Volume 3 - Equity Investments

Question 1

Market Organization and Structure

Answer 1

explain the main functions of the financial system

describe classifications of assets and markets

describe the major types of securities, currencies, contracts, commodities, and real assets that trade in organized markets,
including their distinguishing characteristics and major subtypes

describe types of financial intermediaries and services that they provide

compare positions an investor can take in an asset

calculate and interpret the leverage ratio, the rate of return on a margin transaction, and the security price at which the investor
would receive a margin call

compare execution, validity, and clearing instructions

compare market orders with limit orders

define primary and secondary markets and explain how secondary markets support primary markets

describe how securities, contracts, and currencies are traded in

quote-driven, order-driven, and brokered markets

describe characteristics of a well-functioning financial system

describe objectives of market regulation

Question 2

What are the main functions of the financial system ?

Answer 2

1- Facilitate the transfer of Capital and / or Risk (Saving. Borrowing, Raise Equity Capital, Managing Risks, Exchange assets & Information based trading)

2- Price Discovery : Rates of return

3- Facilitate the efficient allocation of capital : Capital seeks out the bets risk-adjusted return avaible

1,2 & 3 require:
- Speedy transactions (liquidity)
- Low transation costs
- Acces to info
- Regulation

Question 3

Money market < 1 yr
Capital market > 1 yr

Question 4

Public Market : Exchanges
Private Market : Qualified investors only

Question 5

Equity ownership claims:
1- Common

2- Preferred

3- Warrants : 10 years, Right to purchase and can be detached from the bond.

Question 6

Major types of securities:

1- Securities

2- Currencies

3- Contracts

Question 7

Intermediaries: Facilitate the matching of providers and users of capital and structuring products / services to satisfy that function

Answer 7

1:
- Brokers –> Fulfill orders for clients
- Exchanges –> Provide an auction platform and must print best bid and ask
- Alternative Trading System (ATS) –> No regulatory authority over members. (Dark pools –> do not display orders sent to them. Usually used by large traders)

2:
- Dealers –> Will hold inventory, Will become contract counterparties, Create liquidity, Can act as a broker, Primary dealers can buy/sell with the Central Bank

3:
- Securitizers –> Buying assets, placing them in a pool, and selling securities against them

4:
- Depository institution and other financial corporations –> Banks and credit unions that take deposits - pay interest, lend to borrower and charge interests

5:
- Insurance companies –> Contracts to protect

6:
-Arbritageurs –> Trades on mispricing

7:
- Settlement & Custodial Services –> Hold securities on behalf of clients. Clearinghouses arrange for the final settlement and act as counterpary for futures contracts

Question 8

Bid : Prices at which dealers and traders are willing to buy

Ask: Prices at which dealers and traders are willing to sell

Answer 8

You can buy the Ask and sell the Bid

Question 9

Trades validity instructions:
Day - Expire at the end of the day (default)
ATC - good-til-cancelled (max typically 6 months)
FOK - fill or kill
Good on close - Market on close. Execute at the close of trading

Question 10

An IPO can be done as:

1- Underwriting offer ; The IB buys the entire issue at a negociated price then proceeds to sell on the IPO and makes the spread (can put a closure that if they sell to a certain % the company has to sell another % more to the IB)

2- Best effort offer; The IB acts as a broker only and sells what they can sell on IPO. Works on commission

Question 11

Call market trades only take place when the market is called at a particular time and place. They are very liquid markets when called, but completely illiquid otherwise. Most use a single price auction in which the price chosen maximizes the total trading volume. They are usually called once a day.

Answer 11

In continuous trading markets, trades can take place anytime the market is open. It may be difficult if other buyers and sellers are not present. Many continuous trading markets use call market auctions at the beginning and/or end of the trading day.

Question 12

Orders are used by buyers and sellers to communicate with brokers and exchanges. An order will specify the following information:

What instrument to trade
Whether to buy or sell
How much to trade

Answer 12

Execution instructions: How to fill the order
Validity instructions: When the order may be filled
Clearing instructions: How to settle the trade

Dealers are willing to buy at bid prices and sell at ask prices (or offer prices). Traders may specify bid or ask sizes – the amount they are willing to trade at that price. The market bid-ask spread is the difference between the best bid and best offer.

Those who offer a trade are said to make the market, while those who accept those offers are said to take the market.

Question 13

Execution instructions specify how to fill the order.

Market order: trades immediately at the best price, which can be costly in illiquid markets because price concessions are needed to attract traders.

Limit order: specifies either the maximum price that a buyer is willing to pay or the minimum price that a seller is willing to accept. If the limit price is greater than the best offer, the order is described as a marketable limit order because it will be filled immediately (at least partially) as if it were a market order.

Buy orders placed below the best bid are described as being behind the market and will only execute if the best offer price drops. Limit orders waiting to trade are called standing limit orders. A limit order makes a new market if it is between the best bid and offer prices.

All-or-nothing (AON) order: will only be executed if the entire quantity can be filled.

Hidden order: can only be seen by brokers or exchanges, not by other traders.

Iceberg order: only display a fraction of the amount the trader is really willing to transact.

Question 14

Validity instructions indicate when an order may be filled.

Day orders are the most common. They expire at the end of the business day if not filled.

Good-till-cancelled (GTC) orders are valid until executed, but some brokers will automatically cancel them after a few months.

Immediate or cancel orders (aka. fill or kill) expire if they are not filled (at least partly) immediately upon being received.

Good-on-close orders are filled at close of trading. They are also called market-on-close. These orders are typically used by mutual funds because the portfolios are usually valued at closing prices.

Stop orders cannot be filled until the stop price condition has been met.

Stop-loss orders are often used to limit losses. For example, the order will be automatically filled if the price falls below a trigger point. If the price is falling rapidly, there is no guarantee that the order will be executed at the specified price. In such circumstances, a put option may be preferable to a stop-loss order.

Stop-buy orders can be used to limit losses on short positions or to ensure that an undervalued stock is not purchased until interest from other investors bids the price over a certain threshold.

Question 15

Quote-Driven Markets
In quote-driven markets, customers trade with dealers. Most trading is done in this type of market. These are also called over-the-counter (OTC) markets. Most currencies and fixed-income securities are traded in quote-driven markets.

Question 16

Order-Driven Markets:

Order-driven markets are based on a matching system run by an exchange or broker to match traders. Orders can be submitted by customers or dealers. Exchanges use this type of market structure. Often people are trading with strangers, so there is a need to ensure performance. Stocks typically trade in order-driven markets.

In order-driven markets, there are order matching rules. Price is the top priority – the highest buy orders and lowest sell orders are executed first. Among orders with the same price, a secondary precedence rule prioritizes those that were placed earliest.

In markets where hidden orders are permitted, orders with displayed quantities are usually given priority over those with undisplayed quantities. In these markets, orders are prioritized according to price first, display status second, and time of arrival third.

