Equity

Question 1

The main functions of the financial system are to facilitate:

Answer 1

1. The achievement of the purposes for which people use the financial system
2. The allocation of capital to the best uses
3. The discovery of the rates of return that equate aggregate savings with aggregate borrowings

Question 2

Currencies that national central banks and other monetary authorities hold in significant quantities are described

Answer 2

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

Question 3

Traditional investments include

Answer 3

Publicly traded debts and equities and shares in pooled investment vehicles that hold debt and/or equities.

Question 4

Alternative investments include:

Answer 4

edge funds, real estate securities and properties, private equity (including venture capital), precious gems.

Question 5

An ATS will not exercise

Answer 5

> 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.

Question 6

Iceberg or hidden orders are most likely to be used

Answer 6

for large orders that are likely to move the market price if revealed to the market

Question 7

All-or-nothing orders are most likely to be used

Answer 7

where the settlement costs depend on the number of trades made to fill an order

Question 8

Sell-side traders prefer …. markets

Answer 8

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

Question 9

a market is PRE-trade transparent

Answer 9

if the market publishes real-time data about quotes and orders.

Question 10

The objectives of market regulations are

Answer 10

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

Question 11

stock market index

Answer 11

A generally reliable indicator which leads the economy as a whole

Question 12

value of an index

Answer 12

is calculated using either actual or estimated market prices of individual securities

Question 13

Types of equity indices include

Answer 13

broad market, multi-market, sector and style indices

Question 14

Hedge fund indices tend to display

Answer 14

upward bias because of the problems associated with voluntary reporting such as survivorship bias.

Question 15

In a PIPE transaction,

Answer 15

a public company raises additional capital quickly by selling a sizeable ownership stake to a private investor or investor group.

Question 16

An LBO (leveraged buyout) occurs when

Answer 16

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

Question 17

Venture capital investments provide

Answer 17

seed capital to fledgling companies with the ultimate aim of an initial public offering providing a substantial return on investment

Question 18

Level III ADRs

Answer 18

trade on NYSE, NASDAQ and AMEX, and provide the ability to raise capital in the USA.

Question 19

Level I ADRs

Answer 19

trade over-the-counter but do not provide the ability to raise capital in the USA.

Question 20

common to all research reports

Answer 20

Analyst’s investment recommendation and target buy or sell prices
Risks such as evaluation of material downside and upside risks

Question 21

common to initial research reports

Answer 21

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

Question 22

Economies of scope

Answer 22

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

Question 23

The Functions of the Financial System
Uses of financial system
Main functions

Answer 23

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)

Question 24

Saving

Answer 24

• 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

Question 25

Borrowing

Answer 25

* 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

Question 26

Raising equity capital

Answer 26

* 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

Question 27

Managing risks

Answer 27

* 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

Question 28

Exchanging assets for immediate delivery

Answer 28

* Spot market trading * E.g. individuals, companies and governments trading currency

Question 29

Information motivated trading

Answer 29

* 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

Question 30

Determining rates of return

Answer 30

* 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

Question 31

Capital allocation efficiency

Answer 31

* 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

Question 32

Classification of assets and markets Classification

Answer 32

* 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

Question 33

Assets and Contracts Securities

Answer 33

* 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

Question 34

Assets and Contracts Markets

Answer 34

* 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

Question 35

Traditional investment markets vs. alternative investment markets

Answer 35

* 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

Question 36

Financial Intermediaries Brokers and exchanges

Answer 36

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

Question 37

Financial Intermediaries Alternative trading systems (ATSs)

Answer 37

* 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

Question 38

Financial Intermediaries Dealers Broker dealers

Answer 38

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

Question 39

Financial Intermediaries Securitizers (incr. liquidity and predictability)

Answer 39

* 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

Question 40

Financial Intermediaries Depository institutions

Answer 40

* Commercial banks, savings and loan banks, credit unions * Raise funds from depositors and lend it to borrowers

