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CFA > 2024 L1 Equity Investments > Flashcards

2024 L1 Equity Investments Flashcards

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1
Q
A

2024 L1 EQ LM1 - Market Organisation and Structure

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2
Q

What is the purpose of the financial system?

A
  1. Facilitate the transfer of capital between providersand users of capital
  2. Facilitate the transfer of risk to those willing to accept it
  3. Allowing price discovery (rates of return so that I = S)
  4. Facilitate the efficient allocation of capital

2024 L1 EQ LM1 - Market Organization and Structure

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3
Q

Who are the providers and users of capital?

A
  1. Saving: gives more money to the future. Requires someone else willing to pay (or borrow). Sources are individuals, businesses, govt
  2. Borrowing: gives more more to the present. Requires someone else willing to provide (by saving). Sources are ind, biz, govt
  3. Raise equity capital: this is indirect investing. It creates a financial claim on assets
  4. Managing risks: hedging risk, using insurance
  5. Spot markets to exchange assets: ie forex
  6. Information based trading: investors earn a return by bearing risk, speculators expect to earn a return in excess of required RoR

2024 L1 EQ LM1 - Market Organization and Structure

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4
Q

How does the price discovery function of the financial market work?

A
  • Capital costs money (ror)
  • When capital supply is greater than demand, price goes down, and vice versa
  • When capital supply = demand, saving = investment (S=I)
  • This is the equilibrium interest rate (or equilibrium SPREAD above the benchmark)
  • Market tells us how to price in risk

2024 L1 EQ LM1 - Market Organization and Structure

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5
Q

How does the efficient capital allocation function of financial markets work?

A
  • Capital is made to seek out the best risk adjusted return
  • Although requires (like the price discovery function and redistribution function) speedy transactions, low transaction costs, access to info, and regulation
  • All of this contributes to liquidity

2024 L1 EQ LM1 - Market Organization and Structure

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6
Q

What are assets?

A
  1. Fianncial assets: securities, currencies (often ultimately backed by physical assets)
  2. Physical assets: commodities, real assets

2024 L1 EQ LM1 - Market Organization and Structure

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7
Q

Through what metrics can markets be classified?

A
  1. Timing of delivery: spot markets have immediate delivery, forward/futures markets have some agreed upon future date
  2. Who the seller is: if issuer, then it is the primary market. If investor/holder, then it is the secondary market
  3. Maturity of instruments traded: money markets are where debt maturity on debt of issuance is less than 1 year. A capital market is where life at issue is greater than 1 year
  4. Types of securities: traditional (debt, equity, funds). Alternative: PE, securitised debt, HF

2024 L1 EQ LM1 - Market Organization and Structure

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8
Q

What is a security?

A
  • Can be either traded publicly on exchanges, or privately, by qualified investors only
  • Types include fixed-income, equities, pooled investments
  • Fixed income (debt): notes, bonds, bills, CD, repos, money market
  • Equities are ownership claims issued in perpetuity
  • Pooled investments are things like mutual funds. If you own a share of a mutual fund, you have a share of a pool of financial claims on a pool of financial claims
  • Currency is money issued by national monetary authorities, traded in foreign currency market 24/7
  • Contracts are agreements between 2 parties to do something in future. Value depends on value of its underlying component (security, index, interest rate)

2024 L1 EQ LM1 - Market Organization and Structure

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9
Q

What are the 3 types of equity securities?

A
  1. Common stock: voting rights, entitled to discretionary dividends, has the last claim on assets
  2. Preferred stock: higher priority claim, entitled to fixed dividends (stated as a yield)
  3. Warrants: right to purchase stock at a pre specified price before a pre specified date

2024 L1 EQ LM1 - Market Organization and Structure

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10
Q

What is a contract?

A
  • Contracts may be cash settled or required physical delivery
  • ie S&P is technically cash settled
  • Not all contracts are delivered
  • Physical vs financial contract
  • Spot vs forward/future/swap/options contracts
  • A forward contract is a dealer market (OTC) and highly customisable. Both buyer and seller have an obligation to buy & sell a specific asset at a specific date
  • Futures are a standardised exchange traded forward contract
  • A swap is an agreement to exchange a series of cash flows at periodic dates over a period of time (ie fixed for floating)
  • Options give a right to buy/sell (call/put) to buy a specific asset at a specific price by a certain date
  • Other contracts include insurance, and credit default swaps

2024 L1 EQ LM1 - Market Organization and Structure

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11
Q

What are commodities?

