Sept. 29, must buy the stock by close of Sept. 27
$10
stock ‘opens’ lower
by the amount of
9.75
the dividend
9.50
-25¢ +25¢
Sept. 28
cum.-dividend
date
Present Value Models
⇒ Save today to have more tomorrow
(defer consumption)
(future benefits)
∴ Value
today
to have
present value of future
benefits
Simplest PV model ⇒ Dividend Discount Model (DDM)
V0 - value of share today
9
𝐃𝐭
Dt - expected dividend in year t
𝐕𝟎 = N
(𝟏 + 𝐫)𝐭
𝐭'𝟏
r = required rate of return
𝑽𝟎
𝒕𝟏
usually estimated using CAPM
= 𝐫𝐟 + 𝛃(𝐫𝐄 − 𝐫𝐟 )
86
LOS e
- explain
- describe
Last Revised: 06/19/2023
9
𝐃𝐭
𝐕𝟎 = N
(𝟏 + 𝐫)𝐭
LOS e
- explain
- describe
⇒ why use ∞
𝐭'𝟏
- holding period, t = 1
𝐃𝐭
𝐏𝐭
𝐕𝟎 =
+
𝐭
(𝟏 + 𝐫) (𝟏 + 𝐫)
where
𝐏𝐭 =
𝐃𝐭<𝟏
𝐏𝐭<𝟏
+
(𝟏 + 𝐫) (𝟏 + 𝐫)
so at t = 2
𝐕𝟎 =
𝐏𝐭<𝟏 =
𝐃𝐭<𝟐
𝐏𝐭<𝟐
+
(𝟏 + 𝐫) (𝟏 + 𝐫)
𝐃𝐭
𝐃𝐭<𝟏
𝐃𝐭<𝟐
𝐏𝐭<𝟐
+
+
{+
𝟐
𝟑
(𝟏 + 𝐫) (𝟏 + 𝐫)
(𝟏 + 𝐫)
(𝟏 + 𝐫)𝟑
and so on…
𝐃𝐭
𝐃𝐭<𝟏
𝐏𝐭<𝟏
+
+
(𝟏 + 𝐫) (𝟏 + 𝐫)𝟐 (𝟏 + 𝐫)𝟐
and at t = 3
𝐕𝟎 = z
t = n
𝐧
𝐕𝟎 = |N
𝐭'𝟏
e.g./
Div.
where
𝐃𝐭
𝐏𝐧
}+~
• ⇒ terminal stock value
𝐭
(𝟏 + 𝐫)
(𝟏 + 𝐫)𝐧
YR1
2.00
YR2
2.10
LOS e
- explain
- describe
YR3
2.20
P3 = 20
r=10%
Find V0
𝐕𝟎 =
𝟐. 𝟎𝟎
𝟐. 𝟏𝟎
𝟐. 𝟐𝟎
𝟐𝟎
+
+
+
(𝟏. 𝟏𝟎) (𝟏. 𝟏𝟎)𝟐 (𝟏. 𝟏𝟎)𝟑 (𝟏. 𝟏𝟎)𝟑
= 𝟏. 𝟖𝟏𝟖 + 𝟏. 𝟕𝟑𝟔 + 𝟏. 𝟔𝟓𝟑 + 𝟏𝟓. 𝟎𝟐𝟔
= $𝟐𝟎. 𝟐𝟑
V0 depends directly on dividends expected to
be received and indirectly on the (dividends
subsequent to the end of the holding period)
87
Last Revised: 06/19/2023
e.g./ D0 = $4
g = 20%
rf = 6%
rE = 11%
𝛃 = 1.2
est. P1 = $15.40
LOS e
- explain
- describe
(expected growth rate in the
dividend for one year)
What is V0?
𝐃𝐭
𝐏𝐭
𝐕𝟎 =
+
(𝟏 + 𝐫) (𝟏 + 𝐫)
=
𝒕=𝟏
𝟒. 𝟖𝟎
𝟏𝟓. 𝟒𝟎
+
(𝟏. 𝟏𝟐) (𝟏. 𝟏𝟐)
= 𝟒. 𝟐𝟗 + 𝟏𝟑. 𝟕𝟓
= 𝟏𝟖. 𝟎𝟒
Dt = D0(1 + g)
= 4(1.2)
= 4.80
r = rf + 𝛃(rE - rf)
= .06 + 1.2(.11 - .06)
= .06 + 1.2(.05)
= .06 + .06
= .12
- FCFE ⇒ free cash flow to equity
reflects dividend paying capacity
(useful for non-dividend paying stocks)
CFO - (CFInv + Net Borrowings)
CAPEX
9
𝐅𝐂𝐅𝐄𝐭
𝐕𝟎 = N
(𝟏 + 𝐫)𝐭
𝐭'𝟏
Dt
Recall
or/
Usually
𝐫 = 𝐫𝐟 + 𝛃(𝐫𝐄 − 𝐫𝐟 )
CAPM
economic
r = rf + risk premium judgement
gov’t.
