Equity Flashcards
The main functions of the financial system are to facilitate:
- The achievement of the purposes for which people use the financial system
- The allocation of capital to the best uses
- The discovery of the rates of return that equate aggregate savings with aggregate borrowings
Currencies that national central banks and other monetary authorities hold in significant quantities are described
as reserve currencies
> primary reserve currencies are the US dollar and the Euro.
secondary reserve currencies include the British pound, the Japanese yen, and the Swiss franc
Traditional investments include
Publicly traded debts and equities and shares in pooled investment vehicles that hold debt and/or equities.
Alternative investments include:
edge funds, real estate securities and properties, private equity (including venture capital), precious gems.
An ATS will not exercise
> regulatory authority over their subscribers except with respect to the conduct of their trading.
> Both an ATS and traditional exchange now offer dark pools.
> Most traditional exchanges now also just offer online trading facilities.
Iceberg or hidden orders are most likely to be used
for large orders that are likely to move the market price if revealed to the market
All-or-nothing orders are most likely to be used
where the settlement costs depend on the number of trades made to fill an order
Sell-side traders prefer …. markets
opaque
> this gives them an information advantage over those who know less than they do.
Bid-ask spreads and transaction costs tend to be higher in opaque markets
a market is PRE-trade transparent
if the market publishes real-time data about quotes and orders.
The objectives of market regulations are
Control fraud
Control agency problems
Promote fairness
Set mutually beneficial standards
Prevent undercapitalized financial firms from exploiting their investors by making excessively risky investments
Ensure that long-term liabilities are funded
stock market index
A generally reliable indicator which leads the economy as a whole
value of an index
is calculated using either actual or estimated market prices of individual securities
Types of equity indices include
broad market, multi-market, sector and style indices
Hedge fund indices tend to display
upward bias because of the problems associated with voluntary reporting such as survivorship bias.
In a PIPE transaction,
a public company raises additional capital quickly by selling a sizeable ownership stake to a private investor or investor group.
An LBO (leveraged buyout) occurs when
a group of investors (such as company’s management) uses a large amount of debt to purchase all the outstanding shares of a public company, taking the company private
Venture capital investments provide
seed capital to fledgling companies with the ultimate aim of an initial public offering providing a substantial return on investment
Level III ADRs
trade on NYSE, NASDAQ and AMEX, and provide the ability to raise capital in the USA.
Level I ADRs
trade over-the-counter but do not provide the ability to raise capital in the USA.
common to all research reports
Analyst’s investment recommendation and target buy or sell prices
Risks such as evaluation of material downside and upside risks
common to initial research reports
Discussion of issuer’s business model and strategy, and explanatory charts and figures that disaggregate revenues and profits by product or geography
Detailed financial analysis and models Industry overview and competitive positioning such as industry size, growth rate, market share trends, and industry profitability. Evaluation of the company’s competitive position and strategy in each product line or segment is also common
Economies of scope
decline in costs per unit as the number of product or business lines increases. This is a result of shared costs between the product lines
The Functions of the Financial System
Uses of financial system
Main functions
Uses of financial system:
* To save money for the future
* To borrow money for current use
* To raise equity capital
* To manage risks
* To exchange assets for immediate and future deliveries
* To trade on information
Main functions:
* Meeting purposes listed above
* Discovery of rates of return that equate aggregate savings with
aggregate borrowings
* Allocation of capital to best uses (subjective)
Saving
- To move money from present to future
- Savers buy notes, certificates of deposit (CDs), bonds, stocks, mutual funds or real assets, such as real estate
Borrowing
- Money can be borrowed via debt or selling equity interests
- Lenders will demand a higher rate of return if there is uncertainty regarding repayment of borrowings
- Cost can be reduced by supplying collateral
Raising equity capital
- Companies raise money for projects by selling ownership interests
- Financial system facilitates raising equity capital
- Investment banks assist companies, analysts value the securities issued, and regulatory reporting requirements and accounting standards attempt to ensure meaningful financial disclosures
Managing risks
- Risk reduced via hedging with traded contracts
- A liquid market must exist in which risk managers can trade
- Need instruments which are correlated or inversely correlated
- Provided by insurance companies, investment banks and exchanges
Exchanging assets for immediate
delivery
- Spot market trading
- E.g. individuals, companies and governments trading currency
Information motivated trading
- Making a profit from information that allows people to predict future prices e.g. active investment managers
- Buy undervalued, sell overvalued
- Investors may also be information-motivated traders if they believe assets are mispriced
Determining rates of return
- Total money saved = Total money borrowed
- Expected rate of return
- Depends on aggregate supply of saving funds and aggregate demand for funds (borrowings)
Rate too high:
Supply of savings exceed demand for
borrowing – rates should fall
Rate too low:
Supply of savings less than demand for
borrowing – rates should rise - When supply = Demand, interest rate will be at equilibrium
- Different required rates of return, due to risk characteristics, terms and liquidity
Capital allocation efficiency
- Markets in which companies and governments raise capital = primary markets
- Allocationally efficient market:
- Exists when financial systems allocate capital to the most productive uses e.g. only the best projects receive funding due to fear of losses
- Projects undertaken if Value > Costs
- Accurate market information leads to efficient capital allocation
Classification of assets and markets
Classification
- Most actively traded assets
- Securities
- Tradable financial instruments such as bonds and shares
- Currencies
- Monies issued by national monetary authorities
- Contracts
- Agreements to exchange securities, currencies, commodities or other contracts in future
- Commodities
- Precious metals, energy products, industrial metals and agricultural products
- Real assets
- Tangible properties such as real estate
Assets and Contracts Securities
- Debt or fixed-income instruments
- Promises to repay borrowed money
- Equity
- Represent ownership in companies
- Pooled investment vehicles, e.g. exchange-traded funds
- Public securities
- Registered to trade in public markets
- Private markets
- All other securities
- Can often only be purchased by specially qualified investors
- Primary market
- Issuers sell securities to investors
- Secondary market
- Securities sold by investors
Assets and Contracts
Markets
- Money markets
- Trade debt instruments maturing in one year or less
- E.g. certificates of deposit, government bills and commercial paper
- Capital markets
- Trade instruments of longer duration
- E.g. bonds and equities
Traditional investment markets vs. alternative investment markets
- Traditional
- All publicly traded debts and equities and shares in pooled investment vehicles
- Alternative
- Hedge funds, private equities, commodities, real estate, securitized debts, operating leases, machinery, collectibles and precious gems
Financial Intermediaries
Brokers and exchanges
Brokers
* Agents who fill orders for their clients
* Help clients by reducing cost of finding a counterparty
* Block brokers
- Provide brokerage service to large traders
* Investment banks
- Provide advice to clients
- Help arrange initial and seasoned securities offerings
- Help with issuance of securities
Exchanges
* Provide places where traders can meet to arrange their trades
* Distinction between brokers and exchanges has become blurred
* Generally heavily regulated
Financial Intermediaries
Alternative trading systems (ATSs)
- Electronic communication networks (ECNs)
- Multilateral trading facilities (MTFs) - low cost trading
- Function like exchanges but do not exercise regulatory authority over subscribers (except with respect to the conduct of their trading in their trading systems)
- Dark pools
- Do not display client orders
- Protect traders from the market moving against them when their order is revealed
Financial Intermediaries
Dealers
Broker dealers
Dealers
* Fill client orders by trading with them
- Proprietary trading (uses own money)
* Provide liquidity
- Ability to buy/sell with low transaction costs when you want to trade
- Allow clients to trade when they want
* Operations
- Proprietary trading houses, investment banks and hedge funds or sole proprietorships
* Primary dealers (help with money supply)
- Buy/sell government debt
- Dealers with whom central banks trade when conducting monetary policy
Broker-dealers (best price for client , buy low sell high)
* Firms that act as both brokers and dealers
* Conflict of interest
- As brokers must seek the best price for their clients
- As dealers want to buy at lowest price/sell at highest price
Financial Intermediaries
Securitizers (incr. liquidity and predictability)
- Buy and repackage securities or other assets
- E.g. banks issuing mortgage-backed securities
- Securitization
- Process of buying assets, placing them in a pool and selling securities that represent ownership of the pool
- Advantages
- Default losses and early losses are more predictable for a diversified portfolio of
mortgages - Attractive for investors who cannot efficiently service mortgages
- Improves liquidity in mortgage market
- Easier to sell and price than individual mortgages
- Special purpose vehicle (SPV) or special purpose entity (SPE)
- Keeps assets and liabilities off balance sheet of bank
- Investor is also better protected
Financial Intermediaries
Depository institutions
- Commercial banks, savings and loan banks, credit unions
- Raise funds from depositors and lend it to borrowers
Other financial corporations providing credit services
- Acceptance corporations, discount corporations, payday advance corporations,
and factors - Secured by assets such as consumer loans, machinery, future pay checks, or accounts
receivables - Brokers lending funds to clients to buy securities on margin
Insurance companies
- Help people and companies offset risks
- Create contracts (policies) that provide a payment in the event of a loss
- Credit default swaps
- Type of insurance contract
- Sold by insurance companies, investment banks and hedge funds
- Reinsurance policies
- Allow insurance companies to transfer risk to other insurance companies
- Insurance companies have to control various problems
- Fraud
- Moral hazard