A
  • precious or industrial metals
  • Energy, agriculture..
  • Spot market involves buyers and sellers of the physical product
  • Forward / futures market is where hedging and speculating occur
  • Usually close positions prior to delivery date

2024 L1 EQ LM1 - Market Organization and Structure

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12
Q

What are real assets?

A
  • Direct investing in tangible assets
  • Property, factories, equipment
  • Generally illiquid and have high managment costs
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13
Q

Who are the intermediaries?

A
  • Facilitate the matching of providers and users of capital
  • Structure products and services to satisfy that function
  • Brokers fulfil orders directly for clients, and are more critical for large-block traders
  • Exchange provides an auction platform, where they must print the best bid and ask
  • Alternative Trading Systems have no regulatory members. They are sometimes called dark pools, because orders sent to them are not displayed. Typically institutional investors that do large-block trades use these. The ATS has to report the transaction to the exchange, but the exchange does not see the order

2024 L1 EQ LM1 - Market Organization and Structure

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14
Q

What is the difference between a dealer and a broker?

A
  • A broker tries to match buyers and sellers
  • A dealer buys and holds inventory
  • They become the contract counterparty ie for futures, swaps
  • They create liquidity. They are usually very large and global
  • They can also act as a broker sometimes
  • Primary dealers can buy and sell directly with the CB

2024 L1 EQ LM1 - Market Organization and Structure

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15
Q

What is a securitiser?

A
  • Someone that buys assets
  • Places them in a pool
  • And sells securities against them
  • (securitises! as with carbon)

2024 L1 EQ LM1 - Market Organization and Structure

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16
Q

What are depository institutions?

A
  • Banks, credit unions, savings and loans firms
  • They take deposits, pay some interest, and then lend to a borrower charging more interest
  • They are intermediating between depositors that deposit smaller amounts for various times and give it to borrowers that borrower larger amounts for fixed times
  • Turning small random amounts into fixed larger amounts

2024 L1 EQ LM1 - Market Organization and Structure

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17
Q

What are insurance companies?

A
  • Create and sell contracts that protect buyers from risk (car, fire, theft, life)
  • COnnect buyers with investors, creditors and reinsurers
  • When insures for something like a tornado, they will issue catastrophe bonds on the other side
  • These catastrophe bonds pay out UNLESS a catastrophe has occured.
    This transfers the risk
    When you take out insurance on something less dramatic like auto, the insurance company will invest the premium to earn a return. This return helps cover the cost of claims.

2024 L1 EQ LM1 - Market Organization and Structure

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18
Q

What are arbitrageurs?

A
  • They trade on mispricing
  • ## when fraud, moral hazard, and adverse selection has occured

2024 L1 EQ LM1 - Market Organization and Structure

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19
Q

What are settlement and custodial services?

A
  • Hold securities on behalf of a client
  • Ie clearing houses
  • This is helpful in some markets so you can’t just disappear with the assets during a trade

2024 L1 EQ LM1 - Market Organization and Structure

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20
Q

What are the positions an investor can take in an asset?

A
  • Long and short position are most common
  • Long: benefit from increase in proce
  • Owns an asset or has purchased a contract
  • Short: benefits from a decrease in price
  • Sold an asset they do not yet own, or has written a contract

2024 L1 EQ LM1 - Market Organization and Structure

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21
Q

What do long and short positions look like in forwards?

A
  • Long position obligated to take delivery
  • Thus there is very low liquidity
  • Short position obligated to deliver
  • delivery could be the asset, or a cash equivalent
  • When involving a financial asset, delivery often entails cash payoutn, and delivery is never taken.

2024 L1 EQ LM1 - Market Organization and Structure

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22
Q

What positions can you take in options?

A
  • Long a call, or short a put: benefit from an increase in price of the underlying asset
  • Short a call, or long a put: benefit from a drop in price
  • Long a call or put gives you a RIGHT
  • Short a put or short a call gives you an OBLIGATION

2024 L1 EQ LM1 - Market Organization and Structure

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23
Q

What is the most common position for a swap trade?

A
  • Fixed for floating
  • The party that benefits from a rise in interest rates is considered “long”
  • Even though no one is really long or short here!

2024 L1 EQ LM1 - Market Organization and Structure

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24
Q

What positions are taken when trading currencies?

A
  • Traded in pairs
  • The first of the pair puts a 1
  • The next one is a ratio to that first currency
  • You are both long and short the same time
  • Buying USDCAD means you are long USD and short CAD

2024 L1 EQ LM1 - Market Organization and Structure

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25
Q

What does it mean to be short contracts?

A
  • Must deliver the underling at a predetermined date for a pre determined price
  • You would have to deliver if you let it go to maturity

2024 L1 EQ LM1 - Market Organization and Structure

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26
Q

What does it mean to be short securities?