bond
88
company’s
bond yield
LOS e
- explain
- describe
Last Revised: 06/19/2023
Preferred Shares
LOS f
- calculate
- non-callable, non-convertible
(perpetual)
𝐃𝟎
𝐕𝟎 =
PV of a perpetuity
𝐫
e.g./ $100 par value @ 5.5% , r = 6%
Recall: dividend
stated as a fixed
yield
𝐕𝟎 =
𝟓. 𝟓𝟎
= 𝟗𝟏. 𝟔𝟕
. 𝟎𝟔
e.g./ maturity at time n ⇒ same as a bond
𝐧
e.g. $20 par value @ 6% semi
𝐃𝐭
𝐅𝐕
𝐕𝟎 = N
+
maturing in 6 years, r = 8%
(𝟏 + 𝐫)𝐭 (𝟏 + 𝐫)𝐧
𝐭'𝟏
FV = 20
PMT = .60
n = 12
I/Y = 4
CPT PV = $18.12
e.g./ Non-Callable, Non-Convertible, Perpetual
Par value = $100 @ 4.75%
Credit Rating = Ba1/BB, required return on BB = 7.5%
IV = ?
𝐕𝟎 =
𝐃𝟎 𝟒. 𝟕𝟓
=
= $𝟔𝟑. 𝟑𝟑
𝐫
. 𝟎𝟕𝟓
e.g./ Retractable Term Preferred Shares
Par value $25 @ 5% quarterly
retractable in 34 quarters at par
r = 15.5%
What if the
shares were
callable?
FV = 25
n = 34
PMT = (25 x .05)/4
= 0.3125
𝟏𝟓.
𝟓
A𝟒 = 𝟑. 𝟖𝟕𝟓
I/Y =
CPT PV = $12.71
89
LOS f
- calculate
Last Revised: 06/19/2023
Gordon Growth Model
LOS g
- calculate
- interpret
- allows for growth/change of the
dividend over time
⇒ Gordon Growth - assumes dividends grow indefinitely
at a constant rate
(non-cyclical, mature companies)
9
𝐃𝟎 (𝟏 + 𝐠)𝐭
𝐕𝟎 = N
(𝟏 + 𝐫)𝐭
𝐭'𝟏
(𝟏 + 𝐠) (𝟏 + 𝐠)𝟐
(𝟏 + 𝐠)9
= 𝑫𝟎 ‚
+
+
⋯
+
ƒ
(𝟏 + 𝐫) (𝟏 + 𝐫)𝟐
(𝟏 + 𝐫)9
⇒ r strictly greater than g
infinite geometric series
sums to (𝟏 + 𝐠)
(𝟏 − 𝐠)
𝐃𝟎 (𝟏 + 𝐠)
𝐃𝟏
𝐕𝟎 =
=
𝐫−𝐠
(𝐫 − 𝐠)
e.g./ D0 = $5
g = 4%
r = 8%
𝐕𝟎 =
𝐃𝟎 (𝟏 + 𝐠)
𝟓(𝟏. 𝟎𝟒)
=
= $𝟏𝟑𝟎/𝐬𝐡.
𝐫−𝐠
. 𝟎𝟖 − . 𝟎𝟒
PV of a growing perpetuity
𝐃𝟎
- if g = 0 , 𝐕𝟎 =
PV of a perpetuity
𝐫
how do we get g?
g = b × ROE
g = div. growth rate
b = earnings retention rate
(1 - DPR)
ROE = return on equity
90
LOS g
- calculate
- interpret
Last Revised: 06/19/2023
LOS g
- calculate
- interpret
IV = ? with
r = 19%
D0 = 2.28
𝐕𝟎 =
r = .19
g = ?
𝟐. 𝟐𝟖(𝟏. 𝟏𝟒)
= $𝟓𝟏. 𝟗𝟖
. 𝟏𝟗 − . 𝟏𝟒
𝟐. 𝟐𝟖
= $𝟏𝟐
. 𝟏𝟗
∴ g adds $39.98 to V0
if g = 0
𝐕𝟎 =
𝐕𝟎 =
𝐃𝟎 (𝟏 + 𝐠)
𝐫−𝐠
2.28 = 1.35(1 + g)4
= g = .14
∴ share price of $38.91 undervalued
𝟐. 𝟐𝟖(𝟏. 𝟏𝟑)
= 𝟒𝟐. 𝟗𝟒
if g = 13% 𝐕𝟎 =
. 𝟏𝟗 − . 𝟏𝟑
if g = 13%
r = 20%
𝐕𝟎 =
𝟐. 𝟐𝟖(𝟏. 𝟏𝟑)
= 𝟑𝟔. 𝟖𝟏
. 𝟐 − . 𝟏𝟑
strictly
15.8
15.9
19%
- model is extremely sensitive to changes in
both r and g
· as r ➞ g, P0 ↑ dramatically, hence the requirement
that g must be strictly less than r
91
LOS g
- calculate
- interpret
Last Revised: 06/19/2023
LOS g
- calculate
- interpret
assumptions:
1) Dividends are the correct
metric for valuation purposes
2) g is forever ⇒ perpetual and never changes
3) r is also constant over time
4) g is strictly less than r
- 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
e.g./
D5 = 4.00
g = 6%
r = 10%
LOS g
- calculate
- interpret
(expected)
(t5 onwards)
4.00
0
5
r = 10%
𝐕𝟓 =
𝟒. 𝟎𝟎
(𝟏. 𝟏)𝟓
𝟏𝟎𝟔
(𝟏. 𝟏)𝟓
= 𝟐. 𝟒𝟖𝟒 + 𝟔𝟓. 𝟖𝟏𝟖 = 𝟔𝟖. 𝟑𝟎
92
4.00(1.06)....
