CFA 4_Equity Flashcards
Leverage ratio
Value of asset / value of equity position
Initial equity (%) in the margin transaction = 1/Leverage ratio
Initial margin = 1/Leverage ratio
Eg, margin requirement of 50% equity results in 2-to-1 leverage ratio, so 10% increase in price of asset result in 20% increase in equity amount.
Return on a margin transaction
Increase in value of position (including dividends), deducting selling commissions and interest charges and MARGIN REPAYMENT / Margin position invested (excludes non-margin loan), including (plus) purchase commissions.
You only divide by the amount of cash you invested (stock price * margin requirement). The rest that wasn’t on margin was a loan, and must be repaid from the gross return.
Can solve with CF keys.
Margin call price (price at which investor will receive a margin call)
Margin call price = Po * [(1 - initial margin) / (1 - maintenance margin)]
Where Po = initial purchase price
Initial margin = 1/Leverage ratio
Enterprise value
EV = market capitalisation (share price * shares outstanding) + debt - cash and cash equivalents
Enterprise value = common equity at market value + preferred equity at market value + minority interest at market value, if any + debt at market value + unfunded pension liabilities and other debt-deemed provisions - associate company at market value, if any - cash and cash-equivalents.
Equal-weighted index
Calculated as simple average of returns of index stocks.Return A + Return B + … / # of types of stock
Arithmetic avg return of index, matched by returns on portfolio with equal dollar amounts invested in each stock. Weights have to be adjusted periodically as prices change so that values are made equal (REBALANCING). Also weights on smaller cap firms are greater than their proportionate market value, and vice versa for large cap.Reconstitution is adding/deleting securities that make up an index.
Price-weighted index
A price-weighted index assumes that the investor holds an equal number of shares of each stock in the index. Arithmetic avg return of index. Need to rebalance (adjust) for stock splits, but not for dividends. (Market-cap doesn’t need to be adjusted for either). Has a built in downward bias due to stock splits.
Price-weighted index = sum of stock prices / # of different types of stocks, not number of shares, in index, adjusted for splits
Price-weighted index return = (PWI current / PWI previous) - 1
When adjusting for splits, the price for the split stock in the numerator is respectively decreased, and then the denominator is solved for to equal the same as before split.
New pw index = base value * (1 + pw return)
Returns on pw index can be matched by purchasing equal # of shares of each stock n index.
Weights on higher priced stocks are higher in comparison to their proportion.
Market cap-weighted (value-weighted) index
current index value = (current sum of market cap of index stocks / base year sum of market cap of index stocks) * base year index value [100]
market-cap weighted return = current index value / 100
Weights based on market cap. More closely represents changes in aggregate investor wealth. Doesn’t need to be adjusted for stock splits or dividends. Most global stock indexes are market cap-weighted.
Market float: value of shares available to investing public (excludes shares of controlling shareholders).
Relative impact on stock’s return on index increases as its price rises and decreases as its price falls. Therefore holding this is similar to a momentum strategy.
Fundamental weighted
Uses fundamentals (ie earnings, dividends). Unaffected by share price. Has Value tilt (overweighted firms with high value metrics).
Forms of market efficiency
Weak-form: stock prices reflect all currently available (past) market information. Cannot achieve returns with technical analysis.
Semi-strong: reflect all market and (non-market, eg financial statement) publicly available information. Cannot achieve returns with technical or fundamental analysis. Passive should outperform active. Evidence supports that markets are semi-strong. The semi-strong form encompasses the weak form.
Strong: Reflect all public, and private (inside) information. Cannot achieve abnormal returns in any way. No investor has monopolistic access to information.
Depository receipts
Represent ownership in a foreign firm. Depository bank acts as custodian and issues the receipts of foreign shares held.
Unsponsored DR: Firm is uninvolved with issue. Depository bank retains voting rights.
Sponsored DR: firm is involved with DR. Provides investors voting rights.
Book value of equity
Value of firm’s assets on balance sheet less liabilities.
Book value per share: book value of equity / # of shares
Market value of equity: value of firm’s equity shares on market prices.
ROE (accounting ROE)
ROE = Net Income / Avg Book Value
Diversification ratio
Calculated by dividing a portfolio’s standard deviation of returns by the average standard deviation of returns of the individual securities in the portfolio.
Separation theorem
Combining the CML (risk-free rate and efficient frontier) with an investor’s indifference curve map separates out the decision to invest from what to invest in and is called the separation theorem. The investment selection process is thus simplified from stock picking to efficient portfolio construction through diversification.
Methods by which companies can be grouped
Products and services
Sector
Principal business activity
Sensitivity to business cycles
Statistical methods
Industry Classification Systems
Global Industry Classification Standard (S&P): 4 tiers
Russel Global Sectors: 3 tiers
Industry Classification Benchmark (Dow Jones): 4 tiers
Porter 5 Forces
- Rivalry among existing competitors: increases when many firms of relatively equal size compete within industry. Greater concentration reduce competition. Unused capacity results in price competition. Stable market share reduces competition.
2, Threat of new entrants: higher barriers to entry reduce competition
- Threat of substitute products: more differentiation reduces price competition
- Bargaining power of buyers:
- Bargaining power of suppliers: fewer suppliers result in higher bargaining power
Barriers to entry
Greater ease of entry reduces pricing power.
Greater ease of exit increases pricing power (less over-capacity; unused capacity results in price competition).
Industry concentration
Higher concentration usually reduces competition and increases pricing power.
Opercapacity can result in intense price competition (as well as unused capacity)
Industry capacity
Undercapacity increases pricing power and return on capital. Overcapacity decreases pricing power and lowers return on capital.