A
  • Selling securities you don’t own
  • The broker arranges a borrow, and lends them to you to sell
  • If the borrow cannot be maintained, the seller faces a forced buy-in
  • To close a short position, seller initiates a ‘buy to cover’ or ‘buy to close’ order

2024 L1 EQ LM1 - Market Organization and Structure

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27
Q

What is a box trade?

A
  • Not allowed in Canada
  • Let’s say i am short 100 shares of x
  • I go into the market to buy 100 shares of x
  • In the US, I can buy 100 shares of x to close the position OR buy 100 shares of x to open
  • Thus a box trade is where you are long and short the same thing
  • Why do a box trade?
  • MM says there are not too many clear reasons to do this, because you have to pay interest to borrow
  • BUT perhaps it’s when you want to be short long term but know the price is going to go up today, and want to reduce your losses just for today

2024 L1 EQ LM1 - Market Organization and Structure

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28
Q

What are levered positions?

A
  • Borrowing funds from your broker to buy securities
  • the interest rate is the ‘call money’ rate
  • There are minimum margin requirements, set by regulation, the exchange, or the clearing house
  • There is an initial margin and a maintenance margin

2024 L1 EQ LM1 - Market Organization and Structure

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29
Q

What is the leverage ratio?

A
  • Value of your position / value of equity investment
  • Max LR allowed = 1/min margin reqd

2024 L1 EQ LM1 - Market Organization and Structure

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30
Q

What is liquidate last?

A
  • You might be forced to liquidate
  • Ie if you are trading forex and you get a margin call while you’re sleeping!
  • Liquidate last is a way of specifying which of your assets you want to enter liquidation last
  • It can be specified in your broker account

2024 L1 EQ LM1 - Market Organization and Structure

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31
Q

What is the maintenance margin?

A
  • When you have to top up your margin to the value of your initial margin because your position has lost money
  • Ie a margin call

2024 L1 EQ LM1 - Market Organization and Structure

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32
Q

What are bid and ask?

A
  • Bid: price at which dealers and traders are willing to buy
  • Ask: prices at which they are willing to sell
  • Buy at the market: buy at the bid price
  • Sell at the markt: sell at exactly the ask price

2024 L1 EQ LM1 - Market Organization and Structure

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33
Q

What is market depth?

A
  • The size of order that can be filled at the best bid and best ask value
  • 100 x 600 would mean 100 bid size and 600 ask size
  • A board lot is 100 shares
  • In the US they may print the amount of board lots to drop some zeros
  • If you want to buy or sell a lot more than the current depth doing it then will push the price significantly against you
  • Large orders therefore tend to be filled when the depth is large and the spread is thin

2024 L1 EQ LM1 - Market Organization and Structure

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34
Q

What is a limit order?

A
  • Fills at a specified price or better
  • Guaranteed price, but no guaranteed execution
  • Because some market orders may be hidden, you can use limit orders to test how much depth there is in the market
  • If the order fills at the best ask/bid price it suggests there is more depth
  • Limit orders are when you know what price you want, or you have a really big order and don’t want to move the market
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35
Q

What is a market order?

A
  • Fills immediately at the best price
  • Guaranteed execution
  • No guaranteed price

2024 L1 EQ LM1 - Market Organization and Structure

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36
Q

What is a marketable limit order?

A
  • When you limit order ie for an ask is always at least partially fillable
  • ie for an ask is above the best ask
  • It will fill with the best ask until it reaches the level you set the limit
  • This is recommended because you can put down the price you’re willing to pay

2024 L1 EQ LM1 - Market Organization and Structure

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37
Q

Why would you put a limit order in at the bid?

A
  • This is called make the market
  • There may be sellers who want to unload some shares but don’t see enough depth to sell
  • By printing more volume on the bid you might induce bigger sellers to enter

2024 L1 EQ LM1 - Market Organization and Structure

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38
Q

What happens if you put a limit between bid and ask?

A
  • New price prints in the market
  • Creates a new market

2024 L1 EQ LM1 - Market Organization and Structure

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39
Q

What is behind the market?

A
  • When your price limit for a limit order bid is below the market price
  • This is called a standing limit order
  • It executes only if the price drops

2024 L1 EQ LM1 - Market Organization and Structure

40
Q

What is all or none?

A
  • When you want to sell all your shares at the price you put in
  • If it’s important to sell all your shares at once at a particular price you can include this option (when trading on certain markets)
  • On NASDAQ you might get odd lots ie random size orders so you might want to use all or none. This is not a problem on NYSE

2024 L1 EQ LM1 - Market Organization and Structure

41
Q

What are the exposure instructions for an order?

