1.1 Asset Classes- Shares Flashcards
Coupon
A bond’s coupon is the interest rate that the borrower pays to the bondholder, expressed as a percentage of the nominal value.
Redemption Date
The redemption date of a bond is the date on which the borrower agrees to pay back the nominal value of the bond. It is also referred to as the date on which the bond matures, ie, the maturity date.
Flat Yield
The flat yield only considers the coupon and ignores the existence of any capital gain (or loss) if the bond is held through to redemption. As such, it is best suited to short-term investors, rather than those investors who might hold the bond through to its maturity and benefit from the gain (or suffer from the loss) at maturity.
The calculation of the flat yield is as follows:
Flat yield = (annual coupon/price) x 100
Yield
The yield is a measure of the percentage return that an investment provides. For a bond, there are three potential ways yields can be calculated: the flat yield (also known as the interest or running yield), the gross redemption yield (GRY) and the net redemption yield (NRY).
What is an Authorised Share Capital?
Authorised share capital is the maximum amount of capital that can be raised through share issue.
Types of Preference Share
Preference shares can come in a variety of forms.
• Cumulative – a cumulative preference shareholder will not only be paid this year’s dividend before any ordinary shareholders’ dividends, but also any unpaid dividends from previous years.
• Participating – one drawback of preference shares when compared to ordinary shares is that, if the company starts to generate large profits, the ordinary shareholders will often see their dividends rise, whereas the preference shareholders still get a fixed level of dividend. To counter this, some preference shares offer the opportunity to participate in higher distributions.
• Redeemable – these are preference shares that enable the company to buy back the shares from the shareholder at an agreed price in the future. The shares, from the company’s perspective, are similar to debt. The money provided by the preference shareholders can be repaid, removing any obligation the firm has to them.
• Convertible – in this case, the preference shareholder has the right, but not the obligation, to convert the preference shares into a predetermined number of ordinary shares, eg, perhaps one preference share may be converted into two ordinary shares. This is another method of avoiding the lack of upside potential in the preference shares, compared to ordinary shares.
Note that a particular preference share may exhibit more than one of these features.
The Purpose of Dividends for Investors
The payment of dividends represents a share in the profits made by a company; they are paid to a shareholder as a return for providing its risk capital.
For large, listed UK companies, dividends are usually paid twice a year and are expressed in pence per share. Interim dividends are paid in the second half of a company’s accounting period while final dividends, usually the larger of the two payments, are paid after the end of the company’s accounting year.
It is up to the company’s directors to determine the amount of any dividend to be paid, if any, and their decision needs to be ratified by the shareholders at the AGM. Although shareholders can vote for the final dividend to be paid at or below its proposed rate, they cannot vote for it to be increased above this level.
The principal benefit of dividend payments from an investor’s perspective is that there is a recurring income stream paid, which constitutes an integral part of the total return to an investor for allocating capital to that particular asset. Rather than having to realise the return by selling the asset and receiving a one-time capital gain, the investor has the opportunity at any time to do this, but in the interim there is a periodic return, paid as a dividend, which contributes to the investor’s cash flow. For many classes of investors, who desire a regular income from their investments, the receipt of dividends is a vital part of the reward which is obtainable from taking the risk in making the investment.
However, there is no guarantee that the dividend will always be paid. An interesting example is BP, the UK-listed oil company, which had become very popular with pension fund investors due to its regular dividends. Following the Gulf of Mexico oil spill, the dividends ceased. Many long-established companies, which have a reliable history of paying dividends, and even of consistent growth in the dividends paid out, become relatively attractive to certain investors. There is a trade-off between the kinds of new enterprises, which may grow quickly and do not pay dividends, but where the capital gains can be considerable (as also is the possibility of losses), and more mature businesses. For holders of shares in such mature companies, there may be less scope for large capital gains, but the total return to an investor is much enhanced by the regular dividend income that can be obtained from the holding.
Dividend Taxation
If a UK resident receives dividends on shares held, they will probably be subject to UK income tax. However, dividends received are deemed to have already suffered tax at 10% before they are received. This is called the tax credit on the dividends.
The effect of this credit under the applicable rules is that no income tax is payable by any recipient of dividends whose total income is below the higher-rate tax level, after adding in the grossed-up value of those dividends. This means that the investor only has to pay further income tax if they are a higher-rate taxpayer (40%) or an additional-rate (45%) taxpayer.
It is not a proper credit, however, because a non-taxpayer cannot recover it.
When the dividends are received by higher-rate payers, additional tax of 25% of the amount received becomes payable, equivalent to 32.5% of the grossed-up value, minus the tax credit. Note that it is not 40%, as dividends are taxed differently from other income. For additional-rate taxpayers, additional tax of approximately 30.5% of the amount received becomes payable, equivalent to 37.5% of the grossed- up value, minus the tax credit.
Stock Market Indices
A stock market index is a method of measuring the performance of a section of the stock market. Many indices are cited by news or financial services firms and are used as benchmarks to measure the performance of portfolios and to provide the general public with an easy overview of the state of equity investments. Their methods of construction may vary according to whether they are capitalisation weighted or not. Capitalisation weighted refers to market capitalisation which is the number of shares in issue multiplied by the price per share.
There are various organisations that have become specialists in constructing and maintaining equity indices. This includes managing their composition, making periodic adjustments and making index data public in real time and on an historical basis. For example, Standard & Poor’s (S&P), a well-known credit ratings agency in the US, is the manager of the S&P 500 index. This index represents 500 companies that trade on the US markets that are said to be representative of the US market as a whole. The index is weighted according to the market share of each company in the markets and the index is used as benchmark; a basis for comparison to other markets or individual investments within the US markets. The Dow Jones Industrial Average (DJIA), also known as ‘the Dow’, is another example of a US index. The DJIA, however, is made up of only 30 companies that trade on US exchanges: either the NYSE or NASDAQ. The Dow is one of the oldest and most-referenced stock market indices in the world; companies in the DJIA include Disney, General Electric and Microsoft. In addition, the Russell organisation in the US is well known for maintaining several indices of US stocks, including the Russell 2000, which represents the smallest capitalisation issues trading in US markets.