6
7
g = 6%
𝐃𝟓 (𝟏 + 𝐠) 𝟒. 𝟎𝟎(𝟏. 𝟎𝟔)
=
= $𝟏𝟎𝟔
𝐫−𝐠
. 𝟏 − . 𝟎𝟔
𝟒
…. 𝟏 − . 𝟎𝟔†
𝐕𝟒
𝐕𝟎 =
=
(𝟏 + 𝐫)𝟒
(𝟏 + 𝐫)𝟒
= 𝟔𝟖. 𝟑𝟎
Last Revised: 06/19/2023
LOS g
- calculate
- interpret
- Multistage DDM
2-stage: makes use of 2 growth rates
𝐠𝐬
2
1
Vn
high g
- initial finite
period
low g
- perpetuity
use Gordon Growth
model to estimate Vn
use DDM + terminal
value
V0
𝐧
𝐕𝟎 = N
𝐭'𝟏
𝐠𝐋
𝐃𝟎 (𝟏 + 𝐠 𝐬 )𝐭
𝐕𝐧
+
𝐭
(𝟏 + 𝐫)
(𝟏 + 𝐫)𝐧
𝐕𝐧 =
𝐃𝐧<𝟏
𝐫 − 𝐠𝐋
𝐃𝐧<𝟏 − 𝐃𝟎 (𝟏 + 𝐠 𝐬 )𝐧 (𝟏 + 𝐠 𝐋 )
LOS g
- calculate
- interpret
e.g./ D0 = $5.00
gs = 10%/a for 3 years
gL = 5%/a subsequent
r = 15%
D3 = 5.00(1.1)3
g = 10%
𝐕𝟎 =
5
𝐃𝟑 (𝟏 + . 𝟎𝟓) 𝟓. 𝟎𝟎(𝟏. 𝟏)𝟑 (𝟏. 𝟎𝟓)
𝐕𝟑 =
=
. 𝟏𝟓 − . 𝟎𝟓
. 𝟏𝟓 − . 𝟎𝟓
𝟓(𝟏. 𝟏)
𝟔𝟗. 𝟖𝟕𝟕𝟓
+
𝟑
(𝟏. 𝟏𝟓)
(𝟏. 𝟏𝟓)𝟑
= $𝟓𝟗. 𝟔𝟖
4
r = 15%
𝟓(𝟏. 𝟏) 𝟓(𝟏. 𝟏)𝟐
+
(𝟏. 𝟏𝟓)𝟐
𝟏. 𝟏𝟓
𝟑
+
3
-
2
-
1
-
0
5.00
-
-
g = 5%
(90 Sec)
93
= 𝟔𝟗. 𝟖𝟕𝟕𝟓
Last Revised: 06/19/2023
Model Appropriateness
- constant growth
- stable growth
- maturity phase
g < (1 - DPR)ROE
- non-cyclical
- dividend paying company
LOS h
- identify
- multi-stage DDMs - rapidly growing companies
FCFE
3-stage DDM ⇒
growth
transition
maturity
fairly young company
just entering growth
stage
2-stage DDM ⇒
transition
maturity
older companies out of
growth stage or a
revitalized company
Price Multiples
LOS i, j
- explain
- calculate
- interpret
- ratios that compare the share price
with some sort of monetary flow or value
earnings
book value
sales
cash flow
𝐏𝐄 =
𝐏𝟎
𝐄𝐏𝐒
𝐏g = 𝐏𝟎
𝐁 𝐁𝐕g
𝐬𝐡.
𝐏𝟎
𝐏g =
𝐒 𝐒𝐚𝐥𝐞𝐬g
𝐬𝐡.
𝐏g = 𝐏𝟎
𝐂𝐅 𝐅𝐂𝐅g
𝐬𝐡.
- denominators may be based on trailing values
or forward values
94
(or OCF/sh.)