A
  • Can choose to display or hide your order
  • If you hide, only brokers and exchanges can see them
  • If you hide, then you prevent people from trying to “penny you up” and bid one penny better to sell quickly and delay your sale
  • You can also change (reduce) your display size: ie only part of your order is displayed. This might help too
  • This is also why depth might be greater than you can see from the bid ask quote
  • This is known as an iceberg order: most of it is hidden

2024 L1 EQ LM1 - Market Organization and Structure

42
Q

What are the validity instructions you can use when submitting an order?

A
  • Default is day orders: expire at end of business day
  • good til cancelled: stays there for max of 6 months
  • good through: you select an expiry date for an order. I.e., you go on holiday and set some orders just in case you can get a bargain. Can get it to expire on the day you come back
  • fill or kill: as soon as the order is entered it will either fill immediately or disappear
  • good on close: execute at very end of trading day. This might be used when you don’t want to have any loss on your P&L. The value of your position will show no gain, no loss
  • GoC might be useful when the market is pushing the high on the close. This is a bullish sign for the next day. But 9:30 the next day will be too late: the price will already have jumped. So you may want to get in at a good price.

2024 L1 EQ LM1 - Market Organization and Structure

43
Q

What are stop orders?

A
  • Stop loss: long position. Sell when your position hits a minimum price
  • Buy stop: short position. Sell when your position hits a max price
  • both limit losses
  • Trailing stop loss can be used so that you don’t miss out on gains during volatility. Stop increases and trails the price by a set amount (ie 50 cents), so could close with a gain if price goes up but then sharply drops

2024 L1 EQ LM1 - Market Organization and Structure

44
Q

What are primary vs secondary markets?

A
  • Primary: issuer to investor
  • First time and the only time the issuer gets money
  • Ie IPO
  • There may be a follow up secondary OFFERING, but this is still the primary market
  • Secondary market is investor to investor
  • This provides liquidity and ensures an efficient primary market
  • This also sets the price for secondary offerings
  • Giving an easy way to get out increases the valuation of primary offerings
  • This is the issue which causes low VC valuations but higher public company valuations. It’s ultimately a function of liquidity.

2024 L1 EQ LM1 - Market Organization and Structure

45
Q

How do primary market offerings work?

A
  • Issuer goes to investment bank which intermediates between firm and investors
  • Lots of work has to be done ie regulators
  • Roadshow where they ask for interest. This is called book building
  • The investment bank lines up subscribers
  • Can be underwriting offer OR best efforts offer
  • IB buys entire issue at negotiated offering price for underwriting offer, and sells on the IPO
  • They assume risk of ownership. Also called a bought deal for that reason
  • Make money on the spread
  • IB supports the price in the market
  • Best efforts offer is where the bank acts as broker only
  • works on commission
  • For PE there are also private placements where securities not offered to public are placed with qualified investors

2024 L1 EQ LM1 - Market Organization and Structure

46
Q

What 4 questions help us to classify the different types of markets?

A
  1. When can they trade
  2. Who arranges the trade
  3. How do they execute the trade
  4. How do they learn about the price

2024 L1 EQ LM1 - Market Organization and Structure

47
Q

What are call vs continuous markets?

A
  • Call markets: ie US treasury auction. Trades occur only at particular times and prices. Everyone submits their bid. All bids and asks are balanced to determine one price. All trades occcur at this price
  • Quantity bid for = quantity offered.
  • Many continuous markets find their opening price by changing price until buy and sell orders are balanced
  • Continuous markets continuously trade!
  • Call markets are v liquid in session but illiquid otherwise
  • Continuous markets can use either auction process or dealers who quote both bid and ask (eg stock exchanges)

2024 L1 EQ LM1 - Market Organization and Structure

48
Q

What is the difference between quote driven and order driven markets?

A
  • Quote driven markets are price driven or dealer markets
  • Individual dealers make a market ie supply both bid and ask
  • Customers trade with dealers, or dealers trade with other dealers (to pass off inventory)
  • Referred to as OTC (over the counter)
  • Order driven markets are pure auction markets
  • Both buyers and sellers submit bids or offers and the combination of them by the exchange creates the price
  • Any stock exchange operates like this
  • There is a ranking:
    1. Price precedence: best bid/ask
    2. Display precedence: display over hidden at same price
    3. Time precedence: first over others with same price and display properties

2024 L1 EQ LM1 - Market Organization and Structure

49
Q

What are the trade pricing rules in order driven markets?