In the UK, the best-known index is the FTSE 100 index, which consists of the 100 largest companies traded on the London Stock Exchange (LSE) as measured by market capitalisation. FTSE 100 companies represent about 81% of the market capitalisation of the whole LSE. The index is maintained by the FTSE Group, a company which originated as a joint venture between the Financial Times and the LSE. It is calculated in real time while the LSE is open for trading, and published every 15 seconds.
The FTSE 100 started at a base level of 1000 points in January 1984, meaning that the value of the 100 constituent companies at that time equated to 1000 index points. As the value of the constituent companies increases (or decreases), the FTSE 100 increases (or decreases). So, if the value of the constituents grew by 10% in the first nine months following the index publication date, the index would have risen to 1100 index points. At the time of writing, the FTSE 100 stood at 6,855 index points.
The following table provides information on the composition and geographical scope of many of the largest and best-known global equity indices.
National and Sector Indices
A national index represents the performance of the stock market of a given nation and reflects investor sentiment on the state of its economy.
The most regularly quoted market indices are national indices, composed of the stocks of large companies listed on a nation’s largest stock exchanges. The concept may be extended well beyond an exchange.
For example, the Wilshire 5000 index, the original total market index, represents the stocks of nearly every publicly traded company in the US, including all US stocks traded on the NYSE (but not ADRs or limited partnerships) and NASDAQ.
More specialised indices exist, tracking the performance of specific sectors of the market. Some examples include the Wilshire US REIT, which tracks more than 80 American real estate investment trusts, and the Morgan Stanley Biotech index, which consists of 36 American firms in the biotechnology industry.
Construction of Indices and Weighting
The construction of an index usually involves the total market capitalisation of the companies weighted by their effect on the index, so the larger stocks make a greater difference to the index than the smaller market cap companies.
However, the one major exception to this method of construction and calculation is the DJIA which is price-weighted rather than market capitalisation-weighted. Since it is such a widely quoted index, it is worth considering the method of calculation.
The sum of the prices of all 30 DJIA stocks is divided by the Dow divisor. The divisor is adjusted in case of stock splits, spin-offs or similar structural changes, to ensure that such events do not alter the numerical value of the DJIA. Early on, the initial divisor was composed of the original number of component companies, which made the DJIA at first a simple arithmetic average. The present divisor, after many adjustments, is less than one, meaning the index is larger than the sum of the prices of the components.
What is a common criticism of the DJIA
The DJIA is often criticised for being a price-weighted average, which gives higher-priced stocks more influence over the average than their lower-priced counterparts, but takes no account of the relative industry size or market capitalisation of the components. For example, a $1 increase in a lower-priced stock can be negated by a $1 decrease in a much higher-priced stock, even though the lower-priced stock experienced a larger percentage change. In addition, a $1 move in the smallest component of the DJIA has the same effect as a $1 move in the largest component of the average. IBM and Visa are among the highest-priced stocks in the average and therefore have the greatest influence on it. Alternatively, General Electric and Pfizer are among the lowest-priced stocks in the average and have the least amount of sway in the price movement. Many critics of the DJIA therefore recommend the float-adjusted market-value-weighted S&P 500 or the Wilshire 5000 as better indicators of the US stock market.
All FTSE equity index constituents are fully free-float-adjusted, in accordance with FTSE’s index rules, to reflect the actual availability of stock in the market for public investment. Each FTSE constituent weighting is adjusted to reflect restricted shareholdings and foreign ownership, so as to ensure an accurate representation of investable market capitalisation.
Total Return Index
A total return index is one that calculates the performance of a group of stocks, assuming that dividends are reinvested into the index constituents. For the purposes of index calculation, the value of the dividends is reinvested in the index on the ex-dividend date. Total return index data is not available at the stock level.
Some indices, such as the S&P 500, have multiple versions. These versions can differ, based on how the index components are weighted and on how dividends are accounted for. For example, there are three versions of the S&P 500 index:
• price return, which measures the price performance and, therefore, disregards income from dividends;
• total return, which measures the performance of both price return and dividend reinvestment; and
• net total return, which accounts for dividend reinvestment after the deduction of a withholding tax.
Free-Float
The free-float of a public company is an estimate of the proportion of shares that are not held by large owners and that are not stock with sales restrictions (restricted stock that cannot be sold until it becomes unrestricted stock).
The free-float or a public float is usually defined as being all shares held by investors other than:
• shares held by owners owning more than 5% of all shares (those could be institutional investors, strategic shareholders, founders, executives, and other insiders’ holdings);
• restricted stocks (granted to executives who can be, but don’t have to be, registered insiders);
• insider holdings (it is assumed that insiders hold stock for the very long term).
Free-Float Factor
Under market capitalisation-weighted indices, the total market capitalisation of a company is included, irrespective of who is actually holding the shares and whether they are freely available for trading.
The free-float factor represents the proportion of shares that is free-floated as a percentage of issued shares and is then rounded to the nearest multiple of 5% for calculation purposes. To find the free-float capitalisation of a company, first find its market cap (number of outstanding shares x share price) then multiply by its free-float factor.
A free-float adjustment factor is introduced in the calculations of most of the major global equity indices.
For example, the following press release from STOXX ltd, which maintains the various Euro Stoxx indices, reflects the adjustment to the free-float factor for Volkswagen in 2008, and the changes that this had on various indices.