- E.g. people will drive less carefully because they are insured
- Adverse selection
- Only those most at risk buy insurance
- Hold a diversified portfolio of policies
- Loss rates are more predictable
- Insurance premiums reflect portfolio expected loss rate plus costs of running the
company
Arbitrageurs
- Identify identical or similar instruments priced differently in different markets
- Provide liquidity in markets
- Compete with dealers
- Connect buyers and sellers who arrive at the same time but in different markets
- Arbitrage opportunities are rare in well-informed markets
- Replication
- Buying risk in one form and selling it in another
- E.g. equity positions and call options
Settlement and custodial services
- Help clients settle their trades
- Settlement
- Process of transfer of legal ownership of an asset
- Also ensure assets are not stolen or assets pledged more than once as collateral
- Clearinghouses
- Futures markets (derivatives)
- Guarantee as to performance of the contract
- Other markets
- Act as escrow agents transferring money
- Require margin from clients
- Reduce counterparty risks and increase liquidity
- Depositories/custodians
- Hold securities on behalf of their clients
- Help prevent the loss of securities through fraud, oversight or natural disaster
Type of option
Option position
Exposure to underlying risk
Call
Long
Long
Call
Short
Short
Put
Long
Short
Put
Short
Long
Positions
Levered positions
- Money borrowed from brokers to buy securities
- Margin loan
- Call money rate
- Interest-rate buyers pay for margin loan
- Initial margin requirement
- Portion of security price that must be paid to broker by trader
- Minimum %
- Set by government, exchange or exchange clearinghouse
- US Federal Reserve Regulation T (50% loan)
- Brokers margin > Government minimum margin
Positions
Financial leverage
Leverage ratio
- Relationship between risk and borrowing
- A highly leveraged position is large relative to the equity that supports it
- Ratio of the value of position to the value of the equity investment
- Indicates how many times larger a position is than the equity that supports it
- Indicates how much more risky a leveraged position is relative
to an un-leveraged position
Leverage factor = 1 / Initial margin %
Maintenance margin requirement
- Minimum amount of equity position required by broker
- Usually 25% of current value of position
- Margin call
- If equity falls below requirement, buyer will receive a request for additional equity
- Insufficient equity will lead to the position being closed out
- Calculation
Margin call price = price0 * (1- Initial Margin requirement / 1- Maintenance Margin requirement)
Short position (price goes up)
Trader’s equity = Margin requirement x Initial value of short position
Orders
Execution instructions
- Market order
- Instructs broker or exchange to obtain best price immediately
- No price criteria stated
- Generally executed immediately
- Can be expensive to execute, if the order moves the market
- High purchase price or low sale price
- Execution price is uncertain
- Limit order
- Specifies highest buying price or lowest selling price acceptable
- Will trade at the limit or better
- May not be executed
- Limit vs. market order
- On average limit orders trade at better prices than market orders
- Limit buy orders do not fill with rising prices
- Limit sell orders do not fill with falling prices
Orders
Execution instructions
Exposure instructions
Execution instructions
* All-or-nothing orders (AON)
- Can only trade if their entire sizes can be traded
- Traders can also specify minimum fill sizes
- Used when settlement costs depend on number of orders rather than aggregate order
size
Exposure instructions
* Indicate whether, how and to whom orders should be shown
* Hidden orders
- Only exposed to brokers or exchanges that receive them
- Encourages large orders
* Iceberg orders
- Only a specified display size of the total order is shown on the screen (don’t show identity)
* Residual part of the order is hidden
Orders
Validity instructions
- Indicate when an order may be filled
- Day order
- Order expires if unfilled at the close of business
- Good-till-cancelled orders (GTC)
- Cancellation date specified by trader
- Immediate or cancel orders (IOC)
- Cancelled if cannot be filled in whole or in part
- E.g. fill or kill orders
- Good-on-close orders
- Can only be filled at close of trading
- Often market orders
- Market-on-close orders
- Allows traders to trade at the closing price
Orders
Stop orders
- Trader has specified a stop price condition
- May not be filled until stop price condition has been satisfied
- Sell stop order
- Execution is delayed until trade occurs at or below stop price
- Buy stop order
- Execution is delayed until trade occurs at or above stop price
- Often called stop-loss orders
- Contribute to market momentum
- Execution prices are often quite poor
Orders
Clearing instructions
- Tell brokers and exchanges how to arrange final settlement of trades
- Standing instructions
- Indicate entity responsible for clearing and settling trades
- Retail trades
- Customer’s broker
- Institutional trades
- Custodian or another broker
- Give-ups
- Different brokers used for trading and settlement
- Important clearing instruction
- Long/short sale
- Long sale
- Broker must ensure trader can deliver securities for settlement
- Short sale
- Broker must borrow securities or confirm client can borrow
Primary Security Markets
Primary market
Secondary market
Primary Security Markets
Primary market
* Where securities are issued for the first time
* Initial public offering (IPO)
- Also known as a placing
- Issuer sells securities to the public for the first time
* Seasoned security
- Security already issued by issuer
- Seasoned offering
* Also known as secondary offering
Secondary market
* Investors sell securities to other investors
Primary Security Markets
Public offerings
- Corporations contract with investment banks to help them sell their securities
- Book building
- Build up a book of orders to sell the offering
- Book runner (London)
- Accelerated book build (Europe)
- Arranged in one or two days
- Sale will occur at a discounted price
- Underwritten offering
- Bank guarantees sale of the issue at price negotiated with issuer
- Bank will buy up unsold shares
- Best efforts offering
- Bank acts only as broker
- Issuer does not receive guaranteed proceeds
Primary Security Markets
Public offerings
Private placements and other primary market transactions
Public offerings
* Investment bank conflict of interest
- As agents should choose highest price
- As underwriters they have an incentive to select a low price
- Generally results in low offer prices
- Issuers prefer to have oversubscribed issues
Private placements and other primary market transactions
* Corporations sell securities directly to a small group of qualified investors
* Qualified investors
- Sufficient knowledge and experience to assume risk
* Less public disclosure required than public offerings
* Shelf registration
- Shares sold over a period of time, rather than one offering
* Other methods of issuance
- Dividend reinvestment plans (DRPs or DRIPs)
Primary Security Markets
Importance of secondary markets to primary markets
* Primary market investors can sell on securities in secondary market
* Reduces risk of buying securities
- Reduces investors’ required return
- Investors will pay a higher price
- Makes it cheaper for issuers to borrow money
Secondary Security Market and Contract Market Structures
Trading sessions
Execution mechanisms
Trading sessions
* Continuous trading market
- Trades can be arranged and executed whenever market is open
- Generally used when the market is liquid
- May start/end trading session with a call market
* Call markets
- Trades can only be arranged when the market is called
- Highly illiquid between trading sessions
- Use single price auctions to match buyers to sellers
* Single trade price to maximise total volume of trade
Execution mechanisms
* Quote-driven markets (price driven market (electornic ))
* Order-driven markets
* Brokered markets (brokers arrange trades between existing clients)
Secondary Security Market and Contract Market Structures
Order-driven markets
Order matching rules
Order-driven markets
* Use rules to match, buy, and sell orders
* Submitted by customers or dealers
Order matching rules
* Rank orders based on price
* Price priority
- Highest priced buy orders first and lowest priced sell orders first
* Most aggressively priced orders
* Secondary precedence rules
- Determine how to rank orders at the same price
- E.g. time entered or unhidden vs. hidden
Secondary Security Market and Contract Market Structures
Trade pricing rules
- Uniform pricing rule
- Commonly used by call markets
- All trades execute at same price
- Discriminatory pricing rule
- Used by continuous trading markets
- Standing order (i.e. order that arrives first) determines trade price
- Derivative pricing rule
- Used by crossing networks
- Crossing networks
- Matches buyers and sellers who are willing to trade at prices
obtained from other markets - Midpoint of best bid and ask quotes published by the exchange at which the security
primarily trades
Secondary Security Market and Contract Market Structures
Market information systems
- Pre-trade transparent market
- Publishes real-time data about quotes and orders
- Post-trade transparent market
- Publishes trade prices and sizes soon after trades occur
- Buy-side traders
- Prefer transparency
- Dealers prefer opaque markets
- Information advantage
- Opaque markets
- Wider bid/ask spread
- Higher transaction costs
Well-Functioning Financial Systems
Definition
Complete markets
Operationally efficient
- Investors can easily move money from present to future while obtaining a fair rate
of return for risk - Borrowers can easily obtain funds that they need to undertake current projects if
they can credibly promise to repay funds - Hedgers can easily trade away or offset risks
- Traders can easily trade currencies for other currencies or commodities
that they need
Complete markets - Assets/contracts exist to solve these problems
Operationally efficient - Costs of arranging trades is low
Informationally efficient
Market Regulation
Regulators
- Government agencies and self-regulating organisations (SROs)
- Objectives
- Control fraud
- Control agency problems
- Promote fairness
- Traders can trade at prices that reflect fundamental values
- Do not incur excessive transaction costs
- Set mutually beneficial standards
- Prevent undercapitalized firms from exploiting their investors by making excessively risky
investments - Ensure that long-term liabilities are funded
Security market index
- Represents a given security market, market segment or asset class
- Value
- Calculated using actual or estimated value of constituent securities
- Two versions
- Price index
- Only measures percentage change in price
- Total return index
- Price change plus interest/dividends
- Over time
- Performance of total return index > Performance of price index
Value of price return index
VPRI = Sum^N_i n_i*P_i / D
VPRI = The value of the price return index
ni = The number of units of constituent security i held in the index portfolio
N = The number of constituent securities in the index
Pi = The unit of price constituent security i
D = The value of the divisor
The price return of the index portfolio
PR_I = (VPRI1-VPRI0)/VPRI0
PR_I = The price return of the index portfolio (as a decimal)