A
  • Order driven markets are stock exchanges where both buyers and sellers are matched together by the exchange to create the price
    1. Uniform pricing rule: same price is used for all traders (used by call markets)
    2. Discriminatory pricing rule (the limit price of the order/quote that arrived first determines the trade price)
    3. Derivative pricing rule: use the mid-point of the bid-ask from another market

2024 L1 EQ LM1 - Market Organization and Structure

50
Q

What are brokered markets?

A
  • Very thin markets ie not many buyers and sellers
  • For example real estate, fine wine, coins
  • Broker steps in to create liquidity

2024 L1 EQ LM1 - Market Organization and Structure

51
Q

What is pre trade vs post trade transparency?

A
  • Pre trade transparency is where the exchange publishes real time data about quotes and orders
  • This is stock exchanges
  • Post trade transparency is where the exchange publishes data about trade prices after the trade occurs
  • The latter is most dealer markets
  • Dealers are motivated to keep their bid and ask private so only the trade price is disclosed
  • This leads to wider spread and higher transaction costs

2024 L1 EQ LM1 - Market Organization and Structure

52
Q

What are the characteristics of a well functioning financial system?

A
  • A market is complete when savers, borrowers, hedgers and asset exchange on the spot market have all their needs met
  • Timely and accurate disclosures (supports info efficiency)
  • Liquidity (min transaction costs & operationally efficient)
  • Complete markets
  • External/informational effiency (prices respond to changes in fundamental values, and therefore prices reflect all available information)
  • Markets also need intermediaries

2024 L1 EQ LM1 - Market Organization and Structure

53
Q

What do intermediaries need to do to ensure the proper function of markets?

A
  • Match buyers and sellers by organising exchanges, brokerages, and ATS
  • Provide liquidity on demand (ie make markets)
  • Create products to match buyers and sellers (ie ABS)
  • Accept deposits and make loans
  • Provide insurance
  • Provide advisory services
  • Organise clearing houses (settlement, counterparty)
  • Safeguard assets (custodial or depository services)

2024 L1 EQ LM1 - Market Organization and Structure

54
Q

What are the objectives of market reg?

A
  • All these support the operational efficiency, informational transparency and therefore efficient allocations within markets
  • All about confidence in the market and promoting it
  • Objectives are:
  • Control fraud by, or deception of, market participants
  • Set min standards of competence for agents, define and enforce min standards of practice
  • Promote fairness
  • Set standards for financial reporting (fair to both user and provider)
  • Set min capitala requitements for financial firms (to reduce costs and disruption of failure)
  • Insurance and pension funds have sufficient capital to honour their long term commitments

2024 L1 EQ LM1 - Market Organization and Structure

55
Q

What is a market index?

A
  • Individual securities that represent a given security market, market segment or asset class
  • ak constituent securities
  • Most constructed as a portfolio of marketable securities
  • Each may have 2 versions depending on how returns are calculated: price return or total return
  • total return assumes reinvestment of all income received since inception
  • price return

2024 L1 EQ LM2 - Security Market Index

56
Q

What are the uses of market indices?

A
  • Capture performance and direction of the market
  • Benchmark active managers
  • Construct a passive investment portfolio
  • Estimate market or segment risk based on the volatility of the index

2024 L1 EQ LM2 - Security Market Index

57
Q

What are the types of weighting that can be used in an index?

A
  • Price weighting
  • Equal weighting
  • Market cap weighting
  • Floating adjusted market cap weighting
  • Fundamental weighting
  • FAMC and MC weighting are quite similar but with small adjustments

2024 L1 EQ LM2 - Security Market Index

58
Q

What is the divisor in an index?

A
  • A number chosen at inception so the index has a CONVENIENT (but arbitrary) initial value
  • ie 100, or 1000

2024 L1 EQ LM2 - Security Market Index

59
Q

What is market inefficiency?

2024 L1 EQ LM2 - Security Market Index

A
  • The extent to which market prices incorporate available information
  • Inefficient markets is what justifies the entire field of AM
  • Eugene Fama himself has a video on “how to win the loser’s game” of AM
  • Market information hypothesis assumes information is timely, complete, CORRECT and UNDERSTANDABLE
  • Information can be incorporated EFFICIENTLY but still lead to the WRONG price if the information is wrong
  • Market efficiency DOES NOT mean that the prices are right: it means the PROCESS of incorporating new information is right

2024 L1 EQ LM3 - Market Efficiency

60
Q

What is market value versus intrinsic value?

A
  • Market value is price at which an asset can be bought or sold (ie bid ask)
  • Intrinsic value is the price of an asset if complete information and understanding were used (typically present value - future cash flows)
  • Intrinsic val is just a judgement and estimate

2024 L1 EQ LM3 - Market Efficiency

61
Q

What factors affect market efficiency?