Last Revised: 06/19/2023
LOS i, j
- explain
- calculate
- interpret
Price-to-Earnings (P/E)
-
+
- easy to use
- most common measure
- strongly correlated to long-term
returns
+
· useless if EPS < 0,
if earnings are volatile
· earnings are an accounting
measure
Price-to-Sales (P/s)
- not influenced by actg. choices
- better metric if EPS < 0
-
- rev. recognition issues
still apply
- ignores cost structure
Price-to-Cash Flow (P/CF)
+
· more of an economic measure
- ignores non-cash
· more difficult to manipulate
revenues
· tends to be less volatile than EPS
· more reliable over long-term
LOS i, j
- explain
- calculate
- interpret
Price-to-Book Value (P/BV)
· more stable measure
- ignores relative asset
· can be used even if EPS < 0
size in comparisons
· appropriate for firms in
- book value ≠ market value
distress
+
95
Last Revised: 06/19/2023
<
=
>
Ratio
LOS i, j
- explain
- calculate
- interpret
undervalued
fairly valued
overvalued
specified
value
EPS
.96
.84
.72
.60
.48
.36
.24
.12
actual
𝐏𝐄𝐭𝐭𝐦 =
Σ = 3.12
𝐏𝐄𝐟 =
Σ = 1.20
YR1
estimated
Q
𝟑𝟔
= 𝟏𝟏. 𝟓𝟑𝐱
𝟑. 𝟏𝟐
(undervalued)
Target Price = 15 × 3.12 = $46.80
Strong - ‘Buy’
industry P/E = 15
P0 = $36.00
Recall
𝟑𝟔
= 𝟑𝟎𝐱
𝟏. 𝟐𝟎 (overvalued)
LOS i, j
- explain
- calculate
- interpret
𝐃𝟏
𝐕𝟎 =
𝐫−𝐠
Let’s assume that V0 = P0 , then
Divide P0 & D1 by EPS
𝐏𝟎 =
𝐃𝟏
𝐫−𝐠
𝐃𝟏g
𝐏𝟎g
𝐄𝐏𝐒
𝐄𝐏𝐒 = 𝐫 − 𝐠
𝐃𝐏𝐑
justified = 𝐏g =
𝐄 𝐫−𝐠
96
DPR
Last Revised: 06/19/2023
𝐏g = 𝐃𝐏𝐑
𝐄 𝐫−𝐠
So, P/E is positively related
to
① DPR - questionable however
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
- explain
- calculate
- interpret
…and negatively related to r.
- Based on comparables
multiple 1
versus
Company multiple 2
multiple 3 (i.e. compared to)
etc.…
Rationale:
‘Law of one Price’
- identical assets
should sell for the
same price
Benchmark value
of the multiple(s)
· a closely matched
individual stock
typically · avg. multiple of a
called
peer group or industry
‘comps’
· avg. multiple derived
from trend or time-series
analysis
97
LOS i, j
- explain
- calculate
- interpret
Last Revised: 06/19/2023
e.g./
Company
A
B
C
D
E
e.g./
P/E
P/S
⇒ A appears
.14
undervalued ‘Relative’ to its
.26
peers
.32
or/
.48
.64 ⇒ E appears overvalued
‘Relative’ to its peers
Year
2016
2015
11.2
13.6
2014
15.2
2013
16.1
LOS i, j
- explain
- calculate
- interpret
2012
15.8
appears undervalued ‘Relative’ to its
historical trend
Enterprise Value Multiples
- rather than estimate the value of
equity, estimate the value of the enterprise
(𝐏𝟎 × # 𝐨𝐟 𝐬𝐡𝐚𝐫𝐞𝐬) + 𝐌𝐕(𝐏𝐫 ) + 𝐌𝐕(𝐃𝐞𝐛𝐭) − 𝐂𝐚𝐬𝐡
MV(equity)
cost of a takeover
· most useful when
comparing companies with
significant differences in capital structure
e.g./
𝐄𝐕0
𝐄𝐁𝐈𝐓𝐃𝐀
Note: EV may be difficult
to calculate for companies
whose debt is not publicly traded
98
LOS k
- describe
Last Revised: 06/19/2023
Asset-Based Valuation
LOS L
- describe
- uses MVs of a company’s A & L to
determine the value of the company as a whole
- more frequently used with:
· private companies
· companies with few/no intangibles or
off-book assets (i.e. reputation)
· companies with high proportion of CA & CL
· companies being liquidated
· financial companies
Not suitable for · companies whose MV of A & L are
difficult to determine or have a significant
amount of intangible assets
1. Using DDM,
find V0 (r = 10%)
✓
𝐃𝟏
𝐃
𝟎 = (𝟏 + 𝐠)
𝐕𝟎 =
𝐫−𝐠
E
E
E
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
𝐕
=
= $𝟓𝟏. 𝟎𝟎
𝟎
𝐈𝐕 = 𝟒. 𝟎𝟎 × 𝟏𝟒. 𝟕 = $𝟓𝟖. 𝟖𝟎 (U)
. 𝟏 − . 𝟎𝟓
99
Last Revised: 06/19/2023
Asset-Based Valuation
= MV
= MV
x 1.1 = MV
= MV
= MV
MV(A) = 5000 +
15000 + 30000
+ 55000 = 105,000
MV(L) = 3,000 + 17,000
+ 25,000 = 45,000
= MV
1000 shares
DDM ⇒ $51
P/E ⇒ $58.80
P0 = $50.80
MV(A) - MV(L) = 105,000
- 45,000
60,000
20%
𝐕𝟎 =
100
𝟔𝟎, 𝟎𝟎𝟎
= $𝟔𝟎
𝟏𝟎𝟎𝟎
Last Revised: 06/19/2023
REVIEW
101
Last Revised: 06/19/2023
Market Organization & Structure
Review - 1
saving
borrowing
Functions of Financial System/
1) Facilitate transfer of
capital
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/
1) timing of delivery
2) who the seller is
spot
forward/futures
primary
secondary
3) the maturity of the instruments traded
4) types of securities
money mkt.