VPRI1 = The value of the price return index at the end of the period
VPRI0 = The value of the price return index at the beginning of the period
Weighted average of the price movements of the individual securities
PRi = W1PR1 + W2PR2 + … + WNPRN
PR_1 = The price return of the index portfolio (as a decimal)
PR_i = The price return of the constituent security
W_i = The weight of the security i ( the fraction of the index portfolio allocated to security i)
N = The number of securities in the index
Value of total return index
TRI = (VPRI1-VPRI0 + Inc1)/ VPRI0
TRI = The total return of the index portfolio (as a decimal)
VPRI1 = The value of the price return index at the end of the period
VPRI0 = The value of the price return index at the beginning of the period
IncI = The total income (dividends and/or interest) from all securities in the index
over the period
weighted average of total returns of the constituent securities
TRI = W1TR1 + W2TR2 + … + WNTRN
TR_I = The total return of the index portfolio (as a decimal)
TR_i = The total return of the constituent security
W_i = The weight of the security i ( the fraction of the index portfolio allocated to security i)
N = The number of securities in the index
Calculation of index values over multiple time periods
* Geometrically link returns
VTRIT = V_TRI0(1+TRI1)(1+TRI2)…(1+TRIT)
VPRIT = V_PRI0(1+PRI1)(1+PRI2)…(1+PRIT)
Index Construction and Management
Index providers decide
- Target market represented by index
- Asset class
- Equities, fixed income, real estate, commodities, hedge funds
- Geographic region
- Stock exchange and/or other characteristic
- Economic sector, company size, investment style, duration, or credit quality
- Securities selected from target market
- Fixed number, e.g. S&P 500
- Varying number to represent % of target market
- Weighting allocated to each security
- Timing of index rebalancing
Index Construction and Management
Index weighting
Method
Index weighting
* Determines how much of each security to include in an index
* Substantial impact on an index’s value
Method
* Price weighting
* Equal weighting
* Market-capitalization weighting
* Fundamental weighting (looks at unique characteristics)
Price weighting
* Simple method
Σ stock prices / Divisor adjusted for stock splits
- Biased towards the performance of higher priced stocks
- Results in arbitrary weights for each security
Equal weighting
* Simple method
Weighting of each security = 1/ # number of securities
- Large companies will be underrepresented and small companies overrepresented
- Frequent rebalancing required to maintain equal weights
Market-capitalization weighting
* Value weighting
(Sum Price today * No. of shares) / (Sum Price base * No. of shares)
- Float-adjusted market-capitalization weighting
- Market float
- Number of shares of the constituent security available to investing public
- Most indexes are float adjusted
Advantages
* Constituent securities held in proportion to their value in the target market
Disadvantages
* Overweighting of stock increasing in price (may be overvalued)
* Underweighting of stock decreasing in price (may be undervalued)
Fundamental weighting
- Attempts to address disadvantages of market-capitalization weighting
- Weights determined by other measures
- Book value, cash flow, revenues, earnings, dividends and number of employees
- Single measure such as total dividends or
- Composite value from a series of measures
Weighting of each security = Fundamental size measure / Sum of fundamental size measure
- Leads to indexes with a ‘value’ tilt
- Compared to market-capitalization indexes (momentum tilt)
- Higher book value, earnings, dividends etc.
Rebalancing
- Adjusting the weights of the constituent securities in index
- Normally done quarterly by index provider
- Equally weighted indexes
- Necessary because weights change as prices change
- Creates turnover within an index
- Not required for price-weighted indexes
- Market-capitalization indexes largely rebalance themselves
- Adjusted to reflect mergers, acquisitions, liquidations
Reconstitution
- Process of changing constituent securities in an index
- Index providers review initial inclusion criteria
- Select which securities to retain, remove, or add
- Creates turnover in portfolio
Uses of Market Indexes
Major uses
- Gauges of market sentiment
- Proxies for measuring and modeling returns, systematic risk
and risk-adjusted performance - Used in calculation of systematic risk (Beta)
- Proxies for asset classes in asset allocation models
- Help model risk and returns of different asset classes
- Benchmarks for actively managed portfolios
- Benchmark index should reflect investment strategy
- Model portfolios for index funds and exchange-traded funds
- New indexes created to form ETFs
- E.g. Market Vectors
® Vietnam ETF
Equity Indexes
Types
- Broad market
- Represents an entire market index (> 90% of market)
- E.g. Shanghai Stock Exchange Composite Index (SSE)
- E.g. Wilshire 5000 Total Market Index and Russell 3000
- Multi-market indexes
- Comprise indexes from different countries
- MSCI Barra
- Level of economic development
- Developed, emerging and frontier markets
- Geographic region
- Americas, Europe, Pacific, Asia and Middle East
Equity Indexes
Sector indexes
- Represent and track different economic sectors
- Consumer goods, energy, finance, health care, and technology
- National, regional, or global basis
- Investors may choose to overweight or underweight certain sectors depending on
economic cycle - Role in performance analysis
- Helps determine whether a portfolio manager is more successful at stock selection or sector allocation
Equity Indexes
Style indexes
- Securities classified according to market capitalization, value, growth
- Reflect investing styles such as growth, value or small-cap investing
- Market capitalization
- No universal definition of large cap, mid cap, and small cap
- Classification into categories can be based on absolute or relative market capitalization
- Value/growth
- Classified by different factors and valuation ratios
- Value
- Low price-to-book, low price-to-earnings, high dividend yields
- Stocks frequently migrate from one style index category to another
- Much higher turnover than broad market Indexes
Fixed Income Indexes
Construction
- Challenges
- Number of fixed-income securities much greater than equity securities
- Government, corporate
- Different characteristics such as maturities, coupon styles, etc.
- Much greater index turnover due to maturing of fixed-income securities
- Primarily dealer (market makers) markets
- Index providers have to obtain prices from dealers or estimate prices from similar securities
- Indexes can have different numbers of constituent securities for the same market
- More difficult to replicate fixed-income indexes
Fixed Income Indexes
Classification
Categories of index
Classification
* Type of issuer
- Government, government agency,corporation
* Type of financing
- General obligation, collateralized
* Currency of payments
* Maturity
* Credit quality
- Investment grade, high yield, credit agency ratings
* Inflation protection
Categories of index
* Broad market indexes, market sector indexes, style indexes, economic sector
indexes, and specialized indexes
Indexes for Alternative Investments
Commodity indexes
Construction and implications
Construction and implications
* Futures contracts on one or more commodities
- Agricultural products, livestock, precious and common metals
and energy commodities
* Each index uses a different weighting mechanism
- Indexes have different performances as a result
- Can lead to large differences in exposure to specific
commodities
* Different risk and return profiles
* Performance can differ from underlying commodities
- Based on futures contracts, not actual commodities
- Returns reflect:
* Risk-free interest rate, changes in futures prices,
and roll yield
Real estate investment trust indexes (REIT)
Construction
- Represent market for real estate securities and real estate market in general
- Highly illiquid market, infrequent transactions and pricing information
Types - Appraisal, repeat sales, and REIT indexes
- REIT
- Public or private funds which invest in real estate
- REIT indexes based on publicly traded REITs with continuous market prices
- Value of REIT indexes calculated continuously
Hedge fund indexes
Construction
- Reflects returns on hedge funds on a broad global level or strategy level
- Usually equally weighted
- Constituents determine the index
- Voluntary cooperation of hedge fund to compile performance data
- Hedge funds decide which database(s) to report to
- Frequently report to only one database
- Different indexes may reflect very different performance over the same period
- Survivorship bias
- Poorly performing funds less likely to report performance
- Inaccurate performance representation - including only those that were succesful
The Concept of Market Efficiency
Description of efficient markets
- Informational efficient market
- Asset prices reflect new information quickly and rationally
- Asset prices reflect all past and present information
- Consistent, superior, risk-adjusted returns are not possible
- Passive strategy is preferred to active management
- Lower costs
Time-frame - Prices must adjust in the shortest amount of time that a trader needs to execute a trade
Adjustment to prices - Prices should react only to ‘unexpected’ or ‘surprise’ elements of information
The Concept of Market Efficiency
Market value vs. intrinsic value
Market value
* Price at which an asset can be bought or sold
* The intersection of supply and demand
Intrinsic value
* Fundamental value
* Investor’s perception of value, with a complete understanding of asset’s
investment characteristics
* Present value of all expected future cash flows of the asset
* Not known with any certainty
* Estimates require judgments
- Size, timing, and riskiness of future cash flows
Highly efficient market
* Market prices act as a proxy for intrinsic value
The Concept of Market Efficiency
Degrees of efficiency
* Vary through time, across geographical markets and type of market
Factors contributing to efficiency
* Number of market participants
- Number of investors
- Number of financial analysts
* Information availability and financial disclosure
- Should promote market efficiency
- All investors need access to the information
* ‘Fair, orderly and efficient markets’
* Legislation against insider dealing
* Limits to trading
- Arbitrageurs contribute to market efficiency
- Short-selling restrictions hinder market efficiency
The Concept of Market Efficiency
Transaction and information acquisition costs
Transaction costs
* Market should be viewed as efficient within bounds of transaction costs
* Efficient market
- Arbitrage profits do not exceed transaction costs
Information acquisition costs
* Prices must offer a return to information acquisition
* Returns of these expenses are returns for risk incurred
* Inefficient market
- Active investing can earn superior returns after costs
abnormal returns
- If investors can earn abnormal returns market is not efficient
- Abnormal return = Actual return less expected return
Forms of Market Efficiency
Weak-form market efficient
* Security prices fully reflect all past market data
- Investors cannot predict future price movements using technical analysis
* Tests
- Review patterns of prices
* Serial correlations of prices would imply a predictable pattern