There are also trade pricing rules in order-driven markets:

Uniform pricing rules are used by call markets. All trades are executed at the same price. The market chooses the price to maximize the total quantity traded.

Discriminatory pricing rules are used by continuous trading markets. They fill orders incrementally, starting with the most aggressively priced orders on the other side of the book. This allows investors to submit a single large order rather than breaking it up into many smaller orders.

Derivative pricing rules are used by crossing networks that match buyers and sellers. However, these traders must be willing to accept prices that are determined in other markets. Crossing network trades typically execute at the midpoint of the best bid and ask quotes from the exchange where the security is primarily traded.

Question 17

Brokered Markets
In brokered markets, the brokers arrange trades between customers. They are ideal for trading unique assets (e.g., real estate) that dealers would be unwilling to carry in inventory.

Answer 17

Market Information Systems
A market is pre-trade transparent if it publishes information about quotes and orders in real time. It is post-trade transparent if execution prices and trade sizes are published soon after trades are completed. Buy-side traders like transparency, while dealers prefer opaque markets.

Question 18

A complete market will satisfy :
savers
borrowers
hedgers
asset exchange (spot)

Question 19

Features of a well functionning system:
- timely & accurate disclosures
- Liquidity
- Complete market
-External / Informational efficiency

Question 20

Gouv. raise funds with long term bonds in capital markets

Question 21

Which of the following types of financial market participants is least likely to design risk management instruments?

Answer 21

A) Exchanges

B) Investment banks

–> C) Defined-benefit pension plans

Question 22

Private placement securities are illiquid because they cannot be traded in the secondary market. Issuers are forced to accept lower prices than they would receive for an equivalent public offering.

A shelf registration can be used by issuers to sell securities directly to secondary market investors on a piecemeal basis rather than in a single large offering in the primary market. This gives the issuer the flexibility to raise capital as needed.

Dividend reinvestment plans (DRIPs) allow investors to purchase new shares with dividends, sometimes at a discount. The company must issue new shares for DRIPs rather than purchasing existing shares in the secondary market.

Rights offerings grant existing shareholders the option to purchase additional shares at a below-market price. These are effectively warrants that dilute the value of existing shares.

Question 23

Security Market Indexes

Answer 23

describe a security market index

calculate and interpret the value, price return, and total return of an index

describe the choices and issues in index construction and management

compare the different weighting methods used in index construction

calculate and analyze the value and return of an index given its weighting method

describe rebalancing and reconstitution of an index

describe uses of security market indexes

describe types of equity indexes

compare types of security market indexes

describe types of fixed-income indexes

describe indexes representing alternative investments

Question 24

Index: consist of individual securities (coonstituent securities) that represent a given security market, market segment or asset class

Answer 24

1- Price Return Index: reflects only prices

2- Total Return Index: (Price Return +) assumes reinvestment of all income received since inception

Question 25

At inception, Vpri = Vtri

Answer 25

1- Price Return Index: reflects only prices

2- Total Return Index: (Price Return +) assumes reinvestment of all income received since inception

Question 26

Index Construction:
1- Target market Selection
2- Security Selection
3- Weighting
4- Rebalancing
5- Reconstitution

Question 27

Index Weighting:

1- Price Weight (Called Average)
2- Equal Weighting
3- Market-Cap Weighting (float-adjusted–> # shares avaible to the public)
4- Fundamental (uses a value, ex: revenues)

Answer 27

D –> tyoucally set at inception = N (number of shares)

Question 28

Rebalancing : Weights assigned to constituent at inception drift from their target weights as prices change

Question 29

A security market index represents a market segment or asset class. The individual securities that make up the index are called constituent securities.

Question 30

Over time, the divisor can be adjusted so that the index’s performance remains consistent with historical returns despite changes to its constituents and weights.

Question 31

Price weighting simply weights each constituent security based on its price as a share of the sum of all the constituent security prices. The Dow Jones Industrial Average (DJIA) is one of the oldest and best-known price-weighted indexes.
The initial value of the divisor is typically set at the number of securities in the index. To account for stock splits, the divisor must be adjusted to a level that keeps the index value the same as it was before the stock split.

Answer 31

The advantage of price weighting is simplicity. Each constituent security has the same quantity in the index (e.g., buy one share of every security to form the index). The disadvantage is that price is an arbitrary basis for determining index weights. Two otherwise identical companies will have different index weights if one has more shares outstanding. Furthermore, a stock split will impact the weights of all other constituents.

Question 32

Equal weighting is another index weighing technique that offers the advantage of simplicity. Each stock in an equally weighted index has the same proportionate impact on the index’s overall performance.

Answer 32

It is like investing an equal amount of money in each component stock. Each constituent security has the same percentage in the index (e.g., 50% in Company A and 50% in Company B) but not necessarily in exact quantity.

The disadvantages of equal weighting include the disproportionately large influence of relatively small stocks. Also, frequent rebalancing is required because any price changes will cause the index to deviate from its initial equal weighting.

Question 33

Under market-capitalization weighting (a.k.a. value-weighting), the weight of each security is its market capitalization divided by the total market capitalization of all constituent securities. A company’s market capitalization is the number of shares outstanding times the price per share.

Answer 33

Most market capitalization weighting schemes use a float adjustment, which excludes the impact of shares that are not freely exchanged. (Momentum akin)

Question 34

Fundamental weighting uses a measure of company size not dependent upon security price to determine weight. It could use items such as book value, cash flow, or revenues. This leads to indices with value tilt (e.g., ratio of book value to market value is greater than average). This method also tends to have a contrarian bent rather than a momentum approach.

Answer 34

It can also use multiple measures

Question 35

value tilt (e.g., ratio of book value to market value is greater than average). This method also tends to have a contrarian bent rather than a momentum approach.

Question 36

Indexes are rebalanced at regularly scheduled intervals. This is necessary because the weights change as security prices change. Price-weighted indices do not need rebalancing for price changes since the price is the weight. Market-capitalization weights rebalance themselves, except for activities such as mergers and acquisitions,liquidations and other corporate events.

Answer 36

Reconstitution is a process in which the manager reviews and makes changes to the constituent securities. Some indices reconstitute annually. Events such as bankruptcies, mergers, acquisitions, and de-listings may prompt index providers to replace an acquired firm with another representative firm.

Question 37

Indexes are used (usefull) for:

1- Gauges of Market Sentiment :
Indexes can be described as reflections of the collective sentiment of market participants.

2- Proxies for Measuring and Modeling Returns, Systematic Risk, and Risk-Adjusted Performance : model (CAPM). If we know a stock’s beta relative to an index, we can calculate its systematic risk-adjusted required return.

3- Proxies for Asset Classes in Asset Allocation Models: Historical index data is an ideal basis for estimates of risk and expected returns that are used as inputs in asset allocation models, such as mean-variance optimization.