capital mkt.
traditional (debt, equity)
alternative (private equity, securitized
debt)
Securities/
① Fixed-Income (notes, bills, bonds, CDs, Repos, MM)
② Equities (common, preferred, warrants)
③ Pooled Investments (mutual funds, ABS)
102
Last Revised: 06/19/2023
Review - 3
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
to sell
Seller obligation
asset
certain
price
date
b) Futures - exchange-traded forwards (standardized)
c) Swaps - an exchange of cash flows
d) Options Call
Put
a right
to buy
to sell
a specific
asset
at a specific
price
by a certain
date
Sellers ➞ an obligation
e) Others - Insurance, Credit Default Swaps
Review - 4
Commodities - spot
- forward/futures
hedging
speculation
Real Assets - property, factories, equipment
generally illiquid
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)
5) Insurance Companies
103
Last Revised: 06/19/2023
⇒ 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
Review - 5
long - takes delivery
short - delivers
long - buy a call or put
short - sell a call or put
forward/future
options
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/
- margin requirements
Initial margin
maintenance margin
Leverage Ratio = 𝐕𝐚𝐥𝐮𝐞 𝐨𝐟 𝐏𝐨𝐬𝐢𝐭𝐢𝐨𝐧
𝐕𝐚𝐥𝐮𝐞 𝐨𝐟 𝐄𝐪𝐮𝐢𝐭𝐲
𝐏𝐨𝐬𝐢𝐭𝐢𝐨𝐧
𝐦𝐚𝐱.
𝐥𝐞𝐯𝐞𝐫𝐚𝐠𝐞 =
𝐑𝐚𝐭𝐢𝐨
𝟏 − 𝐈𝐧𝐢𝐭𝐢𝐚𝐥 𝐌𝐚𝐫𝐠𝐢𝐧
Margin Call = 𝐏𝟎 × ~
•
𝟏 − 𝐌𝐚𝐢𝐧𝐭𝐞𝐧𝐚𝐧𝐜𝐞 𝐌𝐚𝐫𝐠𝐢𝐧
e.g./ P0 = $60
margin = 50%
maintenance margin = 25%
𝟏 − .𝟓
𝐂𝐚𝐥𝐥 = 𝟔𝟎 ~
• = 𝟔𝟎…. 𝟓g. 𝟕𝟓† = 𝟒𝟎
𝟏 − . 𝟐𝟓
⇒ Order Types/ Execution Instructions
1) Market buy on the Ask
Bid - Ask
sell on the Bid
spread
𝟏
𝐦𝐢𝐧𝐢𝐦𝐮𝐦
𝐦𝐚𝐫𝐠𝐢𝐧
𝐫𝐞𝐪𝐮𝐢𝐫𝐞𝐦𝐞𝐧𝐭
2) Limit - specified price
104
Last Revised: 06/19/2023
⇒ Order Types/ market - guaranteed execution, but not price
limit - guaranteed price, but not execution
x
to Buy:
behind the
market
x
Bid
Standing limit
order
x
make the
market
x
Ask
create a
new market
all earlier orders
at the bid executed
first
Review - 7
x
marketable
limit order
⇒ 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
⇒ Validity Instructions/
Stop orders
Review - 8
stop loss (stop a long pos.)
buy stop (stop a short pos.)