- Only very weak correlations
- Examine specific technical trading rules
* Do not consistently earn abnormal returns in developed markets
> technical analysis does not help
> fundamental and private inform help
Semi-strong form efficient market
- Security prices fully reflect all past and publicly known and available
market data - Fundamental analysis does not work
- Analysis of financial statement data
- Event studies
- Empirical studies of investors’ reactions to information releases
- Identify the period of study
- Identify stock associated with event within study period
- Estimate expected return for each co. for announcement date
- Calculate excess return for each co. in the sample as the actual return on the announcement
date, less the expected return - Perform statistical analyses on the excess returns in the sample to see whether these returns
are different from zero - Consistent excess returns following announcement
- Suggests inefficiency
> technical analysis + fundamental analysis does not help
> private inform help
Strong-form efficient market
- Security prices fully reflect both public and private information
- Insiders would not be able to earn abnormal returns from trading on basis of private
information - Prices reflect everything management knows about financial condition of the company
- Tests show market is not strong-form efficient
Implications of EMH
- Securities markets are weak-form efficient, so technical analysis does not work
- Securities markets are semi-strong efficient, so analysts have to consider if
information is already reflected in the price - Securities markets are not strong-form efficient, because securities laws have to
legislate against insider dealing
Fundamental analysis
- Examination of publicly available information and formulation of forecasts
to estimate the intrinsic value of assets - Uses
- Company data, risk estimates, and economic data
- Importance in an efficient market
- Helps market participants understand the value implications of information
- Facilitates a semi-strong efficient market by disseminating value-relevant information
Technical analysis
- By detecting patterns, analysts assist in maintaining weak-form efficiency
Market Pricing Anomalies
Market anomaly
- If a change in the price of an asset or security cannot be directly linked to current relevant information or new information
- Evidence supporting existence of anomaly must be consistent over reasonably long periods
For example:
Time series:
January effect
Day-of-the-week effect
Weekend effect
Turn-of-the-month effect
Holiday effect
Time-of-day effect
Momentum
Overreaction
Cross-sectional:
Size effect
Value effect
Book-to-market ratios
P/E ratio effect
Value line enigma
Other
Closed-end fund discount
Earnings surprise
Initial public offerings
Distressed securities effect
Stock splits
Super Bowl
Anomaly
January effect
Observations
Excess returns recorded in January. Recent evidence suggests this is not persistent
Anomaly
Turn-of-the month effect
Observations
Returns tend to be higher on last trading day of the month and the first three trading days of the next month
Anomaly
Day-of-the-week effect
Observations
The average Monday return is negative and lower than the average returns for the other four days, which are all positive
Anomaly
Weekend effect
Observations
Returns on weekends tend to be lower than returns on weekdays
Anomaly
Holiday effect
Observations
Returns on stocks in the day prior to market holidays tend to be higher than other days
Cross-sectional anomalies
- Size effect
- Small cap companies outperform large cap on a risk-adjusted basis
- Value effect
- Outperformance by some low P/E, P/B and high dividend yield stocks
- Contradicts semi-strong form efficiency
Time-series anomalies
- Momentum and overreaction anomalies
- Relate to short-term price patterns
- Overreaction effect
- Investors overreact to release of unexpected public information
- Stock prices will be inflated for companies releasing good information
- Strategy
- Buy losers and sell winners
Other anomalies
- Closed-end investment fund discounts
- Shares should trade close to net asset value (NAV)
- Often trade at a discount to NAV
- Due to potential tax liabilities on gains if the fund is liquidated
- Liquidity issues
- Cannot be exploited as it is too expensive to buy all the shares and liquidate the fund
- Earnings surprise
- Slow price adjustments to unexpected earnings news
- IPOs
- Degree of underpricing
- Subsequent long-term performance of IPO stocks is below average
Market Pricing Anomalies
Implications for investment strategies
- Observed anomalies are generally a result of statistical methods used to detect
them - On average, markets are priced efficiently
Behavioral Finance
Definition
- Examines investor behavior and how it affects the financial markets
- Potentially helps to explain anomalies
- Focus on cognitive biases that affect decision-making
Loss aversion
- Most traditional models assume dislike for risk is symmetrical
- Behaviorists believe it is not symmetrical
- Investors dislike losses more than they like comparable gains
- Hold on to losers too long, sell winners too early
Herding
- Where investors trade on the same side of the market in the same securities
- Clustered trading that may or may not be based on information
- May result in under- or over-reaction to information
Overconfidence
- Investors place too much emphasis on their ability to process and interpret
information about a security - Mispricing will result
Information cascades
- Transmission of information from those participants who act first and whose decisions influence the decisions of others e.g. release of accounting information
- Those acting on the choice of others may be ignoring their own preferences in favor of imitating others
- May result in the serial correlation of stock returns which is consistent with overreaction anomalies
- However, others argue that information cascades are rational as they assist the
process or incorporation of information into prices and therefore facilitate market efficiency
Representativeness
- Assess probabilities of
outcomes depending on how
similar they are to current state
Conservatism
- Investors tend to be slow to
react to changes and maintain
their prior views
Mental accounting
- Investors keep track of gains
and losses in separate mental
accounts
Narrow framing
- Investors focus on issues in
isolation
Equity Securities in Global Financial Markets
Importance
Returns
- Examine the relationship between equity market capitalization and GDP
- Indicates whether markets are over or under-valued
- Global equity markets expanded at twice the rate of global GDP (1993-2004)
- Beginning of 2008, global GDP and equity market capitalization
was US$55 trillion - Implied ratio of 100%
- Twice long-run average of 50%
- Suggests the global equity markets were over-valued at the time
Returns
* Annualized real government bonds returns 1-2% (1900-2008)
* Annualized world average equity returns above 5% (1900-2008)
* 2000-2008 zero or negative real equity returns in most markets
Equity Securities in Global Financial Markets
Conclusion
- Return on securities directly related to risk level
- Equities riskier than bonds
- Equities earn higher levels of return
- Equities are more volatile
- Investors’ tolerance for risk will tend to differ across markets
- 2000-2008 equity ownership
- Lowest in South Korea (7.5%)
- Highest in Australia, Canada, and US (almost 50%)
- Relative decline in share ownership
Types and Characteristics of Equity Securities
Debt vs. equity
Types
Debt vs. equity
* Debt is a liability of company
- Contractually obliged to repay principal and pay interest
* Equity
- No contractual obligation to repay capital or make periodic
payments
- Residual claim on assets after liabilities have been paid
- Equity shareholders considered to be owners of the company
* Seeking total return
- Capital appreciation and dividend income
* Expect management to maximize shareholder wealth
Types
* Common shares/ordinary shares/common stock
* Preference shares/preferred stock
Types and Characteristics of Equity Securities
Common shares
Characteristics
Voting
Characteristics
* Represent ownership interest in a company
* Share in operating performance of the company
- Company may pay dividends
* Participate in governance process via voting rights
* Residual claim on net assets in event of a liquidation
Voting
* Statutory voting
- Each share represents one vote
* Cumulative voting (often used when appointing a board member)
- Allows shareholders to direct their voting rights to specific candidates
- Do not have to allocate votes evenly among candidates
- Benefits smaller investors
* Proxy voting
Types and Characteristics of Equity Securities
Callable common shares (aka redeemable common shares)
Putable common shares
Types and Characteristics of Equity Securities
Callable common shares (aka redeemable common shares)
* Gives the issuer right to buy back the shares at call price
- Specified when shares are issued
* Likely to redeem
- Current market price > Call price
Putable common shares
* Gives the investor right to sell shares back to issuing company
at put price
* Likely to sell
- Current market price < Put price
* Limits potential loss for investors
- Makes shares more attractive to investors
Types and Characteristics of Equity Securities
Preference shares
Characteristics
Dividend styles
Characteristics
* Rank above common shares
- Payment of dividend and repayment of capital in event of
a liquidation
* Receive a fixed dividend
- Not a contractual obligation of company
* No voting rights
* Can be callable and/or putable
Dividend styles
* Cumulative preference shares
* Non-cumulative preference shares
* Participating preference shares
- Additional dividend if profits exceed a specified level
- Additional distribution on liquidation
Types and Characteristics of Equity Securities
Convertible preference shares
- Preference shares can be converted into a fixed number of
common shares - Advantages
- Earn higher dividend than common shares
- Allow investors to share in profits of the company
- Allow investor to benefit from a rise in common share price
by converting - Price is less volatile than common shares
- Often used in venture capital and private equity transactions
Private vs. Public Equity Securities
Private equity securities
Private companies
Types
Private companies
* Issued primarily to institutional investors via non-public offerings
- Private placements
* No active secondary market
- Highly illiquid
* Valuation may be difficult due to a lack of information
Types
* Venture capital
- Provides capital to companies in early stage of development
- Exit normally takes between 3-10 years
- Exit via initial public offer (IPO) or sale
* Leveraged buyout (LBO)
- Group of investors use debt to purchase shares in a publicly
traded company
* Private investment in public equity (PIPE)
- Significant amount of shares sold to a private investor
Investing in Non-Domestic Equity Securities
Non-domestic equity securities
Barriers to investing globally
Non-domestic equity securities
Integration and growth of global markets
* Due to technological innovations and improved information exchange
* Easier and cheaper for companies to raise capital overseas
* Provides investors with access to overseas markets
- Provides diversification in their portfolio
Barriers to investing globally