4- Benchmarks for Actively Managed Portfolios: An active manager’s returns should be benchmarked against an investable market index so that investors can evaluate them relative to a low-cost passive alternative.

5- Model Portfolios for Investment Products: Many investors prefer passive exposure to active management. –> low-cost investment vehicles (e.g., ETFs), which are often based on market indexes.

Question 38

Broad Market Indexes
An index is considered to be broadly representative if it includes 90% or more of a market’s equities.

Question 39

Including national markets proportionately to their GDP in a multi-market index is a form of fundamental weighting.

They are important to global investors. Multi-market indices could be based on geography or level of economic development. Some indices weight by market capitalization within the country and by GDP between countries.

Question 40

Sector indexes are used in the performance evaluation process to determine whether a manager has added value through stock selection or sector allocation.

Question 41

In order to be representative of an asset class, fixed-income indexes may need to include several thousand constituents.

Fixed-income markets are also relatively illiquid, leaving index providers to rely on dealers for updated prices of thinly traded issues. (problems: Number of securities, lack of pricing availability and illiquidity)

Answer 41

Fixed-income indexes fall into many of the same categories as equities indexes:

Broad market indexes
Sector indexes (e.g., government, corporate)
Style indexes (e.g., high-yield)

Question 42

Commodity indexes consist of futures contracts on commodities. Indexes are based on futures contracts rather than the underlying commodity prices. As such, index values will reflect unrelated factors such as the risk-free rate.

Question 43

Real estate indexes may be based on appraisals or repeat sales. By contrast, REITs trade on public exchanges, allowing the value of REIT indexes to be calculated continuously.

Question 44

Indexes of hedge funds are typically equally-weighted.

Another issue with hedge fund indexes is that reporting is voluntary, so hedge fund managers may not provide complete and accurate performance data. This creates the potential for survivorship bias, which overstates expected returns.

Question 45

Market Efficiency

Answer 45

describe market efficiency and related concepts, including their importance to investment practitioners

contrast market value and intrinsic value

explain factors that affect a market’s efficiency

contrast weak-form, semi-strong-form, and strong-form market efficiency

explain the implications of each form of market efficiency for fundamental analysis, technical analysis, and the choice between active and passive portfolio management

describe market anomalies

describe behavioral finance and its potential relevance to understanding market anomalies

Question 46

Information efficiency: Assumes info is timely, complete, correct, and understandable

Answer 46

Therefore, it is possible to have a price determined efficiently but being wrong (undervalue or overvalue)

Question 47

Market efficiency : Asset prices reflect new info (unanticipated element) quickly (1m-1hr) and rationally

Answer 47

efficient market, prices reflect all past and present information

Question 48

Passive invest. will beat Active. (counting that passive invest. has lower costs)

Question 49

If a market is efficient, prices will reflect current consensus expectations and should only react to UNEXPECTED (new information or confirmation of something) information such as surprise earnings announcements.

Question 50

Market Participants
There should be a positive correlation between the number of market participants and market efficiency. If more investors and analysts are monitoring prices, it is more likely that mispricings will be noticed and acted on until market prices are reflective of intrinsic values. Any restrictions that limit opportunities for investors to trade can be expected to reduce market efficiency.

Question 51

Information Availability and Financial Disclosure
Markets will be more efficient if investors have more and better information. By contrast, over-the-counter (OTC) markets are less efficient because there can be significant variation in the quality and quantity of information provided by different dealers.

Requiring companies to disclose relevant information to all investors at the same time and penalizing insiders for trading on material nonpublic information make markets fairer and more efficient.

Question 52

Operational inefficiencies, such as restrictions on short selling, and high trading costs decrease market efficiency by making it more difficult for arbitrageurs to trade.

Question 53

Transaction costs: A market can still be considered efficient if mispricings are less than transaction costs. For example, if two identical assets are trading at different prices, investors will not act to eliminate this mispricing if the costs that would be incurred to execute the necessary trades are greater than the potential profit.

Question 54

Information-acquisition costs: Investors should be able to earn a fair gross return as compensation for the risks and costs incurred to acquire new information. A market is only considered inefficient if active investors can outperform a passive approach after deducting information-acquisition costs.

Question 55

The preponderance of empirical evidence supports the view that weak-form inefficiency can be observed in certain developing economies, but not in developed markets.

Question 56

The hypothesis that markets are semi-strong-form efficient can be tested with event studies that measure the speed at which prices respond to company announcements and other significant events. If a market is semi-strong-form efficient, prices will react quickly and fully to the new information.

Answer 56

Most studies indicate that markets in developed economies are semi-strong-form efficient.

Question 57

In a strong-form efficient market, insider trading would not be possible because prices have already incorporated all nonpublic information. In reality, insider trading has been shown to be profitable (albeit illegal) in both developed and developing markets.

Question 58

Implications of the Efficient Market Hypothesis:

1- Fundamental analysis: Analyzing public disclosures (e.g., financial statements) should not generate excess returns in a semi-strong-form efficient market. However, it can still be profitable for those who are able to develop a comparative advantage in analyzing public information.

2- Technical analysis: If markets are weak-form efficient, technicians may be able to generate abnormal profits occasionally, but not on a consistent basis.

3- Portfolio management: Many studies have shown active portfolio managers do not beat the market on average. When fees are considered, investors would be better off using passive strategies.

Answer 58

!! Portfolio managers can still add value by designing investment strategies that are consistent with their clients’ objectives and constraints. !!

Question 59

A market anomaly is a change in a security’s price that cannot be attributed to new information. However, for a market to be considered inefficient, anomalies must persist over long periods.

Answer 59

Apparent anomalies may simply be the product of data mining, which is the practice of analyzing data first and developing a hypothesis based on observed patterns. (Lack of economic rationale before any data are analyzed)

Question 60

Returns in the first few trading days of January are abnormally high, especially for small-cap stocks. This January effect has been observed since the 1980s.

Answer 60

One explanation is that investors sell their “losing” stocks in December to capture capital losses for tax purposes. Others have proposed portfolio managers sell riskier securities at the end of December to make their holdings appear safer in end-of-year reports. More recent evidence indicates this anomaly has not persisted.

Question 61

Other calendar anomalies include:

1- Turn-of-the-month effect: Higher returns at the beginning and end of months

2- Day-of-the-week effect: Monday returns are negative on average

3- Weekend effect: Weekend returns are lower than weekday returns

4- Holiday effect: Higher returns on the day before a market holiday

Question 62

Some studies have shown markets overreact to good and bad news. This could be exploited by purchasing past losers and selling past winners, which is a contrarian investment approach.

Answer 62

Momentum would appear to indicate weak-form inefficiency, although it could simply be a rational reflection of adjustments to market consensus growth rates.

