Equity Investments

JuiceNotes TM
- By FinTree
eBook 7
Equity Investments
CFA® Level 1 JuiceNotesTM 2017

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Market Organization and Structure

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LOS a Main functions of financial system

ª To allow entities to save and borrow money, raise capital, manage risks and trade assets
ª To determine the returns where total supply of savings equals total demand for borrowing
ª To allocate capital to its most efficient uses
LOS b Classification of assets
Financial assets Real assets
Securities Derivatives Currencies Real estate Equipment Commodities Others
ª Equity securities - Represent ownership in a company

ª Debt securities (Fixed income securities) - Promise to repay borrowed funds
ª Publicly traded securities - Traded on exchanges or through securities dealers

ª
ª
ª e
Private securities - Securities that are not traded publically. Often illiquid
Derivatives - Value is derived from the value of underlying asset

Financial derivatives - Underlying assets are equities, equity indexes, debt, debt indexes
re
or other financial assets
ª Physical derivatives - Underlying assets are physical assets such as gold, oil and wheat
Classification of markets
Based on trading
nT
Based on maturity
of security
Primary Secondary Money Capital

market market market market
Fi
Markets for longer-

Subsequent sales Market for debt term debt and
Market for newly equity securities
issued securities of securities occur securities with
in this market maturities ≤ 1 year that have no
specific maturity
date
Markets for immediate delivery are referred to as spot markets

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LOS c Describe the major types of assets that trade in organized markets
1 Securities
Fixed income Equity

securities securities
Intermediate Common Preferred

Short term Long term Warrants
term stock stock
Maturity of Maturity is in Maturity Variable Fixed dividend Similar to

less than the middle of longer than dividend options
one or two short-term five to ten
years and long-term years Last 2nd preference Give the holder
preference in in case of the right to buy
case of liquidity and firm’s equity
liquidity and dividend shares at a
Bonds Notes Bonds dividend payment fixed price
payment prior to the
warrant’s
expiration
e
Commercial paper (firms), Bills (govt.), Certificates of deposit (banks) are all short term securities
re
Pooled investment vehicles
Asset-backed
Mutual funds ETFs and ETNs Hedge funds
securities
nT
Investors can Trade like closed- Represent a claim Mutual Fund like
purchase shares end funds but have to a portion of a structure for HNIs
from the fund itself special provisions pool of mortgages,
(open-end funds) allowing conversion car loans, credit Use leverage, hold
or in the secondary into individual card debt etc. long and short
market (closed-end portfolio securities positions, use
funds) derivatives and
Sometimes referred invest in illiquid
Fi
to as depositories, assets
and their shares as
depository receipts
2 Currencies
ª Issued by a government’s central bank
ª Reserve currencies - Currencies held by governments and central banks worldwide.

Primarily includes Dollar and Euro
3 Contracts
Forward Futures Option Insurance

contract Swap contracts
contracts contracts contracts
Agreements to Used to hedge

exchange a series against
Agreement to of payments on unfavorable,
buy or sell an Long Call - Right periodic unexpected
asset in the to buy settlement dates events.
future at a price
specified in the Similar to Short Call - Currency swap - Eg. Life
contract at its forward contracts Obligation to sell Loan in one insurance, P&C
inception except that they currency for the insurance etc.
are standardized Long Put - Right loan of another
Eg. Agreement and exchange to sell currency Credit default
to buy 200 lbs of traded swaps (CDS) are
wheat 60 days Short Put - Equity swap - a form of
from now for Obligation to buy Exchange of insurance that
$800 return on an makes a
equity index for payment if an
interest payment issuer defaults
on debt on its bonds
4
e
Commodities
re
ª They trade in spot, forward and futures market
ª Include precious metals, industrial metals, agricultural products, energy