* Foreign restrictions on overseas investors
* Reasons
- Limit control of domestic companies by overseas investors
- Give domestic investors opportunity to invest
- Reduce volatility of capital flows into/out of domestic markets
* Studies have shown that reducing restrictions leads to improved performance in
equity markets
Investing in Non-Domestic Equity Securities
Direct investing
- Buy and sell securities directly in foreign markets
- All transactions will be in domestic (i.e. foreign) currency
- Investors must be familiar with local trading, clearing, and settlement
procedures - Less transparency and more volatility
- Lack of audited financial information and less liquid markets
- Alternatives
- Depository receipts and global registered shares
Investing in Non-Domestic Equity Securities
Depository receipts
Definition
* Trades like an ordinary share on a local exchange
* Represents an economic interest in a foreign company
Issuer gives out shares in local currency to depositary bank
depository back pays back in local currency
foreign investor pays depository bank in diff currency
depository bank hands depository receipt in the diff currency ( holds shares, pays dividends, holds ownership deets)
Depository receipt
* Sponsored
- Company has a direct involvement in issuance of the receipts
- Investors have same rights as direct owners of shares
- Greater reporting requirements with regulatory authorities
* Unsponsored
- Underlying foreign company has no direct involvement
- Depository purchases shares in domestic market and issues
receipts
* Depository bank retains voting rights
Investing in Non-Domestic Equity Securities
Global depository receipts (GDRs)
- Issued outside company’s home country and outside US
- Not subject to foreign ownership and capital flow restrictions
- Traded on
- London, Luxembourg, Dubai, Singapore and Hong Kong
- Mostly traded in USD
American depository receipts (ADRs)
- US dollar-denominated security
- Trades like a common share on US exchanges
- Enables foreign companies to raise capital from US investors
- Type of GDR
American depository share (ADS)
- Trades in issuing company’s domestic market
Level I (Unlisted)
Objectives
Raising capital on US markets
SEC registration
Trading
Listing fees
Size/earnings requirements
> Develop and broaden US investor base with existing shares
No
Form F-6
OTC
Low
None
Level II (Listed)
Objectives
Raising capital on US markets
SEC registration
Trading
Listing fees
Size/earnings requirements
> Develop and broaden US investor base with existing shares
No
Form F-6
NYSE, NASDAQ, or AMEX
High
Yes
Level III (Listed)
Objectives
Raising capital on US markets
SEC registration
Trading
Listing fees
Size/earnings requirements
> Develop and broaden US investor base with existing shares/new shares
Yes, through public offerings
Forms F-1/ F-6
NYSE, NASDAQ, or AMEX
High
Yes
Rule 144A (Unlisted)
Objectives
Raising capital on US markets
SEC registration
Trading
Listing fees
Size/earnings requirements
> Access qualified institutional buyers (QIBs)
Yes, through private placements to QIBs
None
Private offerings, resales, trading platforms
Low
None
Investing in Non-Domestic Equity Securities
Global registered share (GRS)
- Common share traded on different exchanges in different currencies
- E.g. Sold on Swiss exchange in Swiss francs and in Japan in yen
- No currency conversion
- Shares represent actual ownership of the company
- More flexible than global depository receipts
Basket of listed depository receipt (BLDR)
- Exchange-trade fund (ETF) represents a portfolio of DRs
- Can be bought, sold and sold short
- Can be purchased on margin
- Designed to track performance of an underlying DR index
Risk and Return Characteristics of Equity Securities
Return characteristics
Source of equity return
- Capital gain on price
- Dividend income
- Foreign exchange gains/losses
- For investors that purchase depository receipts/foreign shares
Risk and Return Characteristics of Equity Securities
Risk of equity securities
Risk of a security
- Based on uncertainty of its future cash flow
- Equity
- Uncertainty of its expected (or future) total return
- Common measurement
- Standard deviation of equity’s expected return
Methods of estimating equity total return and risk - Average historical return and standard deviation as a proxy
- Estimate range of future returns with assigned probabilities
- Calculate expected return and standard deviation
Preference vs. common shares - Preference shares have lower risk and expected return
- Consider characteristics
- Putable less risky than callable
Equity Securities and Company Value
Book value and market value
Primary goal of a company
Management actions
Primary goal of a company
* Maximize shareholder wealth
- Increase book value
* Shareholder equity on balance sheet
- Increase market value
Management actions
* Directly affect book value of company
- Increase by retaining net income
* Indirectly affect market value
- Reflects expectations about amount, timing and uncertainty
of future cash flows
Equity Securities and Company Value
Accounting return on equity (ROE)
Purpose
* Determines whether management is effectively and efficiently using capital to generate profits
ROE = (Net Income / Average Book Value of Equity) = Net Income / (BVE_t + BVE_t-1) / 2
- Beginning year book value method
- Appropriate when BV is stable over time or calculating annually over a period of time
ROE_t = (Net Income_t / Book Value of Equity_t-1)
Equity Securities and Company Value
Increasing ROE
- Not necessarily always a positive sign
- Net income decreases at a slower rate than shareholders’ equity
- Company issues debt and uses proceeds to repurchase shares
- Increases leverage and makes equity riskier
- Use DuPont formula to analyze sources of change in ROE
Price-to-book ratio
- Market-to-book ratio
- Indication of investors’ expectations about a company’s future
investment and cash flow generating abilities - Bigger is better
- Higher growth prospects, larger ratio
- Not appropriate to compare ratios across different industries
Equity Securities and Company Value
Cost of equity and investors’ required rates of return
Cost of equity
- Return required by equity holders
- More difficult to estimate than cost of debt
- No contractual payments to shareholders
- Minimum required rate of return
- Based on future cash flows they expect to receive
- Different expectations for each investor
- Company’s cost of equity may be different to minimum required
rate of return - Cost of equity used as a proxy for minimum required
rate of return - Share price will adjust to maintain this rate of return
- Models used to estimate return
- Capital asset pricing model (CAPM)
- Dividend discount model (DDM)
Company and Industry Analysis Framework
* The process of forming and justifying a view of an issuer’s future financial results
and position involves company and industry analysis
- Company Analysis: Past and Present
- Industry and Competitive Analysis
- Company Analysis: Forecasting
Initial Company Research Report Elements
Front Matter
Issuer name, analysts’ recommendation (buy, hold, sell) and target buy or sell prices, disclosures, disclaimers, and other legally required information
Initial Company Research Report Elements
Recommendation
Analysts’ recommendation with justification
Initial Company Research Report Elements
Company Description
Discussion of issuer’s business model and strategy
Initial Company Research Report Elements
Industry Overview &
Competitive Positioning
Industry size, growth rate and key drivers, market share trends, profitability—historical and outlook, competitive analysis (Porter’s Five forces), external industry influences (“PESTLE” analysis)
Initial Company Research Report Elements
Financial Analysis and Model
Evaluation of key drivers of revenue, costs, profitability, cash flows, and the issuer’s uses and sources of capital. Historic and forecasted financial statements
Initial Company Research Report Elements
Valuation
Estimates of company and security values with target price
Initial Company Research Report Elements
ESG Considerations
Evaluation of ESG indicators and risks
Initial Company Research Report Elements
Risks
Evaluation of material downside and upside risks and discussion of how they are considered in the financial analysis and valuation
Initial Company Research Report Elements
Front Matter
Recommendation
Company Description
Industry Overview & Competitive Positioning
Financial Analysis and Model
Valuation
ESG Considerations
Risks
Subsequent company research reports
* Primary audience is those who are already familiar with the issuer or security and
require an update based on new information and analyses or a change in the
analyst’s recommendation
Front Matter
> Issuer name, analysts’ recommendation (buy, hold, sell) and target buy or sell prices, disclosures, disclaimers, and other legally required information
Recommendation
> Analysts’ recommendation, summary of changes to the recommendation and support explanations
Analysis of New Information
> Comparison of quarterly actual results with expected results, analysts’ interpretation of new information and changes to forecasts. Historical and updated forecasted financial statements
Valuation
> Estimates of company and security values. Discussion of changes from valuation in prior report
Risks
> Update of risk factors from prior report with discussion of changes
Determining the Business Model
Elements
- Discussion of the business model is usually in the first part of a company research report (“Company Description”)
- Describes a company’s operations and includes the following elements:
- Product(s) or service(s) the company sells
- Customers and key customer groups
- Sales channels, including customer acquisition and product/service delivery mechanisms
- How the product(s) or service(s) are priced and paid for
- Resource, supplier, and partner relationships need to operate effectively
Determining the Business Model
Information Sources
- Information sources used by analysts to identify the business model:
- Issuer sources (available freely if the company is public)
- Regulatory filings
- Earnings conference calls, press releases
- Public third-party sources
- Free industry white papers or analyst reports from a consultancy
- Economic or industry indicators from governments and other organizations
- Proprietary third-party sources
- Analyst reports and communications, including from “sell-side” analysts and credit rating agencies
- Reports and data from platforms such as Bloomberg
- Proprietary primary research
- Surveys, conversations, product comparisons, and other studies commissioned by the analyst or conducted directly
Revenue Analysis
Revenue Drivers
- After determining the business model the focus is then an analysis of historical financial results and position of the target company
- For most companies (arguably with the exception of banks, for which the balance sheet comes first) analysts start by analysing revenues
- Involves identifying drivers, which represent causative factors that explain the level of and changes revenues
- Two approaches often used together include:
- Bottom-up approach - decomposes revenues into drivers such as sales volume and price, or revenues by product line, segment, or geography, which may be further broken
down into other drivers - Top-down approach expresses revenues as a function of drivers such as market share, the addressable market or market size, and GDP growth.