⇒ Clearing Instructions/ applies when using more than 1 broker
⇒ Primary Market/ IPOs
Issuer
Investor
underwriting offer - Inv. Bank buys entire issue
- sells to market (spread = income)
best efforts offer - acts as a broker only
(commission = income)
⇒ Secondary Market/ Investor - Investor
⇒ Private Placements/ securities not offered to the public
⇒ Call Markets/ trades occur only at particular times & places
- all bids/asks balanced to determine one
price - all trades occur at this price
105
Last Revised: 06/19/2023
⇒ Continuous Market/ anytime trading when mkt. is open
- auction market or dealer market
Review - 9
⇒ 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.
discriminatory pricing (auction mkt.)
derivative pricing rule/ mid point of bid-ask from
another market
Review - 10
⇒ 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
exchanges
external information efficiency
- prices reflect all information
+ financial intermediaries
+ regulation
106
Last Revised: 06/19/2023
Security Market Indicies
Review - 1
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
uses/ · evaluate performance (active mgrs.)
· construct investment portfolios (passive)
· estimate market risk
∑𝐍𝐢'𝟏 𝐧𝐢 𝐏𝐢
𝐕𝐏𝐑𝐈 =
𝐃
price
return
weightings
value of
divisor
a number chosen at inception
so the index has a nice
initial value
- divisor changes
over time so that
fundamental
changes in index
price
reflect price
equal
changes only
market-cap
float adjusted market cap
⇒ Returns/ · Single Period
𝐏𝐑 𝐈 =
Review - 2
𝑽𝑷𝑹𝑰𝟏 − 𝑽𝑷𝑹𝑰𝟎
𝑽𝑷𝑹𝑰𝟎
𝑷𝒊 − 𝑷𝒊 𝟎
or weighted average of
𝐏𝐑 𝐢 = 𝟏
:
each component
𝑷𝒊 𝟎
𝐍
𝑵
𝐢'𝟏
𝒊'𝟏
𝑷𝒊 − 𝑷𝒊 𝟎
⇒ 𝐏𝐑 𝐈 = N 𝐖𝐢 𝐏𝐑 𝐢 = N 𝒘𝒊 Q 𝟏
R
𝑷𝒊 𝟎
each component
𝑽𝑷𝑹𝑰𝟏 − 𝑽𝑷𝑹𝑰𝟎 + 𝑰𝟏
⇒ Total Return/ 𝐓𝐑 𝐈 =
𝑽𝑷𝑹𝑰𝟎
𝑵
𝑷𝒊 − 𝑷𝒊𝟎 + 𝑰𝒊
= N 𝒘𝒊 𝑻𝑹𝒊
or 𝐓𝐑 𝐢 = 𝟏
𝑷𝒊𝟎
𝒊'𝟏
(VPRI = VTRI at inception)
· Multiple Period Returns/
𝑽𝑷𝑹𝑰 = 𝑽𝑷𝑹𝑰𝟎 Z𝟏 + 𝑷𝑹𝑰𝟏 [Z𝟏 + 𝑷𝑹𝑰𝟐 [ + ⋯ + Z𝟏 + 𝑷𝑹𝑰𝑻 [
𝑽𝑻𝑹𝑰 = 𝑽𝑻𝑹𝑰𝟎 Z𝟏 + 𝑻𝑹𝑰𝟏 [Z𝟏 + 𝑻𝑹𝑰𝟐 [ + ⋯ + Z𝟏 + 𝑻𝑹𝑰𝑻 [
107
· if no
income
𝐕𝐏𝐑𝐈𝐓 = 𝐕𝐓𝐑𝐈𝐓
Last Revised: 06/19/2023
⇒ 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 - 3
how much of each security to include
𝐏𝐢
① Price weighting (simplest)
𝑾𝑷𝒊 = 𝐍
∑𝐢'𝟏 𝐏𝐢
(called an average, not an Index)
② Equal weighting
𝐖𝐢𝐄 = 𝟏g𝐍
e.g./ $10k in 5 stocks
$2000 into
weighting = 𝟏g𝟓 = .2 ⇒
each stock
- may under/over represent securities
⇒ Index Construction/ ③ market-cap weighted Index
④ float-adjusted
# of shares
- most market-cap indicies
available to the
are float adjusted
∑𝐍𝐢'𝟏 𝐰𝐢 𝐏𝐢
𝐈𝐧𝐝𝐞𝐱
=
𝐕𝐚𝐥𝐮𝐞
𝐃
adjusted for
splits
as soon as a
price changes, no
longer have equal
weighting
Review - 4
𝑾𝑴
𝒊 =
𝑸 𝒊 𝑷𝒊
𝑵
∑𝒊'𝟏 𝑸𝒊 𝑷𝒊
investing public
· components are held in proportion to their value
· components whose prices have risen the most have
overweight overvalued stocks
a greater weight
may
underweight undervalued stocks
⑤ Fundamental weighting
𝑾𝑭𝒊 =
𝑭𝒊
∑𝑵
𝒊'𝟏 𝑭𝒊
BV
Rev.