products, and credits for carbon reduction
5 Real assets
nT
ª Real assets include real estate, equipment, machinery etc.
ª Buying real assets directly often provides income, tax advantages, and
diversification benefits
ª There is substantial management cost involved
ª Rather than buying real assets directly, an investor can make investment
in REIT or master limited partnership (MLP) or buy the stock of firms that
Fi
have large ownership of real assets
LOS d Types of financial intermediaries and their services
Ÿ Brokers, exchanges and alternative trading systems connect buyers and sellers of the same security
at the same location and time
Ÿ Dealers match buyers and sellers of the same security at different points in time
Ÿ Arbitrageurs connect buyers and sellers of the same security at the same time but in different venues
Ÿ Securitizers and depository institutions package assets into a diversified pool and sell interests in it
Ÿ Insurance companies manage the risk inherent in providing insurance
Ÿ Clearinghouses reduce counterparty risk and promote market integrity
LOS e Positions an investor can take in an asset
Long position - Represents current or future ownership
Long benefits when the asset value increases
Short position - Represents an agreement to sell or deliver an asset or results from
borrowing an asset and selling it(short sale)
Short benefits when the asset value decreases
Leveraged position - When an investor buys a security by borrowing from a broker, the
investor is said to buy on margin and has a leveraged position
LOS f Leverage ratio, rate of return on a margin transaction and margin call price
Eg. S0 = 100 S1 = 120 Initial margin(IM) = 40% Maintenance margin (MM) = 20%
1 Opening price 1 100

Leverage ratio - Or = Or = 2.5
IM Equity 0.4 40
Rate of return on a
S1 - S 0 120 -100 20
margin transaction - = = = 50%
Equity 40 40
Margin call price - S0

)11 -- MM
IM
) = 100 ) 11 -- 0.4
0.2 )
= 75
LOS g, h
e
Execution, validity, and clearing instructions
Bid price - Price at which dealer buys a security
re
Ask price - Price at which dealer sells a security
Traders who post bids and offers are said to make a market
Those who trade with them at posted prices are said to take the market
1 Execution Market order - ª It instructs the broker to execute the trade immediately
instructions at the best possible price
nT
ª Appropriate when the trader wants to execute quickly

ª Disadvantage - Orders may execute at unfavorable prices
Limit order - ª Used to avoid price execution uncertainty

ª Disadvantage - Order might not be filled
Best bid Best ask

Fi
Buy order with Limit sell Making a new market Limit buy Sell order with
limit price below best bid (Inside the market) above best ask limit price
below best bid is said to be is said to be above best ask
is said to be marketable or marketable or is said to be
behind the aggressively aggressively behind the
market priced priced market
Make the market Make the market
(At best bid) (At best ask)
Limit orders waiting to execute are called standing limit orders

Limit buy order with a price considerably lower than the best bid, or a limit sell order with a
price significantly higher than the best ask, is said to be far from the market
ª All-or-nothing orders - Execute only if the whole order can be filled
ª Hidden orders - Only the broker or exchange knows the trade size
ª Iceberg orders- Some of the trade is visible to the market, but the rest is not
2 Validity instructions
ª Specify when an order should be executed
ª Day orders - They expire if unfilled by the end of the trading day
ª Good-till-cancelled - They last until they are filled
ª Immediate-or-cancel (Fill-or-kill) - They are cancelled unless they can be filled immediately
ª Good-on-close - They are only filled at the end of the trading day. If they are market orders,
they are referred to as market-on-close orders
ª Stop loss sell order - Stop (trigger) below the current market price
ª Stop loss buy order - Stop (trigger) above the current market price
Price Price
100
45
80
Time
e 30
Time
re
Stop loss sell order Stop loss buy order
Used to prevent losses or to protect profits Used by trader with a short position to
limit losses from increasing stock price
By an investor who believes a stock is

undervalued, but does not wish to invest in
nT
it until he thinks the market agrees with

the undervaluation
3 Clearing instructions
ª Tell the trader how to clear and settle a trade
ª Retail trades - settled by the broker

Fi
ª Institutional trades - settled by a custodian or another broker
LOS i Primary and secondary markets