Revenue Analysis
Pricing Power
- Refers to a company’s ability to set prices and other economic terms with customers without affecting its sales volumes
- In the most competitive markets, where firms are selling nearly identical products, firms are “price takers”
- Returns on capital over the long run approximate to the firms’ cost of capital as competition forces prices down to marginal cost
- A low-cost producer can earn long-run returns above its cost of capital in a highly competitive industry, however the low-cost position must be sustained against
competition over time - Highly competitive markets do not always start as highly competitive but become more competitive as new firms enter, the pace of innovation slows, and imitation becomes
widespread, a process known as commoditization - Firms operating in less competitive markets, such as monopolistic competition, oligopoly, or monopoly structures, tend to have some degree of pricing power
- Firms with pricing power often apply value- or cost-based pricing as well as price discrimination strategies
Operating Profitability and Working Capital Analysis
Classification of operating costs
- Operating costs are incurred in generating:
- Current period revenue; all costs related to the acquisition, production, sale, improvement, and delivery of goods and services
- Management of business activities; and
- Compliance with laws and regulations
- Operating costs can be categorised and analyzed in three ways:
1. Behavior with output - Fixed vs. variable
2. Nature - Raw materials, wages, office supplies
3. Function - Cost of goods sold, General and administrative, research and development
Operating Profitability and Working Capital Analysis
Behavior with Output: Fixed and Variable Costs
- Using a fixed/variable operating cost classification, operating profit can be defined as:
Operating profit = [Q×(P−VC)]− FC
- Where:
Q = units of outputs sold in a period
P = price per unit of output
VC = variable operating costs expressed per unit of output
FC = fixed operating costs, which do not change within a given range of output in the short run - For a firm to be profitable
- The contribution margin (P
− VC) must be positive and that Q must be high enough such
that FC is exceeded - The amount of fixed costs in the operating cost structure of an issuer is referred to as operating leverage and that it presents both benefits and risks
- Operating leverage can be measured and compared across firms by using the degree of operating leverage (DOL)
% change in operating income / % change in units sold
A firm can increase its degree of operating leverage by increasing the fixed costs and decreasing the variable costs in its cost base.
Operating Profitability and Working Capital Analysis
Natural and Functional Operating Cost Classifications
- Operating leverage can be measured and compared across firms by using the degree of operating leverage (DOL)
- Rather than fixed and variable, IFRS and US GAAP require issuers to disclose operating costs using either a natural or a functional cost classification
- This is based on “historical and industry factors and the nature of the entity”
- Most issuers choose a functional classification:
- Cost of sales and are predominantly variable
- Selling, general, and administrative expenses (S,G&A) and are predominantly fixed
- Research and development (R&D) and are predominantly fixed
Gross Profit = Revenue – Cost of sales
EBITDA = Revenue – Cost of sales – S,G&A – R&D
EBIT = Revenue – Cost of sales – S,G&A – R&D – Depreciation and Amortisation
Operating Profitability and Working Capital Analysis
Economies of scale and scope
- Economies of scale – refer to decline in costs per unit as output grows
- Generally created from having fixed costs in the cost structure that are spread over more units of output
- Companies with entirely variable costs can also exhibit some economies of scale over time if it increases its bargaining power over suppliers as it grows, driving down variable
costs per unit - Economies of scope - refer to a decline in costs per unit as the number of product or business lines increases
- Generally result from shared costs between the product lines
- Economies of scope have resulted in large global firms competing in many lines of business
Operating Profitability and Working Capital Analysis
Working capital
- Primary measures of a company’s working capital management include:
- Activity ratios that determine its cash conversion cycle and the ratio of net working capital to sales
Cash conversion cycle = DOH + DSO −Payable days
- Inventory processing (days of inventory on hand (DOH)), payables payment and receivables collection (days of sales outstanding (DSO)) is a company’s cash conversion cycle
- A short cash conversion cycle means that the company requires less external financing to fund operations
- Net working capital requirements determine a minimum level of investment, in addition to capital investments, that cannot be distributed to investors.
- Negative net working capital means that suppliers are a source of financing
Capital Investments and Capital Structure
Sources and Uses of Capital
- Firms invest capital from debt and equity investors to hopefully earn returns above their investors’ required rates of return i.e. whether economic value is created for
investors - Therefore, it is an important consideration in company analysis
Sources of Capital:
CFO, including net working capital (if negative)
Debt issuance
Equity issuance
Asset disposals
Uses of capital:
Cash and investments on hand
Net working capital (if positive)
Acquisitions
Capital expenditures and additions to intangibles
Debt paydown
Dividends and share repurchases
Capital Investments and Capital Structure
Evaluating Capital Investments and Capital Structure
- Risks related to the capital structure can be measured using leverage and
coverage ratios, credit ratings by third-party rating agencies, - Analysts can also analyse the degree of financial leverage (DFL):
% change in net income / % change in operating income
- The degree of financial leverage is increased by higher interest expenses that are fixed with respect to operating income
Uses of Industry Analysis
Why analyze an industry?
- Improve Forecasts
- Competitive forces from industry incumbents, substitutes, suppliers, and customers
discipline companies’ prices and costs, market share, and thus profitability - If analysts better understand these drivers they can sharpen their forecasts on what is
important - Identify Investment Opportunities
- Industry analysis can uncover attractive investment targets that an analyst was
previously unaware of until assessing its strengths and weaknesses relative to industry
peers and competitors - Also, some investors may want exposure to industry, not company specific factors
Industry and Competitive Analysis Steps
Overview
- Define Industry
* e.g. Third-party classification schemes - Industry Survey
* Size, growth rate and character, profitability, market share trends - Industry Structure
* Porter’s Five Forces analysis - External Influences
* PESTLE analysis - Competitiveness Analysis
* Evaluate competitive strategy of firm in context of its industry and determine competitive advantage
Industry and Competitive Analysis Steps
1. Industry classification
- An industry is commonly defined as companies that sell similar products or
services, from the perspective of a customer - Third-party industry classification schemes include:
- Global Industry Classification Standard (GICS) by MSCI and S&P Dow Jones Indices
- 11 Sectors, 25 Industry Groups, 74 Industries, 163 Sub-Industries
- Industry Classification Benchmark (ICB) by FTSE Russell
- 11 Industries, 20 Super-sectors, 45 Sectors,, 173 Sub-sectors
- The Refinitiv Business Classification (TRBC) by Refinitiv
- 14 Economic Sectors, 33 Business Sectors, 62 Industry Groups, 154 Industries, 898 Activities
- As well as public companies it also covers private companies, non-profits, and government
entities. - While each scheme differs slightly the goal is to assign a company to a single
grouping that describes the majority of its business
Industry and Competitive Analysis Steps
Limitations of third-party industry classification schemes
- Groupings of companies with business model variations or that sell substitute
products - The classification of multi-product companies
- Geographical considerations
- Classification schemes are less useful for more service-oriented companies that
compete nationally or even locally because of customer behavior or regulations that
restrict competition - Changes in groupings over time that affect prior-period comparability of industry
statistics
Industry and Competitive Analysis Steps
Alternative methods of grouping companies
- Geography
- Companies are classified by country and then countries are aggregated into categories
such as developed, emerging, and frontier markets - Classification by country is typically by the country where the issuer is incorporated, the
country of the primary listing of its equity securities, the location of its headquarters, or
market perception. - Classification by the geographic composition of revenue is generally not the approach
taken, though this aspect may be the foremost concern for an analyst. - Sensitivity to the business cycle
- Groupings such as “defensive” and “cyclical.”