Question 41

Other financial corporations providing credit services

Answer 41

* 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

Question 42

Insurance companies

Answer 42

* 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

Question 43

Arbitrageurs

Answer 43

* 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

Question 44

Settlement and custodial services

Answer 44

* 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

Question 45

Type of option Option position Exposure to underlying risk

Answer 45

Call Long Long Call Short Short Put Long Short Put Short Long

Question 46

Positions Levered positions

Answer 46

* 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

Question 47

Positions Financial leverage Leverage ratio

Answer 47

* 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 %

Question 48

Maintenance margin requirement

Answer 48

* 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

Question 49

Orders Execution instructions

Answer 49

* 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

Question 50

Orders Execution instructions Exposure instructions

Answer 50

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

Question 51

Orders Validity instructions

Answer 51

* 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

Question 52

Orders Stop orders

Answer 52

* 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

Question 53

Orders Clearing instructions

Answer 53

* 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

Question 54

Primary Security Markets Primary market Secondary market

Answer 54

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

Question 55

Primary Security Markets Public offerings

Answer 55

* 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

Question 56

Primary Security Markets Public offerings Private placements and other primary market transactions

Answer 56

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)

Question 57

Primary Security Markets

Answer 57

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

Question 58

Secondary Security Market and Contract Market Structures Trading sessions Execution mechanisms

Answer 58

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)

Question 59

Secondary Security Market and Contract Market Structures Order-driven markets Order matching rules

Answer 59

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

Question 60

Secondary Security Market and Contract Market Structures Trade pricing rules

Answer 60

* 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

Question 61

Secondary Security Market and Contract Market Structures Market information systems

Answer 61

* 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

Question 62

Well-Functioning Financial Systems Definition Complete markets Operationally efficient

Answer 62

* 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

Question 63

Market Regulation Regulators

Answer 63

* 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

Question 64

Security market index

Answer 64

* 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

Question 65

Value of price return index

Answer 65

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

Question 66

The price return of the index portfolio

Answer 66

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

Question 67

Weighted average of the price movements of the individual securities

Answer 67

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

Question 68

Value of total return index

Answer 68

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

Question 69

weighted average of total returns of the constituent securities

Answer 69

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

Question 70

Calculation of index values over multiple time periods * Geometrically link returns

Answer 70

VTRIT = V_TRI0*(1+TRI1)*(1+TRI2)...(1+TRIT) VPRIT = V_PRI0*(1+PRI1)*(1+PRI2)...(1+PRIT)

Question 71

Index Construction and Management Index providers decide

Answer 71

* 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

Question 72

Index Construction and Management Index weighting Method

Answer 72

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)

Question 73

Price weighting * Simple method

Answer 73

Σ stock prices / Divisor adjusted for stock splits * Biased towards the performance of higher priced stocks * Results in arbitrary weights for each security

Question 74

Equal weighting * Simple method

Answer 74

Weighting of each security = 1/ # number of securities * Large companies will be underrepresented and small companies overrepresented * Frequent rebalancing required to maintain equal weights

Question 75

Market-capitalization weighting * Value weighting

Answer 75

(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)

Question 76

Fundamental weighting

Answer 76

* 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.

Question 77

Rebalancing

Answer 77

* 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

Question 78

Reconstitution

Answer 78

* 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

Question 79

Uses of Market Indexes Major uses

Answer 79

* 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

Question 80

Equity Indexes Types

Answer 80

* 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

Question 81

Equity Indexes Sector indexes

Answer 81

* 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

Question 82

Equity Indexes Style indexes

Answer 82

* 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

Question 83

Fixed Income Indexes Construction

Answer 83

* 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

Question 84

Fixed Income Indexes Classification Categories of index

Answer 84

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

Question 85

Indexes for Alternative Investments Commodity indexes Construction and implications

Answer 85

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

Question 86

Real estate investment trust indexes (REIT) Construction

Answer 86

* 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

Question 87

Hedge fund indexes Construction

Answer 87

* 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

Question 88

The Concept of Market Efficiency Description of efficient markets

Answer 88

* 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

Question 89

The Concept of Market Efficiency Market value vs. intrinsic value

Answer 89

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

Question 90

The Concept of Market Efficiency

Answer 90

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

Question 91

The Concept of Market Efficiency Transaction and information acquisition costs

Answer 91

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

Question 92

abnormal returns

Answer 92

* If investors can earn abnormal returns market is not efficient - Abnormal return = Actual return less expected return

