Equity Flashcards
Three main functions of the financial system:
- Allow entities to save/borrow money, raise equity capital, manage risks, trade assets currently or in the future, and trade based on estimates of asset values.
- Determine the returns (i.e., interest rates) that equate the total supply of savings with the total demand for borrowing.
- Allocate capital to its most efficient uses.
Preferred stock
an equity security with scheduled dividends that typically do not change over the security’s life and must be paid before any dividends on common stock may be paid (similar to a bond)
Warrants
the right to purchase a company’s stock at a specific price and at a specific date - issued directly by a company to an investor.
Block brokers
help with the placement of large trades.
An information trader
expects to earn a positive risk-adjusted return
An investor
expects to earn fair (equilibrium) returns over time
‘buy on margin’
using borrowed funds to purchase equity
‘margin loan’
the borrowed funds used to purchase equity
‘call money rate’
the interest rate paid on borrowed funds used to purchase equity
Initial margin requirement
minimum equity % at time of purchase
equity % = (stock value - loan) / stock value
Maintenance margin
minimum equity % after purchase
equity % = (stock value - loan) / stock value
Leverage ratio
1 / initial margin
e.g. if the leverage ratio is 2.5 (40% equity, 60% loan, 1/0.4 = 2.5) a return of 10% on the stock would result in a return of 25% return to the investor
Margin call
Occurs when equity < maintenance margin (i.e. when the value of an investment falls and the debt proportion of the deal represents too much in relation to equity).
In this scenario, the investor must add cash or marginable securities, or close the position.
Margin-call / trigger price
Initial purchase price * ( ( 1 - initial margin ) / ( 1 - maintenance margin ) )
market order
instructs the broker to execute the trade immediately at the best possible price
limit order
places a minimum execution price on sell orders and a maximum execution price on buy orders.
These can either ‘make the market’, be ‘behind the market’ or be ‘far from the market’
All-or-nothing orders
deals with the volume of trade - only executed if the whole order can be filled.
Hidden orders
deals with the visibility of the trade - hidden orders are those for which only the broker or exchange knows the trade size
display size/iceberg orders
where only some of the trade is visible to the market
Immediate-or-cancel / fill-or-kill orders
cancelled unless they can be filled immediately
Good-on-close orders
Executed at end of trading day
e.g. market-on close orders
Stop / stop-loss orders
executed unless the stop price has been met
indications of interest
Investors, identified by the investment bank, who agree to buy part of the issue of a public offering.
This is described as book building
private placement
securities are sold directly to qualified investors, typically with the assistance of an investment bank
shelf registration
enables an equity issuer to issue securities bit by bit
dividend reinvestment plan
allows existing shareholders to use their dividends to buy new shares from the firm at a slight discount.
rights offering
existing shareholders are given the right to buy new shares at a discount to the current market price
call and continuous markets
Call: the stock is only traded at specific times
Continuous: trades occur at any time the market is open
With respect to a well-functioning securities market, a market that exhibits operational efficiency will have
low transaction costs and liquid markets.
operationally efficient market
low transaction costs
Informational efficiency
prices in the market reflect all information currently available to participants
Price continuity
prices do not adjust much from one transaction to the next unless new information about firm value becomes available
An order placed to protect a short position is called a:
stop loss buy.
stop loss buy
A limit order that is placed above the market price. When the stock price reaches the stop price, the stock is sold
When is a limit buy order behind the market
if its limit price is below the best bid.
When is a limit sell order behind the market
if its limit price is above the best ask
Securitizers
Financial intermediaries that assemble large pools of similar financial assets, such as mortgages or loans, and issue securities that represent interests in the pool.
A crossing network
an example of an order-driven market. Orders are batched together and crossed (matched) at specific times during the trading day at prices based on those of another exchange.
pre- and post-market transparency
Pre-market transparency: if investors can obtain pre-trade information regarding quotes and orders
Post-market transparency: if investors can obtain post-trade information regarding completed prices and sizes.