Primary markets Secondary markets
Sale of newly issued securities Securities trade after their initial issuance
Seasoned offerings(secondary issues) - Shares
issued by firms whose shares are currently trading
in the market
Initial public offerings (IPOs) - Shares issued by
firms whose shares are not currently publicly traded
ª Book building - Process of gathering indications of interest
ª Indications of interest - Investors who agree to buy part of the issue
ª Underwritten offering - Investment bank agrees to purchase the entire issue at a price that
is negotiated between the issuer and bank. It must buy the unsold portion of the issue
ª Best efforts offering - Investment bank makes ‘best efforts’ to sell the issue but is not
obliged to buy the unsold portion
ª IPOs are typically underpriced because investment banks have a conflict of interest with the issuer
ª As issuer’s agents, investment banks should set high price to raise the most funds for the issuer
but as underwriters, they prefer to set the price low to sell the whole issue
ª Oversubscribed IPO is referred to as a hot issue
ª Private placement- Securities are sold directly to qualified investors(substantial wealth and
investment knowledge)
ª Shelf registration- Firm makes its public disclosures as in a regular offering but then issues
the registered securities over time when it needs capital
ª Dividend reinvestment plan (DRIP/DRP) - Allows existing shareholders to use their dividends
to buy new shares from the firm at a discount
e
Rights offering- Existing shareholders are given the right to buy new shares at a discount.
Because of rights offering shareholders’ ownership is diluted unless they exercise their rights
Importance of secondary market

re
Ê They provide liquidity
Ê They provide price/value information
Ê Better the secondary market, easier it is for firms to raise capital in the primary market
LOS j Quote-driven, order-driven and brokered markets

nT
Call markets Securities are only traded at specific times

They are liquid when in session but illiquid between sessions
Used in smaller markets but is also used to set opening prices on
major exchanges
Continuous markets Securities are traded at any time when the market is open
Price is set by either auction or by dealer bid-ask quotes
Fi
Quote driven Order driven Brokered
Traders transact with dealers who

post bid and ask prices Brokers find the counterparty to
Orders are executed using trading execute a trade
Dealers maintain inventory of rules
securities Useful when the trader has unique
Order matching rules and trade or illiquid security. Eg. artwork,
aka dealer markets, price-driven pricing rules large blocks of stock etc.
markets or OTC markets
Eg. Exchanges and automated Dealers do not carry inventory of
Most securities other than stocks trading systems these assets
trade in these markets
ª Pre-trade transparent market - Investors obtain pre-trade information regarding quotes & orders
ª Post-trade transparent market - Investors obtain post-trade information regarding completed

trade prices and sizes
ª Dealers prefer opaque markets. Transactions costs and bid-ask spreads are larger in opaque
markets
LOS k Characteristics of a well-functioning financial system
Complete markets - Savers receive a return, borrowers can obtain capital, hedgers can
manage risks, and traders can obtain needed assets
Operational efficiency - Trading costs are low

Informational efficiency - Prices reflect fundamental information quickly
Allocational efficiency - In informationally efficient markets capital is directed to its most

productive use
LOS l Objectives of market regulation
ª Protect unsophisticated investors

ª Establish minimum standards of competency
ª Help investors to evaluate performance
ª
ª
ª
Prevent insiders from exploiting other investors
e
Promote common financial reporting requirements so that information gathering is less expensive
Require minimum levels of capital so that market participants can honor their commitments and
be more careful about their risks
re
nT
Fi
Security Market Indices
LOS a What is a security market index ?
è Used to represent the performance of an asset class, security market, or segment of a market
è An index is a hypothetical portfolio
LOS b Price return and total return of an index
Price return Price index - Uses only the prices of the constituent securities
Rate of return that is based on a price index is referred to as price return
Total return Return index - Uses both prices and income of the constituent securities
Rate of return that is based on a return index is referred to as price return
LOS c Choices and issues in index construction and management
Ê The target market the index will measure
Ê Securities to be include from the target market
e
Ê Appropriate weighting method
Ê How frequently to rebalance the index to its target weights
Ê How frequently to re-examine the selection and weighting of securities

re
LOS d & e Different weighting methods used in index construction
Market
Price Equal Fundamental
capitalization
weighted weighted weighted
nT
weighted
Œ Average Price Œ % Change Œ Market capital
% Change Average Price % Change

Fi
These index returns Uses weights based

can be both price on firm fundamentals
return or total return such as earnings,
dividends or cash flow
Can be based on a
single measure or
combination of
measures
Eg.
Constituent P0 P1 DPS1 Quantity %∆P %∆P Market Market Dividend

securities with DPS capital0 capital1
A 100 140 5 10,000 40% 45% 1,000,000 1,400,000 50,000
B 120 80 6 20,000 (33.33%) (28.33%) 2,400,000 1,600,000 120,000
C 140 154 0 5,000 10% 10% 700,000 770,000 0
D 160 176 0 15,000 10% 10% 2,400,000 2,640,000 0
Average 130 137.5 2.75 6.667% 9.1675% 6,500,000 6,410,000 170,000
Price Equal Mkt. cap.