Question 63

Other Anomalies

1- Shares of closed-end funds trade on stock markets like other equity securities. Most trade at a sizable discount to their net asset value (NAV), although some would still trade at a premium.

2- Earnings Surprise
Many studies have shown companies with positive surprise earnings announcements experience a prolonged period of abnormal positive security returns.

3- Initial Public Offerings (IPOs)
Under pressure from investment banks, companies that issue IPOs tend to set low offering prices. The difference between the issue price and the closing price at the end of the first trading day is referred to as the degree of underpricing.

4- Predictability of Returns Based on Prior Information
Many researchers have documented equity returns are linked to factors including interest rates, inflation rates, volatility, and dividend yields. However, it is not possible to generate abnormal returns because these relationships tend to change significantly over time.

Question 64

The practice of discovering a statistically significant relationship indicating the possibility of earning abnormal returns before establishing a hypothesis is most accurately described as: Data mining

Question 65

The field of behavioral finance seeks to understand how people make investment decisions (individually and collectively) by observing their actions. There is a major focus on cognitive biases that affect decision making. According to the behavioral finance perspective, cognitive biases may explain the existence of market pricing anomalies.

Question 66

Other Behavioral Biases

Representativeness: Relying too much on current state when assessing probabilities
Mental accounting: Keeping track of gains and losses separately for different investments
Conservatism: Failing to incorporate new information in a timely manner
Narrow framing: Focusing on certain issues in isolation

Question 68

Some biases:

1- Loss aversion
2-Herding
3- Overconfidence
4- Information cascades: With information cascades, those who act first will convey information that influences others. This could explain short-term serial correlations in stock returns (i.e., overreactions).

Question 69

Overconfidence bias is most likely attributable to: Inability to accurately process info

Question 70

Overview of Equity Securities

Answer 70

describe characteristics of types of equity securities

describe differences in voting rights and other ownership characteristics among different equity classes

compare and contrast public and private equity securities

describe methods for investing in non-domestic equity securities

compare the risk and return characteristics of different types of equity securities

explain the role of equity securities in the financing of a company’s assets

contrast the market value and book value of equity securities

compare a company’s cost of equity, its (accounting) return on equity, and investors’ required rates of return

Question 71

If a company has more than 50 shareholders, the company is classified as a public company (depends on regulations of the state)

Question 72

The ratio of global equity to global GDP can indicate if markets are overvalued or undervalued. For example, the US share of global equity markets is approximately twice as large as its share of global GDP.

Question 73

Shareholders have the right to vote on major decisions. Many choose to vote by proxy for convenience, allowing a designated party (e.g., another shareholder, management) to cast their votes on their behalf.

Question 74

The standard voting system, known as statutory voting, grants one vote for each share owned. Cumulative voting allows shareholders to direct all of their votes to specific candidates in board elections. For example, in an election for 10 board seats, a shareholder who owns one share would be given 10 votes with no restrictions on how they may be allocated.

Answer 74

gives better representation to shareholders who own a relatively small number of shares.

Question 75

preference shares do not grant any voting rights and owners are generally unable to benefit from any improvement in the issuer’s operating performance.

The call option gives the issuer the ability to buy the shares at a fixed value (benefits the issuer); the put option allows shareholders to sell their shares for a fixed amount (benefits the shareholder).

Question 76

Preference shares can be classified according to whether they are cumulative or non-cumulative, as well as participating or non-participating.

Cumulative preference shares accrue dividends from missed payments that must be paid before common shares receive dividends.

Non-cumulative preference shares permanently forfeit any dividend payments that are not made, but no common share dividends can be paid during a period when non-cumulative preferred dividends have gone unpaid

Participating preference shares can receive an additional dividend if company profits exceed a specified amount. They may also receive additional distributions (over face value) in the event of a liquidation. These securities tend to be issued by smaller, riskier companies.

Non-participating preference shares do not offer any compensation beyond fixed dividend payments and a claim for their face value in the event of a liquidation.

Question 77

Preference shares may also carry an option that allows their owner to convert them into common shares. Convertible preference shares are often used by venture capital and private equity investors

Question 78

Private equity securities are issued via private placements, primarily to institutional investors. They are highly illiquid because they do not trade on public exchanges.

Question 79

Private investments in public equity (PIPE) are used by companies that need to raise capital quickly. Private investors can purchase these equities at a significant discount.

Question 80

Proponents of “going private” argue that the absence of short-term pressures allows them to focus on creating long-term value. Private companies also have lower regulatory and compliance costs compared to publicly listed firms. However, private companies tend to perform worse in terms of corporate governance, perhaps because public companies are subject to more scrutiny from analysts and shareholders.

Question 81

Countries still impose foreign investor restrictions for three reasons:

1- To limit foreign control of domestic companies

2- To give domestic investors the opportunity to own shares of companies that are conducting business in their country

3- To reduce the volatility of capital flows

Question 82

Depository Receipts (DR)
Depository receipts allow investors to overcome some of the challenges associated with investing directly in foreign markets. A depository share represents an economic interest in a foreign company, but it trades on an exchange in the investor’s domestic market. A DR can represent any number of the company’s shares.

Answer 82

The foreign company’s shares are deposited in a bank, which then issues receipts that represent the deposits. In its capacity as custodian and registrar, the depository bank handles dividend payments, stock splits, and other taxable events.

Question 83

A sponsored DR is issued directly by the foreign company and investors receive the same dividends and voting rights as other common shareholders. For an unsponsored DR, the foreign company has no involvement. The depository bank purchases the company’s shares, issues DRs, and retains the voting rights.

Question 84

Global Depository Receipts
GDRs are issued outside the company’s home country and are generally exempt from any foreign ownership and capital flow restrictions that may be imposed by that country’s government.

Question 85

American Depository Receipts
A GDR that can be listed on a US exchange is called an American Depository Receipt (ADR). ADRs are USD-denominated securities that trade like US domestic stocks. The underlying securities, called American depository shares, are traded in the issuing company’s domestic market.

Answer 85

Level I ADRs trade in the OTC market. Level II and III ADRs trade on US exchanges (e.g., NYSE, NASDAQ). The fourth type of ADR, called a Rule 144A depository receipt, is sold to qualified investors through private placements.

Question 86

Global Registered Shares
A global registered share (GRS) is traded on different stock exchanges around the world (including the local market) in different currencies, which eliminates the need for currency conversions. A GRS can be purchased on an exchange in one country for local currency units and sold on another exchange for units of that country’s currency (Actual ownership interest).

Question 87

Basket of Listed Depository Receipts
A basket of listed depository receipts is an exchange-traded fund that represents a portfolio of depository receipts.