CFO
Earnings
Contrarian effect - will overweight
undervalued stocks
- underweight overvalued stocks
108
Last Revised: 06/19/2023
⇒ Rebalancing/ weights drift over time
𝐖𝐢𝐄 = 𝟏g𝐍
𝑾𝑷𝒊 =
𝑾𝑴
𝒊 =
𝑷𝒊
∑𝑵
𝒊'𝟏 𝑷𝒊
𝑸 𝒊 𝑷𝒊
𝑵
∑𝒊'𝟏 𝑸𝒊 𝑷𝒊
Review - 5
· equal weighting - reduce weights of components
that have outperformed, increase ones that
have underperformed
· price weighting - no need to rebalance
· market cap weighting - only need rebalancing
to reflect M&A and liquidations
⇒ Reconstitution/ · changing the securities in the index
· results in a change in all weightings
· reflect changes in target market, bankruptcy, M&A
⇒ Uses of Indicies/ gauge market sentiment, a proxy for measuring
risk & returns, proxies for asset classes, a benchmark for
active managers, basis for the creation of investment products
⇒ 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
Review - 6
⇒ Fixed-Income Indicies/ · aggregate/broad market
· market sector
· style
· economic sector
· specialized
⇒ Alternative Investments/ ① Commodities - futures contracts
② Real Estate/REIT Index
appraisal
repeat sales
③ Hedge Fund Index - rely on voluntary
disclosure
109
Last Revised: 06/19/2023
Market Efficiency
- the process by which the markets incorporates info.
Review - 1
- 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
⇒ Market Value (MV) - price at which asset can be bought or sold
⇒ Intrinsic Value (IV) - price of asset if complete information
and understanding were used
IV < MV - overvalued
IV > MV - undervalued
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
risk
- restrictions
classic view (return = assumed
⇒ Information Acquisition Costs/
modern view (return - Info. = risk
costs assumed
⇒ Forms of Efficiency/
Past data
public info.
weak
√
semi-strong
√
√
strong
√
√
110
private info.
√
Last Revised: 06/19/2023
Review - 3
⇒ 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
turn-of-the month (last day + first 3)
- all lack
Day of the week (avg. M. r. < 0)
persistence
Holiday effect (day prior)
⇒ 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 - 4
⇒ 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/
none supported by
persistent &
consistent evidence
closed-end fund discount
earnings surprises
IPOs
economic
Predictability of Returns based on prior info. cycle
related
111
Last Revised: 06/19/2023
⇒ 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
112
Review - 5
Last Revised: 06/19/2023
Overview of Equity Securities
⇒ Common Shares/ ownership interest (residual claim)
voting rights (governance)
Review - 1
Statutory voting
cumulative voting
1 vote/sh.
# shares × # directors
return - cap. gains, dividends
dual-class shares (ownership & voting differences)
Callable/Putable
⇒ Preferred Shares/ no voting rights
usually stated dividend (before common div.)
(still discretionary)
higher priority of claims
can be perpetual, convertible, callable, putable
prices like debt
Cumulative/ unpaid dividends accrue over time
(may also be non-cumulative)
⇒ Preferred Shares/
participating
Review - 2
in increases in divs. if profit
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
113
Last Revised: 06/19/2023
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
L2 & 3 - exch.
Unsponsored
foreign company directly involved
investors have ownership rights
foreign company not involved
depository has rights of ownership
GDR - global depository receipt - issued outside
home country of company and outside U.S.
Review - 4
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
𝐑𝐭 =
2) dividends
(𝐏𝐭 − 𝐏𝐭8𝟏 ) + 𝐃𝐭
𝐏𝐭8𝟏
3) currency gains/losses
4) reinvestment of dividends (Total Return)
Book Value = A - L
Market Value = # shares × P
𝐑𝐎𝐄𝐭 =
114
𝐍𝐈𝐭
𝐍𝐈𝐭
=
(𝐁𝐕𝐄𝐭 + 𝐁𝐕𝐄𝐭8𝟏 )g
𝐀𝐯𝐠. 𝐁𝐕𝐄𝐭
𝟐
Last Revised: 06/19/2023
Price-to-Book
𝐌𝐕𝐄𝐭g
𝐬𝐡. = 𝐌𝐕𝐄𝐭
𝐁𝐕𝐄𝐭g
𝐁𝐕𝐄𝐭
𝐬𝐡.