Characteristics of a well-functioning financial system
- Investors are able to save for the future at fair rates of return
- Creditworthy borrowers can obtain funds
- Hedgers can manage their risks
- Traders can obtain the assets they need
Objectives of market regulation
- protect unsophisticated investors
- require a minimum standard of competency and make it easier for investors to evaluate performance
- prevent insiders from exploiting other investors
- require common financial reporting requirements so information gathering is less expensive
- require minimum levels of capital
Problems that persist within financial markets
- fraud + theft
- insider trading
- costly information
- defaults
price index
uses only prices in the return calculation
price return: (end price / bgn price) -1
return index
uses both prices and income in the return calculation (‘total return’)
total return: ( (end value + cash flows) / bgn value) - 1
Index Construction Decisions
- What market does the index represent?
- Which securities to include?
- What weighting method to use?
- When to re-balance the weighting?
- When will the index’s securities be re-examined?
price-weighted index
sum of stock prices / # of stocks in index
Purchase an equal number of shares of each stock.
∴ changes in stocks with a higher price, have a higher impact on the price of the index.
- e.g. DJIA and Nikkei Dow Jones average
market-cap weighted index
(current total market value of index stocks / base year total value of index stocks) * base year index
Match portfolio weights to each stock’s % total market value of index stocks.
∴ firms with larger market caps have larger influence on index.
‘Momentum tilt’: overpriced stocks have higher weights and more influence in the value-weighted index
market float-weighted index
an index that excludes any shares not available to the public
free float index
an index that excludes any shares not available to foreign investors
fundamental weighted index
weightings are based on firm fundamentals (such as earnings, dividends or cash flow).
- unaffected by changes in share prices
- tend to have a ‘value tilt’: overweighting firms with high value-based metrics.
Index reconstitution
adding and deleting securities from an index periodically
Rebalancing
adjusting index weights to target weights periodically
uses of an index (6)
- reflection of market sentiment
- performance benchmark
- measure of market return
- calculate beta
- calculate expected and risk-adjusted returns
- model portfolio for index funds
Equal weighting is the most common weighting methodology for indexes of which of the following types of assets?
Hedge funds
Most hedge fund indexes are equal-weighted. Equity and fixed income indexes are predominately market capitalization weighted.
An informationally efficient capital market
where the price of an asset reflects all available information
- in a perfect market, investors should invest through passive strategies
Factors affecting market efficiency
- number of market participants
- availability of information
- impediments to trading
- transactions and information costs
weak form efficiency
prices reflect market information only
semistrong efficiency
prices reflect market info + public (non-market) info
strong efficiency
prices reflect market info + public (non-market) info + private info
market anomalies
observed market efficiencies
Technical analysis
Aims to achieve positive risk-adjusted returns using historical price and volume data
(not possible in weak-form efficient markets as info used for technical analysis is already priced into the stock)
Fundamental analysis
Aims to achieve positive risk-adjusted returns using all public data.
(not possible in semi-strong efficient markets as info used for fundamental analysis is already priced into the stock)
Event study
A method of testing for semi-strong market efficiency. Event studies examine abnormal (risk-adjusted) returns before and after the release of new information (e.g. earnings announcements / dividend changes).
The null hypothesis: investors are unable to achieve positive risk-adjusted returns based on firm events because these are immediately priced into assets.
Calendar effects (time series anomalies):
- lower January returns
- lower returns on a Monday, higher on Friday (weekend effect)
- higher turn-of-month returns
Overreaction effects (time series anomalies):
- prices inflated after good news
Momentum effects (time series anomalies):
- prices that go up, still going up
Size effects (cross-sectional anomalies):
- small-cap stocks outperform large cap-stocks
Value effects (cross-sectional anomalies):
- value stocks outperforming growth stocks
Loss aversion
Risk aversion is asymmetric - losses more significant than gains
information cascades
uninformed investors mimic actions of informed investors (this IMPROVES market efficiency)
A limitation of a fully efficient market
The gains to be earned by information trading can be less than the transaction costs the trading would entail
Sponsored depository receipts
Firm is involved with issue of the DR
- same voting and dividend rights as shareholders
- greater reporting requirements
Unsponsored depository receipts
Firm not involved with issue of DR
- depository (bank) buys shares in foreign market and retains voting rights
Global depository receipts
- issued ex-US
- underlying shares traded outside of US
American depositary receipts
- issued ex-US
- underlying shares traded on US exchanges
Global registered shares
identical common shares that trade in local currencies on stock exchanges worldwide
Baskets of listed depositary receipts
a traded portfolio of depository receipts (in form of ETF)
Cost of equity
Estimated total return on a stock (different to ROE as it considers the market value of stock)
= ( DPS / PPS ) * g
Most risky type of share
Callable shares: these give the investor the right to re-purchase the shares in rising markets - limiting the gains for the investor.