Question 88

There are three potential sources of equity returns:

Price change
Dividend income
Foreign exchange gains or losses

Answer 88

Foreign exchange gains are available to investors who either purchase depository receipts or invest directly in foreign equity markets. From their perspective, returns are enhanced if the foreign currency appreciates relative to their domestic currency

Question 89

Analysts must recognize that net income and BVE (rather than the market value) can be affected by management’s choices regarding accounting policies. Adjustments may be required for ROE comparisons among companies that have different accounting policies or even a time-series analysis of a company that has changed its policies.

Question 90

An increase in ROE is not necessarily a positive sign. A company with slowing sales can post higher ROE if net income decreases at a slower rate than BVE. Alternatively, issuing debt and using the proceeds to repurchase shares will increase ROE while increasing both a company’s leverage and the riskiness of its equity.

Question 91

The price-to-book ratio (or market-to-book ratio) reflects investor sentiment. A higher ratio indicates greater optimism about the company’s future investment opportunities. However, P/B ratios should not be used to compare companies in different industries because this measure also reflects investors’ opinions about a company’s sector.

Question 92

Company Analysis: Past and Present

Answer 92

describe the elements that should be covered in a thorough company research report

determine a company’s business model

evaluate a company’s revenue and revenue drivers, including pricing power

evaluate a company’s operating profitability and working capital using key measures

evaluate a company’s capital investments and capital structure

Question 93

Product or service –> What does the firm sell?
Customers –> Who does the company sell to?
Sales channels –> How does the company acquire customers and deliver its product/service?

Price –>How much does the company charge and what are the payment terms?

Suppliers and partners –> Who does the company buy from and rely upon?

Question 94

Valuations of financial institutions, such as banks, are primarily influenced by the assets and liabilities on their balance sheets. For any other company, the most important factor to analyze when estimating its value is its ability to generate sales

Question 95

Bottom-up revenue analysis looks at the key factors driving a company’s overall revenue. For example, key revenue drivers for retailers are sales growth at existing locations (same-store sales) and new store openings (focus on unit sales and pricing).

Question 96

A top-down approach to revenue analysis begins by looking at macroeconomic or industry-level factors. Industry size and market share are key top-down revenue drivers because a company can increase sales by either increasing its market share of a static industry or by maintaining the same share of a growing market.

Question 97

In practice, analysts often use a hybrid approach that combines elements of top-down and bottom-up analysis.

Question 98

A company has pricing power if it is able to increase its prices without negatively affecting its sales volume. One of the main determinants of pricing power is market structure. For example, a monopolist has more ability to increase prices than a company operating in a monopolistically competitive market. Another key factor driving pricing power is a company’s competitive position in its industry. The leading firm in a monopolistically competitive market likely has more pricing power than its competitors with smaller market shares.

Question 99

At the extreme, firms operating under perfect competition are price takers, meaning that they have no pricing power and must sell for the market equilibrium price.

Question 100

Pricing power is reduced by commoditization, which is when competitors imitate innovations that make a product distinct.

Question 101

There are several ways to organize and classify operating costs.

Behavior with output: Whether the cost is proportional to output in the short run (e.g., variable or fixed).

Nature: What the cost has been incurred for (e.g., raw materials, rent, compensation).

Function: The cost’s purpose (e.g., COGS, SG&A, R&D, depreciation/amortization).

Question 102

In this formula, is the contribution margin from each sale that helps a company first cover its fixed costs and then earn a profit. A company’s profitability and the volatility of its profits are significantly affected by the relative shares of its fixed and variable costs. A higher share of fixed costs in a company’s cost structure increases its operating leverage. The impact of cost structure choices can be captured by the the degree of operating leverage (DOL)

Question 103

Long-term profitability projections should be based on an analysis of market structure and competitive positioning. Over the short term, companies can improve their profitability by capturing economies of scale and economies of scope.

Question 104

Economies of scope are generated when a company spreads its fixed costs over various segments or product lines. Administrative costs for functions such as accounting can be centralized, which allows business units to operate at a lower cost as part of a larger entity than they would if they were separate businesses.

Question 105

A company’s total working capital is the difference between its current assets and current liabilities. The adjusted net working capital measure excludes cash and marketable securities from current assets and interest-bearing debt from current liabilities.

Question 106

Common uses of capital include:

Cash on hand and short-term investments
Net working capital (if positive, which is typical)
Capital expenditures and additions to intangibles
Acquisitions
Debt repayments
Dividends and share repurchases

Question 107

Managers create long-term value by generating a return on invested capital (ROIC) in excess of the weighted-average cost of capital (WACC).

Question 108

Industry and Competitive Analysis

Answer 108

describe the purposes of, and steps involved in, industry and competitive analysis

describe industry classification methods and compare methods by which companies can be grouped

determine an industry’s size, growth characteristics, profitability, and market share trends

analyze an industry’s structure and external influences using Porter’s Five Forces and PESTLE frameworks

evaluate the competitive strategy and position of a company

Question 109

Sell-side analysts have been shown to estimate a company’s earnings more accurately when they also cover its suppliers, indicating that an approach that adequately weights industry dynamics can improve forecasts compared to one that overemphasizes company-specific factors. Incorporating industry analysis can also help identify investment opportunities such as diversifying holdings to gain exposure to an attractive industry while minimizing exposure to company-specific risk.

Question 110

Industry and Competitive Analysis Steps:
1- Define industry
Requires judgment on similar and substitute products, multidivisional companies, geography
Can use third-party industry classification schemes

2- Industry survey
Size, growth rate and character, profitability, market share trends

3- Industry structure
Porters’s Five Forces analysis
Determine the most important factors and what to monitor

4- External influences
Political, economic, social, technological, legal, environmental (“PESTLE”) influences on the industry

5- Competitive analysis
Evaluate competitive strategy of firm in context of its industry and determine competitive advantage

Question 111

Three widely used classification systems are the Global Industry Classification System (GICS), the Industrial Classification Benchmark (ICB), and The Refinitiv Business Classification (TRBC).

Answer 111

Global Industry Classification Standard (GICS): The GICS was designed for global comparisons of industries. It classifies companies in both developed and developing economies according to their primary business activity (as measured by revenue). The four levels (from broadest to narrowest) are sectors, industry groups, industries, and sub-industries.

Industry Classification Benchmark (ICB): The ICB classifies companies based on the source of the majority of their revenues. The broadest groupings are called industries, followed by supersectors, sectors, and subsectors at the most granular level.

The Refinitiv Business Classification (TRBC): Unlike the GICS and ICB, which are limited to public companies, this scheme includes private companies, non-profits, and government entities. From the broadest to narrowest categories, companies are classified into economic sectors, business sectors, industry groups, industries, and activities.

Question 112

To determine whether an industry offers attractive risk-adjusted returns, its performance should be compared to its own historical data as well as to how other industries are performing.