A
  • Number of participants (more is better; hence why private market participants ie PE, private debt tend to do a lot better - less participants)
  • More information avail ability
  • Financial disclosure
  • Limits to trading (speed, transparency, restrictions
  • Transaction costs
  • Information acquisition costs

2024 L1 EQ LM3 - Market Efficiency

62
Q

What are the three forms of market efficiency according to Fama 1970?

A
  • Weak form: market prices reflect only past market data
  • Semi-strong form: market prices reflect past market data plus all public information
  • Strong form: market prices reflect all of the above PLUS private information

2024 L1 EQ LM3 - Market Efficiency

63
Q

What is a callable common share?

A
  • Issuer has the right to buy back shares at a pre-determined call price
  • Trading value thus has a ceiling

2024 L1 EQ LM4 - Overview of Equity Securities

64
Q

What is a putable common share?

A
  • Putable: investor has the right to sell shares back to the company at a predetermined price
  • Risky companies might do this to incentivise investors

2024 L1 EQ LM4 - Overview of Equity Securities

65
Q

What are preferred shares?

A
  • Do not participate in operating performance
  • No voting rights
  • Receive dividends before common stock
  • Dividends stated as a yield on par and can be fixed or variable
  • Can be a good investment for retirees looking for income as may be taxed lower than interest gains or any other debt instrument
  • Prices like debt, pays like equity
  • Can be perpetual, convertible, callable, putable

2024 L1 EQ LM4 - Overview of Equity Securities

66
Q

What are cumulative, non-cumulative, and participating prefererd shares?

A
  • Cumulative preferred shares: where unpaid dividends that accrue over time must be paid in full before any common dividends can be paid
  • Non cumulative: do not accrue (fortified permanently): will have to offer a higher yield
  • Participating preferered receives more dividend (ie special dividend) if profits exceed a certain threshold
  • Also higher priority during a liquidation event (bankruptcy)
  • Non participating preferred shares have the stated preferred dividend yield only

2024 L1 EQ LM4 - Overview of Equity Securities

67
Q

Why would you issue convertible preferred shares?

A
  • VCs may issue convertible preferred because prevents repricing of the equity
  • Convertible means convertible to common shares
  • This means participating in equity with higher yield
  • If VC sells some of their stock then this triggers capital gain
  • Issuing convertible is raising a new form of capital so doesn’t trigger CGT

2024 L1 EQ LM4 - Overview of Equity Securities

68
Q

What is a forced conversion?

A

If the common share price is greater than the conversion price company may force conversion by calling at a low price.
This avoids overhanging convertibles

2024 L1 EQ LM4 - Overview of Equity Securities

69
Q

What are the characteristics of private shares?

A

-Not listed on public exchanges
Prices not mkt determined
- Highly iliquid
- Exception: if more than 49 shareholders have to report as if a public company. So firms will stop at 49
- Tends to be institutional investors (PE/VC) and accredited investors
- No secondary market

2024 L1 EQ LM4 - Overview of Equity Securities

70
Q

What are the types of private investments?

A
  1. venture capital
  2. LBO/MBO
  3. Private investment in Public Equity

2024 L1 EQ LM4 - Overview of Equity Securities

71
Q

What is an LBO/MBO?

A
  • LBO is group of investors
  • MBO is management buyout
  • Use debt to purchase all outstanding shares of a publicly trade company
  • Usually restrucured and reissued

2024 L1 EQ LM4 - Overview of Equity Securities

72
Q

What do VCs do?

A
  • Seed to growth financing
  • VC firm set up as a limited partnership
  • Usually have c. 10 year life

2024 L1 EQ LM4 - Overview of Equity Securities

73
Q

What is PIPE?

A
  • Private investment in Public Equity
  • Investing in restricted stocks or preferreds. usually at a discount
  • Warren did this in GM and Goldman
  • Adv of PE: mgmt more focused on long term value creation, more inefficient markets means higher RaR, lower company costs due to a lack of filing requirements, listing fees, and reg costs

2024 L1 EQ LM4 - Overview of Equity Securities

74
Q

What is the difference between sponsored and unsponsored depository receipts?

A
  • depository receipts are traded on exchanges and represent a claim to a share in a foreign company
  • Sponsored are issued by the company and the receipt owners have ownership rights
  • Non sponsored are not issued by the company, and the depository institution has the ownership rights

2024 L1 EQ LM4 - Overview of Equity Securities

75
Q

What are the sources of return on equities?