Question 93

Forms of Market Efficiency

Answer 93

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

Question 94

Semi-strong form efficient market

Answer 94

* 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

Question 95

Strong-form efficient market

Answer 95

* 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

Question 96

Implications of EMH

Answer 96

* 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

Question 97

Fundamental analysis

Answer 97

* 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

Question 98

Technical analysis

Answer 98

* By detecting patterns, analysts assist in maintaining weak-form efficiency

Question 99

Market Pricing Anomalies Market anomaly

Answer 99

* 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

Question 100

Anomaly January effect

Answer 100

Observations Excess returns recorded in January. Recent evidence suggests this is not persistent

Question 101

Anomaly Turn-of-the month effect

Answer 101

Observations Returns tend to be higher on last trading day of the month and the first three trading days of the next month

Question 102

Anomaly Day-of-the-week effect

Answer 102

Observations The average Monday return is negative and lower than the average returns for the other four days, which are all positive

Question 103

Anomaly Weekend effect

Answer 103

Observations Returns on weekends tend to be lower than returns on weekdays

Question 104

Anomaly Holiday effect

Answer 104

Observations Returns on stocks in the day prior to market holidays tend to be higher than other days

Question 105

Cross-sectional anomalies

Answer 105

* 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

Question 105

Time-series anomalies

Answer 105

* 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

Question 106

Other anomalies

Answer 106

* 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

Question 107

Market Pricing Anomalies Implications for investment strategies

Answer 107

* Observed anomalies are generally a result of statistical methods used to detect them * On average, markets are priced efficiently

Question 108

Behavioral Finance Definition

Answer 108

* Examines investor behavior and how it affects the financial markets * Potentially helps to explain anomalies * Focus on cognitive biases that affect decision-making

Question 109

Loss aversion

Answer 109

* 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

Question 110

Herding

Answer 110

* 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

Question 111

Overconfidence

Answer 111

* Investors place too much emphasis on their ability to process and interpret information about a security * Mispricing will result

Question 112

Information cascades

Answer 112

* 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

Question 113

Representativeness

Answer 113

* Assess probabilities of outcomes depending on how similar they are to current state

Question 114

Conservatism

Answer 114

* Investors tend to be slow to react to changes and maintain their prior views

Question 115

Mental accounting

Answer 115

* Investors keep track of gains and losses in separate mental accounts

Question 116

Narrow framing

Answer 116

* Investors focus on issues in isolation

Question 117

Equity Securities in Global Financial Markets Importance Returns

Answer 117

* 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

Question 118

Equity Securities in Global Financial Markets Conclusion

Answer 118

* 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

Question 119

Types and Characteristics of Equity Securities Debt vs. equity Types

Answer 119

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

Question 120

Types and Characteristics of Equity Securities Common shares Characteristics Voting

Answer 120

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

Question 121

Types and Characteristics of Equity Securities Callable common shares (aka redeemable common shares) Putable common shares

Answer 121

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

Question 122

Types and Characteristics of Equity Securities Preference shares Characteristics Dividend styles

Answer 122

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

Question 123

Types and Characteristics of Equity Securities Convertible preference shares

Answer 123

* 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

Question 124

Private vs. Public Equity Securities Private equity securities Private companies Types

Answer 124

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

Question 125

Investing in Non-Domestic Equity Securities Non-domestic equity securities Barriers to investing globally

Answer 125

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

Question 126

Investing in Non-Domestic Equity Securities Direct investing

Answer 126

* 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

Question 127

Investing in Non-Domestic Equity Securities Depository receipts

Answer 127

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

Question 128

Investing in Non-Domestic Equity Securities Global depository receipts (GDRs)

Answer 128

* 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

Question 129

American depository receipts (ADRs)

Answer 129

* US dollar-denominated security - Trades like a common share on US exchanges * Enables foreign companies to raise capital from US investors * Type of GDR

Question 130

American depository share (ADS)

Answer 130

* Trades in issuing company’s domestic market

Question 131

Level I (Unlisted) Objectives Raising capital on US markets SEC registration Trading Listing fees Size/earnings requirements

Answer 131

> Develop and broaden US investor base with existing shares > No > Form F-6 > OTC > Low > None

Question 132

Level II (Listed) Objectives Raising capital on US markets SEC registration Trading Listing fees Size/earnings requirements