- Defensive companies are those whose sales growth, profitability, and valuations are less
affected by changes in broad macroeconomic activity (e.g., GDP growth), while the
opposite is true of cyclicals. - Defensive: Consumer staples, healthcare, and utilities
- Cyclical: Financials, basic materials, consumer discretionary, and industrials are
considered cyclical - Statistical similarities, or the use of clustering analysis
- group companies based on similarities of financial ratios and market data or comovements of their securities’ investment returns e.g. grouping by market capitalization
- ESG characteristics
- For example, using the ratio of carbon emissions to revenues, measures of board and
executive personnel diversity - The ESG metrics can be aggregated into composite ESG ratings or scores that enable
cross-issuer comparability
Industry and Competitive Analysis Steps
2. Industry survey
- The next step in industry and competitive analysis is to survey the industry by
estimating factors such as: - Industry size and growth rate
- Size is typically measured by total annual sales from the product or customer perspective
- Growth rate is calculated either as year-over-year rates each year or as a compounded annual growth rate (CAGR) over a multi-year period.
- Characterising industry growth
- The pattern of historical growth of an industry can be used to characterise it based on the magnitude of its growth rate and sensitivity to the business cycle
- One approach is to use a Style Box:
Defensive Mature: Utilities, Beverages,
Pharmaceuticals
Defensive Growth: Biotech, Software, Gaming
Cyclical Mature: Crude oil, Natural gas,
Freight transportation
Cyclical Growth: Fintech, Semi-conductors,
Digital advertising
- Industry profitability measures
- Best measure of industry profitability is a time series of the distribution of Returns on Invested Capital (ROIC) this captures after-tax operating profits for each dollar of invested capital
- Market share trends and major players
- Market shares can be measured by expressing industry participants’ annual revenues as percentages of the industry size each year, and also the analysing the trend over time
- Degree of industry concentration:
Herfindahl−Hirschman Index (HHI) = Sum (s^2_i) - Where s is the market share of market participant i stated as a whole number (i.e., 40% share = 40, not 0.40)
- The maximum HHI is for a monopoly, with a value of 100^2 = 10,000
- HHI between 1,500 and 2,500 moderately concentrated
- HHI over 2,500 highly concentrated
- A rule of thumb is that acquisitions in highly concentrated markets that increase the HHI by
more than 200 points are often subject to regulatory challenges
Industry and Competitive Analysis Steps
3. Industry structure
- Porter’s Five Forces
- A framework for assessing industry structure that determines an industry’s long-run
profitability measure by its returns on invested capital
-Threat of substitutes
* Is there another product or service that fulfills the same or similar customer need? Is it lower priced?
* Is the substitute product improving in performance relative to the industry’s product?
- Threat of new entrants
- Have there been significant numbers of new industry entrants in recent history?
- Do incumbents benefit from economies of scale from significant fixed costs in the cost structure?
-Bargaining power of customers
* Are there few, concentrated customers for the industry?
* Are the industry’s products standardized or undifferentiated?
-Bargaining power of suppliers
* Is there a history of price competition among competitors?
- Rivalry among existing competitors
Industry and Competitive Analysis Steps
4. External influences on industry growth
- It is important for analysts to look outside the industry for factors that influence the industry’s economic outcomes.
- A framework to achieve this is PESTLE analysis which is more concerned with
an industry’s growth rate and market share dynamics:
Political:
Include changing fiscal and monetary policies,
governments’ direct selling and purchasing
activities, regulatory changes, and geopolitical conditions and actions.
Often significant for Energy, Healthcare
and Defense.
Economic:
Include changes in GDP or personal income, inflation, interest rates, and exchange rates. Can be related to the business cycle (cyclical) or structural.
Most important for cyclical sectors such as financials, basic materials, and consumer
discretionary and auto industry.
Social:
Include cultural and consumer trends,
demographic changes and changes in lifestyles.
Technological:
Technological changes can create new or improved products or render existing
products obsolete, radically changing industries and companies.
Sustaining innovations are improvements in
product or service performance and the
addition of marginal features, but without a
fundamental change in functionality or operation.
Disruptive innovation is most likely to come from new entrants, because they do not have an existing profitable business to protect.
Legal:
Include changes in laws and regulations from courts and policymakers that alter an industry’s business practices or economic outcomes.
Environmental:
Often closely associated with legal
influences
Include risks and opportunities related
to the transition to a lower-carbon economy, laws and practices concerning waste and land use, and environmental protections
Industry and Competitive Analysis Steps
- Competitive Positioning
* Competitive strategies that have worked in a variety of industries include:
- Cost leadership
* Economies of scale from fixed costs
* Favorable access to raw materials
* Culture of strict cost control
* Aggressive pricing to gain high volume
* Low-cost distribution
* Economies of scope
- Differentiation
* Investments in advertising, brand, customer service, proprietary distribution channels
* Protection using trademarks, copyright, patents
* Superior quality, unique features
* Culture of strong customer experience
* Premium pricing
* Integration of services, software, and hardware
- Focus
* Proximity to customers and strong understanding of their needs
* May incorporate elements of strategy from both cost leadership and differentiation, but focused on particular group
Forecast Objects, Principles, and Approaches
What to forecast?
- Analysts focus on different forecast objects related to issuers’ financial statements:
- Drivers of financial statement lines
- Forecasting drivers rather than financial statement lines outright has the benefit of improved
explanatory value and may improve accuracy - A financial statement line item can have multiple drivers moving in different directions, which might
be difficult to forecast on an aggregated basis - Individual financial statement lines
- Rather than drivers, analysts can also directly forecast individual financial statement lines
- Often used for lines without clear drivers, for less-material items, and for items that the analyst does not have a perspective on
- Summary measures
- E.g. free cash flow, earnings per share, and total assets
- The benefit of using these as forecast objects is efficiency
- However, the disadvantage is less transparency, making it difficult to audit the forecast. This approach is most appropriate if the summary measure is stable and predictable, or if issuer
disclosures are severely limited - Ad hoc objects
- Which may not yet be reported on historical financial statements e.g. an company announcing a material legal proceeding, government regulatory action, a tax dispute, or a natural disaster
Forecast Objects, Principles, and Approaches
Forecast approaches
- For any object, there are four general forecast approaches which, in practice, are
often combined:
1. Historical Results: Assume Past is Precedent - Uses past observed or calculated values (such as a historical median) as a forecast
- Easiest approach and the default
- May be appropriate for companies operating in industries where the analyst does not expect the industry structure (e.g., Porter’s Five Forces, PESTLE influences) to change, and also for
companies that have a low sensitivity to changes in the business cycle - Also commonly used for forecast objects that are not material or that the analyst does not hold an opinion on
2. Historical Base Rates and Convergence - Uses an industry or peer group average or median, computed over a long period of time, as a “base rate” for forecasting that an object will converge to over some time frame e.g. GDP growth
- Used for companies in well-established industries with many publicly traded peers, such as banks, airlines, restaurants, automakers, and retailers, especially when the analyst’s industry analysis does not call for material changes in industry structure or external industry influences
- Also logical for smaller companies that are “maturing into” a financial profile similar to that of larger peers with scale
3. Management guidance - Public companies may publicly provide targets for earnings, revenues, and other measures (e.g.,
capital expenditures) for the next quarter, year, or longer term, known as management guidance - A key focus of investors is understanding management’s assumptions embedded in guidance and
questioning their plausibility - Appropriate when it is provided and when management has shown a track record of reliable
estimates - Caution against its use for companies that are highly sensitive to the business cycle, given the
management does not have an informational advantage over investors at forecasting
macroeconomic variables like GDP or the prices of commodities
4. Analyst’s discretionary forecast - All other forecast approaches are grouped together and identified as analysts’ discretionary forecasts e.g. those based on surveys, quantitative models, probability distributions
- Most common for companies in cyclical industries, companies that have no or few comparables, those not providing management guidance, and/or those undergoing a fundamental change like a
shift in the competitive or regulatory environment
Forecast Objects, Principles, and Approaches
Selecting a forecast horizon
- The choice of the forecast time horizon is determined by the:
- Investment strategy for which the security is being considered
- E.g. long-term-oriented fund managers may direct their forecasting primarily on a time period of three to five years. On the other hand, shorter-term-oriented managers may focus more on the next one or two quarters
- Cyclicality of the industry
- Forecast period should be long enough to allow the business to reach an expected mid-cycle level of sales and profitability
- Company-specific factors
- Recent acquisition or restructuring activity could influence the selection of the forecast period in order to allow enough time for the realisation of the expected benefits to be realised and reflected in the financial statements
- Analyst’s employer’s preferences
- There might be no individual analyst choice in the sense that the analyst’s employer has specified fixed parameters
Forecasting Revenues
Forecast objects for revenues
- Forecast objects for revenues are typically either:
- Top-down
- Growth relative to GDP growth