A
  • In any one period? Capital gains and dividends
  • For depository receipts and dir foreign inv: currency gains (or losses)
  • Over multiple periods: dividend reinvestment (the compounding effect)
  • Note the compounding effect does not have to occur in the same company
  • Since dividend reinvestment CAN involve lower fees and the stock will drop after paying a dividend, dividend reinvestment plans can be smart

2024 L1 EQ LM4 - Overview of Equity Securities

76
Q

What is accounting value of equity?

A
  • ROE = NI/Avg book value of equity = NI - Pref Dividend / (BVE1 + BVE2)/2

2024 L1 EQ LM4 - Overview of Equity Securities

77
Q

What does price to book ratio being high mean?

A
  • The market expects high earnings growth
  • Also assumes this company is less risky than a lower priced one

2024 L1 EQ LM4 - Overview of Equity Securities

78
Q

What is contribution margin?

A
  • Average price per unit less average variable cost per unit
  • If contribution margin exceeds fixed costs there is an operating profit
  • If contribution margin is negative then the company is operating below the shutdown point ie even variable costs are not covered

2024 L1 EQ LM5 - Company Analysis

79
Q

What is operating leverage?

A

% change in operating profit / % change in sales
- It’s ultimately a function of fixed versus variable costs

2024 L1 EQ LM5 - Company Analysis

80
Q

What are economies of scope?

A
  • When cost per unit decreases as number of product lines increases
  • Contrast to economies of scale where per unit cost decreases as volume of production in a single product line increases

2024 L1 EQ LM5 - Company Analysis

81
Q

What drives return on invested capital and could cause it to be greater than the cost of capital?

A
  • If ROIC > CoC then this is economic profit
  • uses of capital include cash on hand, net working capital, capex, acquisitions, debt repayment, dividends and share repurchases
  • Sourcdse and cost of each source of capital come from cash flow from operations, as well as net working capital, debt issuance, equity issuance, and asset disposals

2024 L1 EQ LM5 - Company Analysis

82
Q

What is the measure for financial leverage?

A

% change in net income / % change in operating income

2024 L1 EQ LM5 - Company Analysis

83
Q

What is the interest coverage ratio?

A

EBIT / interest
- However there are issues in how you define interest expense

2024 L1 EQ LM5 - Company Analysis

84
Q

What factors might complicate company industry classification?

A
  • Classifications used to be done by govts, now companies like Refinitiv
  • Companies operating across multiple sectors (ie Amazon ecommerce plus AWS)
  • Companies with superficial similarities but very different use cases (ie military cybersecurity, shopify are both software companies)
  • Changes in industry classification affect comparability. Ie changes in business model or new sectors emerging
  • Companies might be grouped together but not compete, if they cover different geographies
  • Alternatives might be to use statistical similarities ie clustering analysis and ignore the intuitions, to group by geography, by business cycle sensitivity (defensive/cyclical), and ESG characteristics

2024 L1 EQ LM6 - Industry and Competitive Analysis

85
Q

What is HHI

A
  • Hirschman Herfindahl index of market concentration
  • Taken as market share squared for each firm in the industry
  • 10,000 is max value (100^2), high concentration 2,500, moderate 1,000-2,500
  • Any acquisition which moves HHI by +200 is likely to attract attention of the regulators

2024 L1 EQ LM6 - Industry and Competitive Analysis

86
Q

What are Porter’s Five Forces?

A
  1. Threat of new entrants
  2. Threat of substitutes
  3. Bargaining power of customers
  4. Bargaining power of suppliers
  5. Rivalry among existing competitors
  • We want low threat of new entrants, substitutes, low bargaining power of customers and suppliers, and low rivalry among existing competitors
  • Porter’s Five Forces

2024 L1 EQ LM6 - Industry and Competitive Analysis

87
Q

What are PESTLE external influences on a business?

A
  1. Political: fiscal policy, MP, regualtion, govt purchasing
  2. Economic: GDP, inflation, rates, cycle
  3. Social: Trends, demographics. Can be endogeneous as well as external
  4. Technological: sustaining (evolutionary), disruptive (revolutionary) ie AI
  5. Legal: laws, regulations. Products can be outright banned
  6. Environmental: low carbon, transition risk

2024 L1 EQ LM6 - Industry and Competitive Analysis

88
Q

How can we assess competitive strategy on a forward looking basis?

A
  1. Does it create a defense against Porter’s five 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?

There are three strategies:
1. Cost leadership: lowest cost producer
2. Differentitation: create a superior product and generate brand loyalty beyond cost based decisions
3. Focus: focus on a specific niche or customer group not served by anyone else: ie resorts that cater to childless couples for those that want a quiet time by the pool etc.

Strategy 4 is being stuck in the middle of these!