Question 113

A highly concentrated industry is dominated by a small number of large companies while an industry with low concentration is characterized by a large number of firms with relatively small market shares. In general, the intensity of competition is greater in less concentrated industries, although intensity will be lower if an industry is highly service-oriented or more geographically-limited in scope, or if firms offer highly differentiated products or services.

Answer 113

There are various ways to quantify the level of concentration within an industry. One commonly-used measure is the Herfindahl-Hirschman Index (HHI), which is the sum of squared market shares for each firm. A higher HHI score indicates greater concentration.

Maximum of 10 000 (100% **2)

As a general rule, competition regulators consider an industry to be moderately concentrated if its HHI value is between 1,500 and 2,500 while any value over 2,500 indicates a highly concentrated industry. Another general rule is that any proposed merger that is expected to increase a high concentrated industry’s HHI value by more than 200 points is likely to be challenged by regulators.

Question 114

Porter’s framework are:

Threat of entry: Competition will be more intense if potential competitors can easily enter the industry.

Threat of substitutes: A company’s pricing power will also be limited to the extent that substitute products or services are available. Substitutes may not necessarily be similar. For example, customers may choose to use the public library rather than going to the movie theatre during an economic downturn.

Bargaining power of customers: Companies that operate in industries with many competitors selling to relatively few customers will be limited in their ability to charge higher prices.

Bargaining power of suppliers: Being in a weak bargaining position relative to its supplier will increase a company’s costs.

Rivalry among existing competitors: Factors that increase the intensity of competition include increased fragmentation, higher fixed costs, higher exit barriers, and less differentiation (i.e., commodity-like products and services).

Question 115

Significant barriers to entry include:

High fixed costs and capital spending needed to benefit from economies of scale
Large incumbents with multiple lines of business that generate economies of scope
Strong brand loyalty and legal protections for trademarks, copyrights, etc.
Significant switching costs
Incumbents with preferential access to customers (e.g., retail shelf space arrangements)
Long-term contracts with suppliers, particularly for critical inputs
Legal or policy barriers that advantage incumbents (e.g., subsidies for domestic firms)

Question 116

The research that produced the Five Forces framework also identified three generate corporate strategies that have been used to achieve above-average performance:

Be a cost leader, operating more efficiently than competitors while offering comparable products or services (e.g., low-cost air travel)

Differentiate by offering unique products or services that can be sold at premium prices (e.g., luxury watches)

Focus on specific segments within an industry (e.g., mobile phones designed to be user-friendly for senior citizens)

Question 117

A company may pursue a low-cost strategy as a defensive measure to protect its market share in an industry with low rivalry among incumbents. Alternatively, a low-cost strategy could be part of an aggressive (or even predatory) campaign to gain market share if the rivalry is intense. In either case, successful execution requires tight cost controls, efficient operating and reporting systems, and appropriate managerial incentives.

Answer 117

Means of execution:

Generating economies of scale from large capital investments
Leveraging economies of scope by centralizing functions for different business lines
Preferential access to key inputs (e.g., raw materials)
Developing a strong culture focused on controlling costs
Increasing sales volume and market share through aggressive, even predatory, pricing
Achieving a low-cost distribution advantage

Question 118

Differentiation Means of execution:

Developing brand loyalty through investments in advertising and customer service
Establishing proprietary distribution channels
Protecting intellectual property through trademarks, copyright, and patents
Emphasizing unique features and superior quality
Developing a customer-focused culture supported by market research
Commanding premium prices
Offering integrated products and services

Question 119

Focus Means of execution:

Operating in close proximity to customer and developing a strong understanding of their needs
Emphasizing either cost leadership or differentiation while remaining focused on a specific segment of consumers

Question 120

Common forecast objects include:

1- Drivers of financial statement lines: These include top-down and/or bottom-up factors. (sales, COGS, and SG&A expenses). Drivers provide explanatory power that can help improve a forecast’s credibility and accuracy.

2- Individual financial statement lines: For items that are less material and/or lack clear drivers, an analyst may defer to estimates provided by management or assume a linear trend. An outside analyst may lack access to the information needed to provide a better estimate of items such as depreciation or other current assets.

3- Summary measures: Forecasting a high-level summary measure (e.g., earnings per share) is appropriate if the metric is relatively stable and predictable. While this approach is less transparent than a projection of a company’s complete set of financial statements, it may be the only option available when the company is not required to issue public financial disclosures.

4- Ad hoc objects: These include items that have not yet appeared on a company’s historical financial statements, such as an anticipated write-down of an asset that the company is currently carrying at its historical value. Analysts may also forecast the financial impact of ad hoc events such as natural disasters and legal proceedings.

Question 121

Company Analysis: Forecast

Answer 121

explain principles and approaches to forecasting a company’s financial results and position

explain approaches to forecasting a company’s revenues

explain approaches to forecasting a company’s operating expenses and working capital

explain approaches to forecasting a company’s capital investments and capital structure

describe the use of scenario analysis in forecasting

Question 122

Forecast Approaches
Company forecasts are typically developed using one (or a combination of) the following approaches:

1- Historical Results: Assume past is precedent: However, the PESTLE factors and Five Forces that heavily influence industry and company performance are continually evolving and structural breaks from the past can emerge relatively quickly.

2- Historical Base Rates and Convergence: This approach is based on the assumption that a forecast object will converge to a base rate (e.g., peer group average) over a sufficiently long time horizon. For example, it is reasonable to assume that a developed economy’s GDP growth rate is likely to converge around the average for its peers over a period of a decade or longer.

3- Management Guidance:Incorporating management guidance into forecasts is more appropriate when a company has established a track record of providing reasonably accurate estimates.

4- Analyst’s Discretionary Forecast:This is a catch-all category that includes all other forecast methods not mentioned above. Analysts apply discretion when incorporating survey data, quantitative models, probability distributions, and historical precedents into their forecasts.

Question 123

Using a longer time frame allows the analyst to develop an expectation of normalized earnings, which is a company’s expected profit in equilibrium economic conditions with no impact from unusual or temporary factors such as mergers, restructurings, or changes in strategy.

Question 124

Projected free cash flows should be normalized to mitigate the impact of temporary macroeconomic or company-specific factors.

The assumed terminal growth rate must be consistent with macroeconomic reality (i.e., a company cannot grow faster than the overall economy in perpetuity) and may differ significantly from the company’s historical growth rate. Estimates of terminal value are heavily influenced by the growth rate assumption, so this input must reflect a realistic assessment of the conditions that a company is likely to encounter in the future.

Forecasts can be skewed by inflection points that mark a structural change in the business cycle or the company’s life cycle. Inflection points can be difficult to predict because they are often driven by relatively unpredictable factors such as technological change.

Valuations are inherently uncertain. Disruptive events (e.g., financial crises) significantly impact all companies, even those with solid business models, particularly if they have high levels of operating and financial leverage.

