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)