weighted weighted weighted
Œ Price return - Œ Price return - Œ Price return -
137.5 6.667% 6,410,000

-1 = 5.77% - 1 = (1.38%)
130 (Avg. of % ∆ Price) 6,500,000
Total return - Total return - Total return -

6,410,000 + 170,000 - 1
137.5 + 2.75 9.1675% 6,500,000
- 1= 7.88%
130
ª e
(Avg. of % ∆ P with DPS) =
In price-weighted index, denominator must be adjusted for stock splits

1.23%
re
ª Equal weighted portfolio requires most frequent rebalancing (adjusting periodically)
ª Market capitalization-weighted index is also known as value-weighted index

ª It can be adjusted for a security’s market float (excluding shares held by controlling
shareholders) or free float (Market float − shares not available for foreign buyers)
LOS f Rebalancing and reconstitution of an index

nT
Rebalancing Adjusting weights of securities in portfolio to their target

weights after weights are changed due to changes in price
Usually done quarterly
Reconstitution Adding or deleting securities that are included in an index

The price of security added to an index increases and the
Fi
price of security deleted from an index decreases
LOS g Uses of security market indices

ª Reflection of market sentiment
ª Benchmark of manager performance
ª Measure of market return
ª Measure of beta and excess return
ª Model portfolio for index funds

LOS h Types of equity indices
Broad market Multi-market Multi-market index

Sector index Style index
index index with fundamental
weighting
Uses market
It is used to
capitalization
measure the Measures value or
weighting for
equity returns of growth strategies
Usually contains securities within a
a geographic Measures returns
more than 90% country’s market
location for a sector (Eg. Higher constituent
of the market’s but weight the
pharmaceuticals) turnover than
total value countries within
Contains the broad market
the global index
indexes of indexes
by a fundamental
several countries
factor
LOS i Types of fixed-income indices
ª Fixed income indexes can be classified by issuer, collateral, coupon, maturity, default
risk and inflation protection
e
ª Fixed income security universe is much broader than the equity universe
ª Since fixed income securities mature, they must be replaced in fixed income indexes. As
a result, fixed income indexes have a high turnover
re
ª Fixed income securities are primarily traded by dealers, so index providers have to
depend on dealers for recent prices
LOS j Indices representing alternative investments

nT
Commodity Real estate Hedge fund

indexes indexes indexes
Can be based on
Equally weighted
Based on appraisals of
indexes
commodity properties, repeat
Fi
futures not property sales or

Exhibit upward
spot prices the performance
bias
of REITs
LOS k Types of security market indices

è Geographic location - Eg. regional or global indexes
è Sector/industry - Eg. indexes of pharmaceuticals producers
è Level of economic development - Eg. emerging market indexes
è Fundamental factors - Eg. indexes of value stocks or growth stocks
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Market Efficiency © 2017 FinTree Education Pvt. Ltd.
LOS a Market efficiency and related concepts
Informationally efficient All information available about a security is reflected fully,

capital market quickly, and rationally in its current price
In a perfectly efficient market, investors should use passive investment strategy

(investing in indexes) because active investment strategies will underperform due to
transactions costs and management fees
Market’s efficiency can be determined by the time taken

by information to reflect in the price of the security
Market prices are not affected by the release of information that is well anticipated.
Only new information that is unexpected causes changes in prices
LOS b Market value Intrinsic value