Question 125

Top-down Approaches to Modeling Revenue

Growth relative to GDP growth: First, the analyst forecasts an expected growth rate for the overall economy in nominal terms. Then, a spread or multiple from that growth rate is applied to estimate a growth rate for an individual company. For example, a company’s revenue could be assumed to grow at a rate of 300 basis points above the nominal GDP growth rate.

Market growth and market share: Analysts begin by forecasting the growth rate in a particular market, such as an industry. Regression analysis can be used to determine if there is a predictable relationship between industry revenues and overall GDP growth. A company’s revenues can then be estimated as the product of its current market share and expected industry-level sales.

Question 126

Bottom-up Approaches to Modeling Revenue

Volume and average sale price: A bottom-up version of the market growth and market share approach, projected revenues are calculated as the product of expected unit sales and the average price per unit. This approach is often used for firms that disclose sales volumes and easily-identifiable prices (e.g., commodity producers, airlines, internet service providers).

Product-line or segment revenues: This approach produces an overall revenue forecast by aggregating forecasts for individual products, business lines, or reporting segments. It is preferable when companies report segment-level data for business units with different economic exposures.

Capacity-based measures: This approach is often used to model revenues in the retail sector, using measures such as same-store sales growth combined with an assumed level of sales expected to be generated from each newly-opened store.

Returns- or yield-based measures: Commonly used for financial institutions, revenue is estimated based on a company’s revenue-generating assets. For example, a bank’s revenues can be projected by applying an expected average yield on its loan portfolio.

Question 127

Forecast objects should either be disclosed regularly or be directly calculable using what is disclosed regularly. Information that is not disclosed regularly (such as a third-party consultancy’s report) is suitable to inform forecasts but can be problematic for direct use, because forecasts cannot be confirmed in a timely manner. While it may be intuitive to forecast individual discrete items, such as sales and gross margin by individual product line, if gross margin is disclosed only on a consolidated basis, it will be difficult for analysts to verify their product-line gross margin estimates.

Question 128

Separating Recurring and Non-Recurring Revenue or Revenue Growth
Non-recurring items should be taken out of earnings before being used to forecast future earnings. Analysts should exclude unusual items, extraordinary items, restructuring charges, and discontinued operations from their projections.

Answer 128

Sources of disclosed non-recurring revenues include “one-time” gains from divestitures, additional sales generated by time-limited incentives, or gains from exchange rate fluctuations.

Question 129

It is often reasonable to assume that the SG&A expenses, or at least the fixed components, will grow at the rate of expected wage inflation.

Question 130

Bottom-up estimates may be adjusted based on a complementary top-down analysis. For example, if an analyst anticipates slower economic growth and decreasing industry sales, a company’s forecasted inventory level may higher than expected based solely on its long-term trend as a percentage of sales.

Question 131

Maintenance capital expenditures are necessary in order for the company to continue the operating at its current level. Annual depreciation and amortization costs are a useful proxy for the amount of capital spending that is needed for this purpose, although adjustments for inflation are prudent.

Answer 131

Growth capital expenditures are investments in assets and projects that allow a company to expand the size and/or scope of it operations. Analysts may be able to infer expectations for these expenses from the Management Discussion & Analysis section of a company’s financial statements or other information sources that contain insights about the management team’s plans.

Question 132

Capital spending may be broken down into maintenance expenditures, growth projects, and acquisitions. Companies may also specify whether these investment have been allocated to property, plant, and equipment (PP&E), which are depreciated, or intangibles, which are amortized.

Question 133

An analyst notes that a company’s capital expenditures do not follow a discernible pattern; the company seems to have periods of very low capital expenditures and periods of high capital expenditures. Management does not provide any guidance on capital expenditures. The analyst should develop a forecast of capital expenditures based on:

Answer 133

Based on the company’s spending pattern, it most likely makes capital expenditures based on capacity needs as it grows. If it is approaching full usage of existing capacity, it will expand.

Question 134

An analyst predicts that if a company’s technological developments are a success, the company’s operating costs will be reduced by 15% per unit. As a result of the reduction in costs, the company will reduce the average selling price of its products by 5% and the volume of sales will increase by 8%. The company’s current gross profit margin is 40%. If technological developments occur, the company’s gross profit margin will be closest to:

Answer 134

Sales = 100(0.95)(1.08) = 102.6

Cost of sales = 60(0.85)(1.08) = 55.1

Gross profit = 102.6 - 55.1 = 47.5

Gross profit margin = 47.5/102.6 = 46.3%

Question 135

When dividend payments follow a complex pattern, it is best to use the multistage dividend discount model.

Question 136

Equity Valuation: Concepts and Basic Tools

Answer 136

evaluate whether a security, given its current market price and a value estimate, is overvalued, fairly valued, or undervalued by the market

describe major categories of equity valuation models

describe regular cash dividends, extra dividends, stock dividends, stock splits, reverse stock splits, and share repurchases

describe dividend payment chronology

explain the rationale for using present value models to value equity and describe the dividend discount and free-cash-flow-to-equity models

explain advantages and disadvantages of each category of valuation model

calculate the intrinsic value of a non-callable, non-convertible preferred stock

calculate and interpret the intrinsic value of an equity security based on the Gordon (constant) growth dividend discount model or a two-stage dividend discount model, as appropriate

identify characteristics of companies for which the constant growth or a multistage dividend discount model is appropriate

explain the rationale for using price multiples to value equity, how the price to earnings multiple relates to fundamentals, and the use of multiples based on comparables

calculate and interpret the following multiples: price to earnings, price to an estimate of operating cash flow, price to sales, and price to book value

describe enterprise value multiples and their use in estimating equity value

describe asset-based valuation models and their use in estimating equity value

Question 137

Market value can be determined from market quotes and transactions.

Its intrinsic value is the objective “true” value that investors would ascribe to it if they had all relevant quantitative and qualitative information.

Answer 137

If an analyst estimates a security’s intrinsic value to be greater than its market value, the security is undervalued. On the other hand, if the security is trading above its intrinsic value, it is overvalued.

Question 138

If several different models produce similar results, the analyst can have a higher level of confidence in this estimate. An outlier estimate may indicate a flaw in the model’s construction or assumptions.

Question 139

1- Present Value Models (Discounted Cash Flow Models) : The intrinsic value is the present value of future benefits from the security. Benefits could be viewed as dividends or free cash flows.

2- Multiplier Models (Market Multiple Models) : Share price multiples or enterprise value multiples. The fundamental variable can be on a forward or trailing basis. This is commonly used to compare relative values. Enterprise values (EV) subtract the cash and short-term investments from the company’s total market value. The denominator could be EBITDA or total revenue.

3- Asset-based Valuation Models : The intrinsic value is estimated as the market value of assets minus the estimated value of liabilities and preferred stock.