Answer 132

> Develop and broaden US investor base with existing shares > No > Form F-6 > NYSE, NASDAQ, or AMEX > High > Yes

Question 133

Level III (Listed) Objectives Raising capital on US markets SEC registration Trading Listing fees Size/earnings requirements

Answer 133

> 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

Question 134

Rule 144A (Unlisted) Objectives Raising capital on US markets SEC registration Trading Listing fees Size/earnings requirements

Answer 134

> Access qualified institutional buyers (QIBs) > Yes, through private placements to QIBs > None > Private offerings, resales, trading platforms > Low > None

Question 135

Investing in Non-Domestic Equity Securities Global registered share (GRS)

Answer 135

* 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

Question 136

Basket of listed depository receipt (BLDR)

Answer 136

* 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

Question 137

Risk and Return Characteristics of Equity Securities Return characteristics Source of equity return

Answer 137

* Capital gain on price * Dividend income * Foreign exchange gains/losses - For investors that purchase depository receipts/foreign shares

Question 138

Risk and Return Characteristics of Equity Securities Risk of equity securities Risk of a security

Answer 138

* 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

Question 139

Equity Securities and Company Value Book value and market value Primary goal of a company Management actions

Answer 139

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

Question 140

Equity Securities and Company Value Accounting return on equity (ROE)

Answer 140

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)

Question 141

Equity Securities and Company Value Increasing ROE

Answer 141

* 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

Question 142

Price-to-book ratio

Answer 142

* 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

Question 143

Equity Securities and Company Value Cost of equity and investors’ required rates of return Cost of equity

Answer 143

* 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)

Question 144

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

Answer 144

1. Company Analysis: Past and Present 2. Industry and Competitive Analysis 3. Company Analysis: Forecasting

Question 145

Initial Company Research Report Elements Front Matter

Answer 145

Issuer name, analysts’ recommendation (buy, hold, sell) and target buy or sell prices, disclosures, disclaimers, and other legally required information

Question 146

Initial Company Research Report Elements Recommendation

Answer 146

Analysts’ recommendation with justification

Question 147

Initial Company Research Report Elements Company Description

Answer 147

Discussion of issuer’s business model and strategy

Question 148

Initial Company Research Report Elements Industry Overview & Competitive Positioning

Answer 148

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)

Question 149

Initial Company Research Report Elements Financial Analysis and Model

Answer 149

Evaluation of key drivers of revenue, costs, profitability, cash flows, and the issuer’s uses and sources of capital. Historic and forecasted financial statements

Question 150

Initial Company Research Report Elements Valuation

Answer 150

Estimates of company and security values with target price

Question 151

Initial Company Research Report Elements ESG Considerations

Answer 151

Evaluation of ESG indicators and risks

Question 152

Initial Company Research Report Elements Risks

Answer 152

Evaluation of material downside and upside risks and discussion of how they are considered in the financial analysis and valuation

Question 153

Initial Company Research Report Elements

Answer 153

Front Matter Recommendation Company Description Industry Overview & Competitive Positioning Financial Analysis and Model Valuation ESG Considerations Risks

Question 154

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

Answer 154

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

Question 155

Determining the Business Model Elements

Answer 155

* 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

Question 156

Determining the Business Model Information Sources

Answer 156

* 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

Question 157

Revenue Analysis Revenue Drivers

Answer 157

* 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.

Question 158

Revenue Analysis Pricing Power

Answer 158

* 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

Question 159

Operating Profitability and Working Capital Analysis Classification of operating costs

Answer 159

* 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

Question 160

Operating Profitability and Working Capital Analysis Behavior with Output: Fixed and Variable Costs

Answer 160

* 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.

Question 161

Operating Profitability and Working Capital Analysis Natural and Functional Operating Cost Classifications

Answer 161

* 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

Question 162

Operating Profitability and Working Capital Analysis Economies of scale and scope

Answer 162

* 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

Question 163

Operating Profitability and Working Capital Analysis Working capital

Answer 163

* 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

Question 164

Capital Investments and Capital Structure Sources and Uses of Capital

Answer 164

* 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

Question 165

Capital Investments and Capital Structure Evaluating Capital Investments and Capital Structure

Answer 165

* 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

Question 166

Uses of Industry Analysis Why analyze an industry?