- First an analyst forecasts the growth rate of nominal GDP. They then consider how the growth rate of the target company will compare with nominal GDP growth
- E.g. an analyst may conclude that a company’s revenue will grow at a rate of 150 bps above the nominal GDP growth rate
- Market growth and market share
- The analyst first forecasts a growth rate for a company’s product market, and then considers the company’s current market share and how that share is likely to change over time
- Bottom-up drivers
- Volumes and average selling prices
- Forecasts for volumes and prices of the company’s products are prepared individually and multiplied to arrive at a revenue forecast
- Product-line or segment revenues
- Forecasts for individual products, product or business lines, geographic areas, or reporting
segments are made and then aggregated into a total revenue forecast - Capacity-based measures
- Return- or yield-based measures
- E.g. net interest income for a bank
Forecasting Operating Expenses and Working Capital
Cost of sales (Cost of Goods Sold (COGS)) and gross margins
- Issuers’ disclosures about operating costs are typically less detailed than revenue
disclosures - Analysts are often forced to use more aggregated forecast objects such as
consolidated financial statement lines (e.g., cost of sales, SG&A) or summary measures like EBITDA margins on a consolidated or segment basis. - Given COGS it has a direct link with sales, forecasting this item as a percentage of
sales (or as a gross margin) is a sound approach - If a company is losing market share to new substitute products with lower prices,
gross margins are likely to decline - COGS is typically a large cost, so even a small change in a gross margin forecast can have a material impact on forecasts of operating profit and free cash flow
- Analysts should incorporate a company’s hedging strategy into a forecast
Forecasting Operating Expenses and Working Capital
SG&A expenses
Working capital forecasts
- SG&A expenses are often more indirect costs i.e. have a less direct relationship
with revenues - Working capital forecasts are typically made by using efficiency ratios (such as the
cash conversion cycle seen in earlier modules) as the forecast object to project
accounts receivable, inventories, accounts payable, and other current assets and
liabilities
Forecasting Capital Investments and Capital Structure
Capital Investments
- Projections for long-term assets are based on cash flow statement and income statement projections because net PP&E on the balance sheet primarily increase due to capital expenditures and decrease due to depreciation
- Capital expenditures can be broken down into:
- Maintenance capital expenditures
- Necessary to sustain the current business
- Forecasts are often based on historical depreciation and amortization expenses with a small adjustment upward to account for inflation
- Growth capital expenditures
- Required to expand the business
- Forecasts are more discretionary and are tied to management’s expansion plans and revenue
growth
Forecasting Capital Investments and Capital Structure
Capital structure
- Leverage ratios (debt-to-capital, debt-to-equity, and debt-to-EBITDA) are often
used as the forecast object to then project future debt and equity levels - When projecting the future capital structure analysts should consider:
- Historical company practice
- Management’s financial strategy, and
- Capital requirements implied by the capital expenditure assumptions
Forecasting Capital Investments and Capital Structure
Scenario Analysis
- The final step in forecasting involves incorporating the possibility of different
outcomes based on key risk factors as well as judging their likelihood of occurrence - Generic risk factors that affect all companies:
- Changes in the business cycle
- Competition
- Inflation and deflation, and
- Technological developments
- Rather than develop single point estimate forecasts, analysts make several forecast
scenarios that vary based on different outcomes with respect to key risk factors
Major Categories of Equity Valuation Models
Present value models
* Discounted cash flow models
* Intrinsic value of a security
* Present value of future benefits received
* Dividend discount models
* Free-cash-flow-to-equity models
Multiplier models
* Market multiple models
− Price to earnings, price to sales
− Enterprise value (EV) multiples
Asset-based valuation models
* Value of a business is equal to the value of a
business’s assets
* Intrinsic value (IV) of a security
Assets - Liabilities - Preferred shares = IV of common share
Stock Dividend (Bonus Issue)
- Shareholder receives additional shares
instead of cash - Divides the market value of shareholder’s
equity into smaller pieces - Value of the company and shareholder’s
proportional ownership is not affected - share price of the company is reduced by a stock dividend because the number of shares in the company increases without a change in the value of the company.
- market capitalisation does not change because the fall in the share price is offset by the increase in the numbers of shares
Stock Split
- Increase in the number of shares
outstanding and decrease in share
price - No economic effect on the company or
shareholders
Share repurchase (buyback)
- Company uses cash to buy back shares
- Shares repurchased are not considered for dividends, voting or for the computation of EPS
- Viewed as equivalent to the payment of a cash dividend in term’s of shareholder’s
wealth - Key reasons for engaging in a share repurchase:
- Signaling a belief that their shares are undervalued
- Flexibility in the amount and timing of distributing cash to shareholders
- Tax efficiency where tax rates on dividends exceed those of capital gains
- Ability to absorb increases in shares outstanding due to the exercise of stock options
Dividends Payment chronology
- Declaration date
- Company makes a statement regarding payment of dividend
- Ex-dividend date
- Normally one or two business days before holder-of-record date
- First day shares trade without the dividend
- Share price reduces by the foregone dividend
- Holder-of-record date
- Shareholders listed on the company’s books on this date will receive the upcoming
dividend
Present Value Models: The Dividend Discount Model
Perpetuity formula
- Non-callable, non-convertible perpetual preferred share
Value = Div0 / r
- Callable/putable preferred shares value
- Non-callable > Callable
- Non-putable < Putable
Present Value Models: The Dividend Discount Model
Assumptions
Alternatives to using the Gordon model
- Dividends are correct metric for valuation purposes
- Dividend growth rate is perpetual and never changes
- Required rate of return is constant over time
- Dividend growth rate < Required rate of return
Alternatives to using the Gordon model
* Use a more robust DDM that allows for varying growth patterns
* Use a cash flow measure instead of dividends
* Use another approach, such as a multiplier method
Multistage dividend discount model
- Often used to model rapidly growing companies
- Two-stage DDM
- Initial high growth period
- Assumes company will begin to pay dividends that grow
at a constant rate - Method
Step 1 Calculate dividend cash flows
Step 2 Calculate present value of dividends received in high-growth years
Step 3 Use Gordon Growth Model to calculate value once there is constant growth
Step 4 Add Step 2 and Step 3 together
> The Gordon Growth Model calculates value for prior year. Remember to calculate present value
Relationship among price multiples, present value models and fundamentals
* The justified (P/E) using Gordon Growth Model
Dividend t = Div payout ratio x EPSt = p x EPSt
Divide both sides by EPS
P0 / E1 = p / (r-g)
Multiplier Models
P/E relationships
Changes in assumptions
P/E relationships
* Inversely related to required rate of return
* Positively related to growth rate
* Relationship with payout ratio
- Not necessarily positive
- Higher payout ratio may result in lower growth rate
* Dividend displacement of earnings
Changes in assumptions
* Justified P/E can be sensitive to changes in assumptions
- Analyst should perform sensitivity analysis
Multiplier Models
Method of comparables
Multiplier Models
Method of comparables
* Most widely used approach for analyst relative valuations
* Uses a price multiple to evaluate if asset is fairly priced, relative
to a benchmark multiple
* Benchmark multiple
- Closely matched individual stock
* Many companies operate in several lines of business
* Analyst needs to identify similar companies according to a number of dimensions
* E.g. overall size, product lines and growth rate
- Average/median value, industry value
Advantages
* Allows for relative comparison on a cross-sectional and time-series basis
Disadvantages
* Stock may be overvalued when using other intrinsic valuation methods
* Accounting differences may result in differences in multiples
Multiplier Models
Enterprise value (EV)
Definition and uses
Market capitalisation + Market values of preferred stock + Market value of debt
- Cash and investments
- Often viewed as the cost of a takeover
- Most useful when comparing companies with significantly different capital structures
- Widely used in Europe
- Multiples
- EV/EBITDA
- EBITDA used as proxy for operating cash flow (excludes depreciation and amortisation)
- EBITDA is a source of funds to pay interest, dividends and taxes
- EBITDA is calculated prior to payment to any of the company’s financial stakeholders; using it to estimate enterprise value is therefore appropriate
- EBITDA is usually positive and useful for loss-making companies where P/E is inappropriate
Asset-Based Valuation
Definition and uses
- Method uses estimates of market or fair value of the company’s assets and liabilities
- Appropriateness
- Companies that do not have a high proportion of intangible or ‘off the books’ assets
- Companies that have a high proportion of current assets and current liabilities
- Uses
- Used with multiplier models to value private companies
- Conclusions
- Fair values may be very different from book values
- Can provide a ‘floor’ value where there are significant intangibles
- Forward-looking cash flow valuation may be more appropriate
- More difficult to estimate asset values in a hyper-inflationary economy
There are four sources of availability bias which an investor is most likely to experience.
Retrievability; Categorization; Narrow range of experience; Resonance.
Which version of the dividend discount model (DDM) would most likely be appropriate for valuing a fairly young, publicly traded company
three stages: (1) growth, (2) transition, and (3) maturity. This assumption supports the use of a three-stage DDM.
dates in the dividend chronology can fall on a weekend
The payment date can occur on a weekend or holiday unlike other pertinent dates, such as the ex-date and record date, which occur only on business days.
source of capital
net working capital was negative then it would be a source, however a positive net working capital means that a company’s resources (capital) will be used to support a level of current assets higher than current liabilities