Intrinsic Value (IV)
PV (expected future cash flows)
Cost of Equity 𝐫𝐞 = 𝐫𝐟 + 𝛃(𝐑 𝐦 − 𝐫𝐟 )
115
higher ratio
overvalued
or/ higher growth
opps. priced in
Review - 5
Last Revised: 06/19/2023
Equity Valuation
IV - Intrinsic Value
IV
<
=
>
Review - 1
MV - Market Value
MV
- overvalued
fairly valued
undervalued
+ 10 - 20%
- 10 - 20%
- must consider expected time frame of convergence
⇒ Valuation Models/
1) Present Value Models
dividends
cash flow
2) Multiplier Models - MV or EV
3) Asset-based valuation
⇒ Present Value Models/
1) Dividend Discount Model
9
⇒ 𝐕𝟎 = N
𝐧
𝐭'𝟏
𝐃𝐭
𝐏𝐧
𝐕𝟎 = N
+
𝐭
(𝟏 + 𝐫)
(𝟏 + 𝐫)𝐧
𝐭'𝟏
explicit forecast
period
𝐃𝐭
(𝟏 + 𝐫)𝐭
𝒓𝒆 = 𝐫𝐟 + 𝛃(𝐑 𝐦 − 𝐫𝐟 )
(usually)
terminal
value
Review - 2
⇒ Present Value Models/
2) FCFE · free cash flow to equity
(useful for non-dividend paying stocks)
CFO - FCInv + Net Borrowings
1
𝐕𝟎 = G
𝐭&𝟏
𝐅𝐂𝐅𝐄𝐭
(𝟏 + 𝐫)𝐭
CAPEX
𝐫 = 𝐫𝐟 + 𝛃(𝐑 𝐌 − 𝐫𝐟 ) or
⇒ Preferred Shares/ 𝐕 = 𝐃𝟎
𝟎
𝐫
(perpetuity)
r = rf + risk premium
gov’t.
bond
judgement
company’s bond
yield
- div. stated as a yield (stable)
⇒ Gordon Growth Model/ - assumes divs. grow indefinitely at a
constant rate
𝐃𝟎 (𝟏 + 𝐠)
(g < r)
𝐃
- a growing perpetuity
𝐕𝟎 =
= 𝟏g𝐫 − 𝐠
𝐫−𝐠
sensitive to changes in r & g
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Last Revised: 06/19/2023
⇒ Gordon Growth DDM/
assumes
Review - 3
1) Divs. are correct metric for
valuation
2) g is forever
3) r is constant
4) g < r
g - (1 - DPR)ROE = RR
ROE
⇒ Multi-Stage DDM - uses 2 growth rates
high g
low g (perpetuity)
(Initial growth period)
𝐠𝐬
𝐧
𝐃𝟎 (𝟏 + 𝐠 𝐬 )𝐭
𝐕𝟎 = N
(𝟏 + 𝐫)𝐭
𝐭'𝟏
𝐕𝐧
+
(𝟏 + 𝐫)𝐧
- rapidly growing companies
transition
2-stage
maturity
𝐃𝐧<𝟏
𝐕𝐧 =
𝐫−𝐠
3-stage
𝐠𝐋
𝐃𝐧3𝟏 = 𝐃𝟎 (𝟏 + 𝐠 𝐬 )𝐧 (𝟏 + 𝐠 𝐋 )
𝐃𝐧<𝟏
growth
transition
maturity
⇒ 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
Œ𝐒𝐚𝐥𝐞𝐬
𝐒
g𝐬𝐡.
- ignores cost structure
⇒ P/CF - less volatile than EPS
𝐏g = 𝐏𝟎
Œ𝐅𝐂𝐅g
𝐂𝐅
- ignores non-cash revenues
𝐬𝐡.
⇒ P/BV - more stable, appropriate for
𝐏
𝐏g
= 𝟎Œ𝐁𝐕
𝐁𝐕
g𝐬𝐡.
firms in distress
⇒ Justified P/E/
- denominator may be
𝐃𝟏
based on trailing values or
- assume V0 = P0, then 𝐏𝟎 =
𝐫−𝐠
forward values
𝐃𝟏 /𝐄𝐏𝐒
𝐏𝟎g
𝐄𝐏𝐒 = 𝐫 − 𝐠
𝐏𝐄 =
117
𝐃𝐏𝐑
𝐫−𝐠
Review - 4
Last Revised: 06/19/2023
⇒ Justified P/E/
𝐃𝐏𝐑
=
𝐫−𝐠
· higher DPR, lower RR,
lower reinvestment
(dividend displacement of earnings)
⇒ Comparables/ Company vs.
- rationale - ‘Law of One
Price’
⇒ Enterprise Value/
P/E positively related to:
① DPR
② g = RR(ROE)
…and negatively related to r
Review - 5
closely matched stock
peer group/industry multiple
avg. historical trends
(𝐏𝟎 × # 𝐨𝐟 𝐬𝐡𝐚𝐫𝐞𝐬) + 𝐌𝐕(𝐏𝐫 ) + 𝐌𝐕(𝐃𝐞𝐛𝐭) − 𝐂𝐚𝐬𝐡
- most useful for comparing companies with sig. diff. in
capital structure
e.g. 𝐄𝐕g
𝐄𝐁𝐈𝐓𝐃𝐀
⇒ Asset Based Valuation/
- use MV of A & L to determine value of company
for/ · private companies
· companies with no/few intangibles
· high proportions of CA & CL
· companies being liquidated
· financial companies
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Review - 6