Value that a rational
investor would willingly
pay
Current price of the asset
Can’t be known with
Can be known with certainty
certainty
eChanges constantly as
new information becomes
available
re
LOS c Factors that affect market efficiency
Market participants More the market participants, more efficient the market
Availability of information More information available to investors, more efficient the
market
nT
Impediments to arbitrage Limit arbitrage activity and allow some price inefficiencies
to persist
Short selling Improves market efficiency. Restrictions on short selling
reduces market efficiency
Transaction and If information cost > potential profit, market prices will
information costs be inefficient
Fi
LOS d & e Weak-form Semi-strong Strong-form

market form market market
Efficient markets EMH states that security EMH states that security
hypothesis (EMH) states prices fully reflect all prices fully reflect all
that security prices fully publicly available public and private
reflect all past price and information information
volume information
Technical analysis does Fundamental analysis Active management does

not result in abnormal does not result in not result in abnormal
profits abnormal profits profits
LOS f Market anomalies
Market anomaly - Something that deviates from the efficient market hypothesis
Anomalies
Time-series Cross-sectional
data data
Calendar Overreaction Momentum

Size effect Value effect
anomalies anomalies anomalies
January effect or
turn-of-the-year Firms with poor High short-term
effect stock returns over returns are
previous 3 to 5 followed by Small-cap stocks Value stocks
For first five years have better continued high outperform outperform
days of January, subsequent returns large-cap stocks growth stocks
stock returns for return
small firms are Violates semi- Violates semi-
significantly
higher than they
are for the rest
of the year
Violate weak form
of market
efficiency because
profitable e
Violate weak form
of market
efficiency because
profitable
strong form of
market efficiency
because
information is
strong form of
market efficiency
because
information is
re
strategy is based strategy is based publicly available publicly available
Reasons - tax- only on market only on market
loss selling and data data
window dressing
Other anomalies
ª Closed-end investment funds trading at large discount to NAV
nT
ª Slow adjustments to earnings surprises
ª IPOs are typically underpriced, but long-term performance of IPO shares as a group is below average
suggesting investors overreact (too optimistic about a firm’s prospects on the offer day)
ª According to research, stock returns are related to known economic fundamentals such as dividend
yields, but relationship between them is not consistent over all time periods
Fi
LOS g Behavioral finance
Examines the actual decision-making processes of investors
Investors exhibit biases in their decision making, base decisions on the actions
of others and not evaluate risk in the way traditional models assume they do
Investor behaviors:
Loss aversion (dislikes risk)
Investor overconfidence (overestimate their abilities to analyze security)
Herding (mimicking investment actions of other investors)
Overview of Equity Securities
LOS a Characteristics of types of equity securities

1 Common shares
è Most common form of equity
è Capital appreciation
è Variable dividend (no obligation to pay)
è Dividend is a function of profitability
è Last preference in case of liquidity and dividend payment
Voting system Options
Statutory Cumulative
Callable Putable
voting voting
Shareholders can
Each share held is Firm has right to Shareholder has right
cast all their votes
assigned one vote in repurchase the stock to sell the stock back
to one single board
the election of each
member of the BODs
candidate or divide
them among others
e at a pre-specified
price
to the firm at a
pre-specified price
re
2 Preference shares
è Features of both common stock and debt
è Usually do not mature
è Can have call or put features just like common stock or debt
nT
è Do not have voting rights
è Fixed dividend (no obligation to pay)
è Dividend is a function of profitability
è 2nd preference in case of liquidity and dividend payment

Fi
Based on accumulation Based on receipt of Based on

of dividend extra dividend conversion
Cumulative Non- Participating Non- Convertible Non-

cumulative participating convertible
Dividends Dividends Receive extra Do not receive Can be Can not be

that are not do not dividends if firm extra dividends converted to converted
paid in past accumulate profits exceed a if firm profits common to common
must be paid over time pre specified exceed a pre stock stock
level specified level
LOS b Ownership characteristics among different equity classes
Ê Some companies’ equity shares are divided into different classes, such as Class A
and Class B shares
Ê Different classes of common equity may have different voting rights and priority
in liquidation. They may also be treated with different dividends, stock splits etc.
Ê Such information can be found in the company’s filings with securities regulators
LOS c Private equity compared to public equity

è Usually issued to institutional investors
è Less liquidity
è Direct negotiation between the firm and its investors
è Limited financial disclosure
è Lower reporting costs
è Potentially weaker corporate governance
è Greater ability to focus on long-term prospects
è Potentially greater return
LOS d
e
è Main types - VCs, LBOs, MBOs, PIPE
re
Methods for investing in foreign equity securities
Integrated markets - Capital flows freely across borders
Obstacles to direct Investment and return are denominated

foreign investment - in foreign currency
Foreign stock exchange may be illiquid
nT
Reporting requirements may be less strict