industry rotation
overweighting / underweighting particular industries based on phase of business cycle
cyclical firms
follow trend of business cycle
A firm’s earnings are most likely to be cyclical if:
the firm produces luxury items.
Producers of luxury items tend to have cyclical earnings because consumers typically decrease their purchases of these items during economic recessions. The earnings of firms with high percentages of variable costs are not as likely to be cyclical as those of firms with high percentages of fixed costs (i.e., high operating leverage). A growth industry has demand that is strong enough that earnings remain relatively unaffected by the business cycle.
Porter’s five forces of industry competition
- Rivalry amongst existing competitors
- Threat of entry
- Threat of substitutes
- Power of buyers
- Power of suppliers
embryonic stage
- slow growth
- high prices
- large investment required
- high risk of failure
growth stage
- rapid growth
- little competition
- falling prices
- increasing profitability
shakeout stage
- slowing growth
- intense competition
- industry overcapacity
- declining profitability
- cost cutting
- increased failures
mature stage
- slow growth
- consolidation
- high barriers to entry
- stable pricing
- opportunity to gain market share
stock dividend
Payment to shareholders in shares of stock, as opposed to cash. As a result there are more shares outstanding, but each one is worth less than before.
A 20% stock dividend means every shareholder gets 20% more stock proportionate to their current shareholding.
Stock split
Divides each existing share into multiple shares, creating more shares. You can also have ‘reverse stock splits’ where there are fewer shares after the split.
In a 3-for-1 stock split, each old share is split into three new shares.
Share repurchase
When a company buys outstanding shares of its own common stock, as a result the remaining shares held by shareholders increase in value. Seen as an alternative to cash dividends.
Four dates in a payment of a dividend
- Declaration date (approval of dividend)
- Ex-dividend date (the first day at which the share purchaser will not receive the dividend for the prior period, ∴ the share price of the firm will fall on this day by the amount of dividend)
- Record date (the date the company checks to see who is eligible for the dividend)
- Payment date (dividend paid)
Free Cash Flow to Equity
= CFO + FCInv - net borrowing
cash available to shareholders after a firm meets its debt and capital exp
estimating growth rate (g) in the constant growth rate model (DDM)
retention rate (RR) * ROE
RR = ( 1 - dividend payout ratio)
price multiples based on comparables
comparing multiples with industry multiples
price multiples based on fundamentals
comparing multiples with multiples in a valuation model (not market)
Enterprise value
total market value of firm
= mkt value of c. stock + mkt value of debt - ( cash + short-term investments)
EV / EBITDA ratios useful when:
- firms have difficult capital structures
- earnings are negative and p/e cannot be used
Advantages/disadvantages of present value valuation models (e.g. DDM)
✓ theoretically sound
✓ widely accepted
✖ inputs must be estimated
✖ valuation can be very sensitive to input values
Advantages/disadvantages of multiplier models (e.g. P/E)
✓ widely used
✓ easily calculated
✓ time-series / cross sectional analysis
✖ differences in accounting methods, comparisons
✖ multiples for cyclical companies highly variable
internal growth rate
retention ratio * ROE
equity multiplier / total leverage
TA / TE
Roles of dealers, brokers and investment banks
Dealers: maintain inventories of securities and buy them from and sell them to investors.
Brokers: do not trade directly with clients but find buyers for and sellers of securities to execute customer orders
Investment banks: are primarily involved in assisting with the issuance of new securities.
validity instruction
An instruction regarding when to fill an order
the disposition effect
investors tend to avoid realizing losses and seek to realize gains
The gambler’s fallacy
a behavioural bias in which recent outcomes affect investors’ estimates of future probabilities.