Answer 166

* 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

Question 167

Industry and Competitive Analysis Steps Overview

Answer 167

1. Define Industry * e.g. Third-party classification schemes 2. Industry Survey * Size, growth rate and character, profitability, market share trends 3. Industry Structure * Porter’s Five Forces analysis 4. External Influences * PESTLE analysis 5. Competitiveness Analysis * Evaluate competitive strategy of firm in context of its industry and determine competitive advantage

Question 168

Industry and Competitive Analysis Steps 1. Industry classification

Answer 168

* 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

Question 169

Industry and Competitive Analysis Steps Limitations of third-party industry classification schemes

Answer 169

* 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

Question 170

Industry and Competitive Analysis Steps Alternative methods of grouping companies

Answer 170

* 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

Question 171

Industry and Competitive Analysis Steps 2. Industry survey

Answer 171

* 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

Question 172

Industry and Competitive Analysis Steps 3. Industry structure

Answer 172

* 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

Question 173

Industry and Competitive Analysis Steps 4. External influences on industry growth

Answer 173

* 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

Question 174

Industry and Competitive Analysis Steps

Answer 174

5. 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

Question 175

Forecast Objects, Principles, and Approaches What to forecast?

Answer 175

* 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

Question 176

Forecast Objects, Principles, and Approaches Forecast approaches

Answer 176

* 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

Question 177

Forecast Objects, Principles, and Approaches Selecting a forecast horizon

Answer 177

* 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

Question 178

Forecasting Revenues Forecast objects for revenues

Answer 178

* 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

Question 179

Forecasting Operating Expenses and Working Capital Cost of sales (Cost of Goods Sold (COGS)) and gross margins

Answer 179

* 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

Question 180

Forecasting Operating Expenses and Working Capital SG&A expenses Working capital forecasts

Answer 180

* 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

Question 181

Forecasting Capital Investments and Capital Structure Capital Investments

Answer 181

* 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

Question 182

Forecasting Capital Investments and Capital Structure Capital structure

Answer 182

* 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

Question 183

Forecasting Capital Investments and Capital Structure Scenario Analysis

Answer 183

* 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

Question 184

Major Categories of Equity Valuation Models

Answer 184

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

Question 185

Stock Dividend (Bonus Issue)

Answer 185

* 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

Question 186

Stock Split

Answer 186

* Increase in the number of shares outstanding and decrease in share price * No economic effect on the company or shareholders

Question 187

Share repurchase (buyback)

Answer 187

* 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

Question 188

Dividends Payment chronology

Answer 188

* 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

Question 189

Present Value Models: The Dividend Discount Model Perpetuity formula

Answer 189

* Non-callable, non-convertible perpetual preferred share Value = Div0 / r * Callable/putable preferred shares value - Non-callable > Callable - Non-putable < Putable

Question 190

Present Value Models: The Dividend Discount Model Assumptions Alternatives to using the Gordon model

Answer 190

* 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

Question 191

Multistage dividend discount model

Answer 191

* 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

Question 192

Relationship among price multiples, present value models and fundamentals * The justified (P/E) using Gordon Growth Model

Answer 192

Dividend t = Div payout ratio x EPSt = p x EPSt Divide both sides by EPS P0 / E1 = p / (r-g)

Question 193

Multiplier Models P/E relationships Changes in assumptions

Answer 193

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

Question 194

Multiplier Models Method of comparables

Answer 194

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

Question 195

Multiplier Models Enterprise value (EV) Definition and uses

Answer 195

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

Question 196

Asset-Based Valuation Definition and uses

Answer 196

* 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

Question 197

There are four sources of availability bias which an investor is most likely to experience.

Answer 197

Retrievability; Categorization; Narrow range of experience; Resonance.

Question 198

Which version of the dividend discount model (DDM) would most likely be appropriate for valuing a fairly young, publicly traded company

Answer 198

three stages: (1) growth, (2) transition, and (3) maturity. This assumption supports the use of a three-stage DDM.

Question 199

dates in the dividend chronology can fall on a weekend

Answer 199

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.

Question 200

source of capital

Answer 200

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