2024 L1 EQ LM6 - Industry and Competitive Analysis

89
Q

What objects could one forecast when analysing a company?

A
  1. Drivers of FSs ie stores opened, sales per store, opex, % of sales
  2. Ind FS lines: less material lines or those without clear drivers ie depreciation expense
  3. Summary measures: ie FCF. ERS, total assets/ This is efficient but less transparent and usually used when the measure is stable, predictable, and disclosures are minimal
  4. Ad hoc objects: items not yet reported in FSs, eg. forecast results of legal proceedings

2024 L1 EQ LM7 - Company Analysis: Forecasting

90
Q

What are the 4 forecast approaches?

A
  1. Assume past is present and use historical results. Simple, default, but low sensitivity to biz cycle. Good when industry structure not expected to change
  2. Historical base rates and convergence. Assume convergence to peer group average. Discretion required in choosing object, sample, and time frame. Suited to mature stable industries not for cyclical or dominant companies. Ie Alphabet and Meta (digital advertising)
  3. Public company published mgmt guidance: check the track record but can be sensitive to business cycle which is good
  4. All other methods at the analyst’s discretion: surveys, quant models, probability distribution. Used when change is likely.

Forecast method used depends on investment strategy, cyclicality of industry, company factors and your employer

2024 L1 EQ LM7 - Company Analysis: Forecasting

91
Q

What are top down forecasts of revenues vs bottom up?

A
  • Top down would adjust growth relative to GDP ie 0, +1 or -2%
  • Or forecast growth rate for company’s product market and then forecast market share and calculate together
  • Bottom up would look at individiual product lines or items on the FSs

2024 L1 EQ LM7 - Company Analysis: Forecasting

92
Q

What non recurring items in FSs might you not include in your forecasts?

A
  • Changes in FX rates
  • Extra days or weeks in a period
  • Acquisitions or divestures
  • Unusual or infrequent expenses. Be aware however some firms may put expenses down as unusual too often

2024 L1 EQ LM7 - Company Analysis: Forecasting

93
Q

What is the difference between IV and MV?

A
  • Intrinsic Value or fundamental value can be greater less than or equal to Market Value
  • Overvalued is where IV > MV, undervalued where IV < MV
  • In some cases fairly valued securities might still be desirable i.e. for a dividend investor not looking for capital appreciation
  • Our assessment of IV also depends on the confidence of the inputs. MM says +-10 to 20% from IV counts as IV: treat IV as a band
  • Lower confidence should increase the size of your bands
  • Also depends on the timeframe you are thinking about. It may take a long time for MV to converge to MV. If you are looking at something in a 5 year time horizon you may be more interested in deep value stocks whereas stocks with more market attention already on them may converge within 12 months

2024 L1 EQ LM8 - Equity Valuation: Concepts and Basic Tools

94
Q

What are the 3 major categories of valuation model?

A
  1. PV / DCF models. Present value of the future benefits to be received from the security. Either future dividends paid (dividend discount mode) or fututure cash available to pay dividends
  2. Multiplier models. Market value or enterprise value plus multiplier. Price is some multiple of a fundamental variable. E.g., Price/Earnings or Price/Sales ratio. Stated either on a forward basis based on an estimate, or on a trailing basis based on observed value
  3. Asset based valuation models: est. value of assets - (est value of liabilities _ est value of pref shares)

The latter is only used when there is a company about to be liquidated (with little going concern) or financial companies

2024 L1 EQ LM8 - Equity Valuation: Concepts and Basic Tools

95
Q

What is the DDM?

A
  • The dividend discount model is the simplest PV model
  • Value of share today = sum of (expected dividend for that year - (1+required ROR)^t) for all years
  • This is valid no matter the holding period because when we sell the stock we get a different price. You determine that price based on future dividends as well.
  • Trust the formula when the real world is complicated!

2024 L1 EQ LM8 - Equity Valuation: Concepts and Basic Tools

96
Q

Why would we use FCFE to value a firm using PV?

A
  • In some sense dividend is a token amount returned to shareholders. Dividend paying capacity is more important, especially for firms with high potential returns for investments
  • Free Cash Flow to Equity is a measure not affected by the discretion of the company of how much dividend should be
  • Also some firms ie growth stocks pay no dividends
  • CFO - (CF from investing + Net Borrowing)
  • Where CF from Investing = CAPEX
  • We could arrive at our discount rate without necessarily using CAPM other ways: taking a company’s bond yield and adding a risk premium as well, since bond yield is always available and already prices in the premium from the risk free rate

2024 L1 EQ LM8 - Equity Valuation: Concepts and Basic Tools

97
Q
A

CFA (4 decks)

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