Question 140

Because market values of a company’s outstanding bonds are often not readily available, determining enterprise value can be difficult. Analysts may be required to make subjective estimates of this input based on the book value of a company’s debt or market prices of comparable debt issues.

Compared to the P/E ratio, the EV/EBITDA ratio is more flexible across capital structures because it takes into account the obligations that a company has to its debt owners and preferred shareholders.

Another advantage of the EV/EBITDA ratio is that it may provide useful information for companies with negative earnings. This is because EBITDA is always greater than net income.

Question 141

Which of the following is most likely a disadvantage that is common to dividend discount models, multiplier models, and asset-based valuations?

Answer 141

A : They are all simplistic versions of realityModels of any type are, by necessity, simplifications of reality. Only multiplier models are based on the law of one price.

Question 142

Dividends: Background for the Dividend Discount Model

Regular dividends are paid at known intervals, which tend to vary by region (e.g., quarterly in North America, semiannually in Europe, annually in China).

Answer 142

4 important milestones in the standard chronology of dividend payments:

1- Declaration date: This is the day that the dividend’s authorization is announced.

2- Ex-dividend date: Starting this day, new owners will not be eligible to receive the previously declared dividend (declaration date).

3- Holder-of-record date: On this day, the company records the list of owners who held shares at the close of trading on the day before the ex-dividend date. It is usually one or two days after the ex-dividend date to reflect the fact that trades are not settled immediately.

4- Payment date: This is when the dividend is actually paid.

Example : 1- XYZ Corp. may announce on 1 April that the board has voted to pay a $5 per share dividend on 31 May with an ex-dividend date of 16 April. 2- Company’s shares closed at $100 on 15 April, they will trade for $95 when the market opens on 16 April (the ex-dividend date) because the $5 dividend. 3- An investor who paid $100 for XYZ shares just before the market closed on 15 April is entitled to receive the $5 dividend that was declared on 1 April. However, this trade may take 24 to 48 hours to settle, so XYZ Corp. will wait until after the market closes on 17 April to finalize its list of shareholders

Question 143

Extra (special) dividends may be paid at any time outside the regular schedule (cyclocal industries).

Question 144

A liquidating dividend is paid to return capital to shareholders when a company goes out of business.

Question 145

Stock dividends grant extra shares to investors rather than cash. Stock splits increase the number of shares outstanding, while reverse stock splits reduce the number of shares outstanding.

Answer 145

These three types of transactions also have no effect on a company’s valuation.

Question 146

Share repurchases can be used as an alternative to paying cash dividends. Management can choose to repurchase shares if they believe that they are trading below their intrinsic value.

Answer 146

Shareholders may prefer share repurchases if capital gains are taxed at a lower rate than dividends.

Question 147

The Dividend Discount Model: Description

The dividend discount model (DDM) estimates a stock’s fair value based on forecasts of the dividends to be received and the terminal value (Pn), which is the expected selling price at the end of an T-year holding period. All future cash flows are discounted at the required rate of return on equity (r).

Question 148

Free-cash-flow-to-equity (FCFE) valuation model uses the dividend-paying capacity rather than expected dividends. This model can also be used for non-dividend-paying stocks.

Answer 148

FCFE is a measure of the cash flow that is available for distribution to common shareholders. It is the cash flow from operations less cash needed for fixed capital investment, plus net amount borrowed during the period

Question 149

Preferred Stock Valuation :

Preferred stock shares pay fixed dividends, which makes these securities easier to value because there is far more certainty about future cash flows.

Question 150

If the preferred shares have an embedded option :

Call options reduce the value of the preferred stock because the issuer can recall the shares if they are trading above the call price. Similarly, the retractable (putable) preferred stock tends to be more valuable since investors have the option to force issuers to repurchase their shares for more than their market value.

Question 151

Gordon Growth Model :

The Gordon constant growth model (GGM) estimates future dividend payments by assuming a constant dividend growth rate (g) and the required return on equity.

Answer 151

1- This is a forward-looking model because the stock’s value is determined by the next dividend to be paid (D1).

2- The assumption of constant dividend growth is more appropriate for stable, mature companies, but this model is less appropriate for companies that are growing rapidly and/or are not currently paying a dividend.

3- The dividend growth rate must be less than the required rate of return.

4- The sustainable rate of dividend growth can be estimated as the product of accounting return on equity (ROE) and the earnings retention rate (b), which is 1 minus the dividend payout ratio (g = b * ROE).

Question 152

Multistage Dividend Discount Models :

Analysts may use a multistage model that allows for two or more periods of different growth. Many companies experience temporarily high short-term growth before transitioning to a long-term sustainable growth rate.

Answer 152

Often used for companies in which the GGM do not apply.

Question 153

As the projection period increases, the stock’s terminal value represents a smaller proportion of its estimated present value because the future value is discounted over additional periods.

Question 154

Price multiples are ratios of the share price to some other value related to the relative worth of the company’s stock.

These can be retrospective (i.e., price/last year’s earnings) or forward-looking (i.e., price/next period’s earnings forecast).

Answer 154

Price-to-earnings (P/E)
Price-to-book (P/B)
Price-to-sales (P/S)
Price-to-cash-flow (P/CF)

Question 155

Time-series analysis considers changes in a company’s ratios over time, while cross-sectional analysis compares ratios among companies within the same industry or peer group.

Question 156

Relationships among Price Multiples, Present Value Models, and Fundamentals :

Price multiples are often used independently of present value models, but these models are connected. For example, the price-to-earnings ratio can be calculated by extrapolating from the Gordon growth formula to get a justified P/E ratio

Question 157

Method of Comparables :

This popular method is based on the law of one price, which states that identical assets should sell for the same price. In theory, a company trading at 14 times earnings is attractively priced compared to a similar company with a P/E ratio of 20.

Question 158

Enterprise value is calculated as the sum of the market values of all forms of capital (e.g., common stock, preferred stock, debt) net of cash and short-term investments.

Answer 158

It represents the cost of a takeover, since the acquiring company assumes (repays) the target company’s debt and receives its cash (useful for comparing companies with different capital structures).

Question 159

An advantage EV/EBITDA has over P/E is that EBITDA is typically positive even when earnings are negative.

Question 160

Asset-Based Valuation : This method values a company’s equity as the difference between the market values of its assets and liabilities.

Answer 160

Used in conjunction with other models to value private companies.

Financial firms, natural resource producers, and companies that are being liquidated are among the best fits for this method.

Question 161

Some important considerations for analysts include:

• Asset-based valuation is difficult for companies with large amounts of PP&E
• This method is easier to use for companies that have a high proportion of current assets/liabilities
• Estimates of value for intangible assets are highly subjective
• Asset values are difficult to estimate in hyper-inflationary environments

Question 162

A price earnings ratio that is derived from the Gordon growth model is inversely related to the:

A
growth rate.

B
dividend payout ratio.

C
required rate of return

Answer 162

C)