Low capacity is associated with pricing power because it increases the likelihood that supply in the short run will be less than demand at current prices.
Both under and over capacity increase pricing competition.
Market share stability
Greater pricing power if more stable. Stable market share reduces competition.
Industry life cycle
1) Embryonic: slow growth, high prices, large required investment, high risk of failure
2) Growth: rapid growth, limited competition, falling prices, increasing profitability
3) Shakeout: Slowed growth, intense competition, overcapacity, declining profitability, cost cutting, failures
4) Mature: slow growth, consolidation, high barriers to entry, stable pricing, superior firms gain market share
5) Decline: negative growth, declining prices, consolidation
Experience curve
Shows cost per unit relative to output over time.
Major categories of equity valuation models
1) Discounted CF models (PV models): include dividend discount and free CF to equity models
2) Multiplier models: ratio of stock price to a fundamental, or CF per share to a fundamental. Good for comparing similar companies.
3) Asset-based models: intrinsic value of common stock is estimated as total asset value minus liabilities and preferred stock. (typically using fair values)
Dividend discount model (DDM)
Assumes intrinsic value of stock is the PV of its future dividends
One year holding period DDM:
P0 = [dividend to be received / (1 + ke)] + [year end price / (1 + ke)]
or simply
P0 = D1 + P1 / (1 + ke)
ke = cost of common equity (use CAPM)
Multiple year holding period DDM:
P0 = [D1 / (1 + ke)] + [D2 / (1 + ke)^2] + [P2 / (1 + ke)^27/]
Free cash flow to equity (FCFE)
FCFE may be used as the numerator in the DDM instead of the dividend and price.
The cash available to equity holders after a firm has met all of its other obligations. FCFE is a measure of the firm’s dividend paying capacity.
FCFE = net income + depreciation - increase in working capital - fixed capital investment - debt principal repayments + new debt issues
or
FCFE = CFO - fixed capital investment + net borrowing
The DDM formula can be restated so that:
Value = FCFEt / (1 + ke)^t
Value of preferred stock
Value = Dividend / kp
kp = required RoR on preferred stock
Gordon growth model (constant growth model)
Assumes annual growth of dividends is constant. Assumes constant g and kc. ke must be greater than g.
P0 = D1 / (ke - g)
ke = RoR on equity (not the expected return for market, don’t be fooled, solve it by CAPM)
g = dividend growth
Can also estimate amount of stock value that is due to dividend growth by calculating with g = 0 and subtracting from when g = estimate.
Estimating sustainable growth rate:
g = (1 - dividend payout ratio) * ROE
(1 - dividend payout ratio) = retention rate
dividend payout ratio = dividends / net income
dividend = (dividend payout ratio) * (earnings per share)
Multistage dividend growth model
1) Determine ke and g*
g* = dividend growth during high growth period
2) Calculate dividends over high growth period
D1 = D0(1 + g) = ~
…
D4 = …
3) The final high growth dividend is computed with the high g, but will from then on be computed with normal g. So use that divided (eg D4 here) to calculate price (eg P3 here).
P3 = D4 / ke - g
4) Sum the PVs of D1—D3 and the P3 together. Careful here, the D4 has been transformed into P3; don’t double count! Discount them all. Careful again, D1 is only discounted as 1 + rate… no exponent for first forward period. The answer is the value of the stock.
Price multiples based on comparabless vs. based on fundamentals
based on comparables: eg P/E of a firm to other firms based on market prices
based on fundamentals: tells us what a multiple should be based on a valuation model, not dependent on market prices of other firms to establish value.
P/E based on fundamentals (aka Earnings multiplier model)
Normal Gordon growth model:
P0 = D1 / (k - g)
P/E based on fundamentals (aka justified P/E):
P0 / E1 = (D1 / E1) / (k - g)
or:
P/E = dividend payout ratio / (k − g)
Note that D1 / E1 can also be represented decimally by the expected dividend payout ratio. Some problems may give this.
Enterprise value
EV = market value of common and preferred stock + market value of debt - cash and ST investments
Types of fixed income indices
The bond universe is larger than the stock universe and has higher turnover. Most markets are dealer markets and have infrequent trading. Creation of a bond index is more difficult than a stock index is due to the fact that the universe of bonds is constantly changing because of numerous new issues, bond maturities, calls, and bond sinking funds.Also illiquidity, transaction costs, and high turnover. Bonds lack continuous price trading data.
The bond universe is less stable than the stock universe.
Overreaction effect
The overreaction effect refers to stocks with poor returns over three to five-year periods that had higher subsequent performance than stocks with high returns in the prior period. The result is attributed to overreaction in stock prices that reverses over longer periods of time. Stocks with high previous short-term returns that have high subsequent returns show a momentum effect.
Stop loss buy
An order to protect a short position.A buy stop market order is typically used to limit a loss (or to protect an existing profit) on a short sale. A buy stop price is always above the current market price. For example, if an trader sells a stock short hoping the stock price goes down in order to book profits at a lower price, the trader may use a buy stop order to protect himself against losses if the price goes too high.
Continuous markets
Continuous markets are markets where trades occur at any time the market is open (i.e. they do not need to be open 24 hours per day). Setting one negotiated price is a method used in major continuous markets to set the opening price.
Information cascades
“Information cascades” refers to uninformed traders watching the actions of informed traders when making investment decisions. Herding behavior is when trading occurs in clusters, not necessarily driven by information. Narrow framing refers to investors viewing events in isolation.
Buy limit order
An order to purchase a security AT or BELOW a specified price.
Market bid price * 1 + bid-ask spread = price stock can be bought at