Investors must be familiar with the regulations
Depository receipts (DRs)

Global depository Issued outside US and outside
Represent ownership in a foreign firm receipts (GDRs) the issuer’s home country
Traded in the markets of other countries in
Fi
local market currencies American depository Denominated in USD and are

receipts (ADRs) traded on U.S. exchanges
Bank deposits shares of the foreign firm
and then issues receipts representing
ownership of foreign shares Global registered Trade in different currencies
shares (GRS) on stock exchanges around
If the firm is involved with the issue, it is a
sponsored DR or it is an unsponsored DR the world
Basket of listed Is an ETF that is a collection

depository receipts of DRs
Investor has Bank has voting (BLDR)
voting rights rights
LOS e Risk and return characteristics of equity securities
Returns consist of dividends, capital gains/losses from changes in
share prices, and foreign exchange gains or losses if any
Common measure of risk for equity securities is standard deviation
Putable shares - Least risky

Callable shares - Most risky
Cumulative preferred shares - Less risky

Non-cumulative preferred shares - More risky
LOS f Role of equity securities in the financing of a company’s assets
ª Used for the purchase of long-term assets, equipment and research and development
ª Used to buy other companies
ª Used to offer to employees as compensation
ª Publicly traded equity securities provides liquidity
LOS g Market value Book value

Share price X No. of shares Assets - Liabilities
Reflects investors’
expectations about timing,
amount and risk of firm’s
future cash flows e Reflects firm’s financial
decisions and operating
results since its inception
Increases when firm has

re
positive net income
LOS h Investors’ required

Return on equity Cost of equity
nT
return
Net income Estimated expected

Equity market return
Minimum rate of return
Usually higher the better that investors require Estimated return >
Minimum return = Invest
Measures whether Usually estimated using
management is generating DDM or CAPM Reflected in the market
Fi
a return on common equity price of firm’s share

Introduction to Industry And Company Analysis
LOS a Uses of industry analysis
ª Provides a framework for understanding the firm
ª Can provide information about the firm’s potential growth, competition,

risks, appropriate debt levels and credit risk
LOS b Ways to group companies and industry classification systems
ª Commercial Classifications:
Ÿ Global Industry Classification Standard

(GICS) - S&P and MSCI Barra
Firms can be grouped into industries Ÿ Russell Global Sectors (RGS)
according to their products and services, Ÿ Industry Classification Benchmark (ICB) -
business cycle sensitivity or through Dow Jones and FTSE
statistical methods such as cluster analysis
ª Government Classifications:
Sector - Group of similar industries Ÿ International Standard Industrial
Classification (ISIC) - United Nations
Ÿ Australian and New Zealand Standard
Industrial Classification - Australia and NZ
e Ÿ North American Industry Classification

System (NAICS) - US, Canada & Mexico
re
Commercial Government
classification classification
Do not identify constituent firms

Identifies the constituent firms
Updated less frequently
nT
Updated frequently
Does not distinguish b/w small or
Includes for-profit and public
large firms, profit or not-for-profit
firms
firms, or private or public firms
Fi
LOS c Cyclical firms Non-cyclical firms
è Earnings are less dependent on business

è Earnings are highly dependent on business cycle
cycle
è Can be further separated into defensive
è Have high operating leverage (stable) or growth industries
è Their products are often expensive, non- è Defensive - least affected by business cycle
necessities whose purchase can be delayed
until the economy improves è Growth - Demand is strong. Largely
unaffected by business cycle
LOS d Peer group It consists of companies with similar business activities, demand drivers,
cost structure drivers and availability of capital
LOS e Elements needed to be covered in thorough industry analysis

ª Evaluate the relationships between macroeconomic variables and industry trends
ª Estimate industry variables using different approaches and scenarios
ª Check estimates against those from other analysts
ª Compare the valuation for different industries
ª Compare the valuation for industries across time to determine risk and rotation strategies
ª Analyze industry prospects based on strategic groups
ª Classify industries by their life-cycle stage
ª Position the industry on the experience curve
ª Consider demographic, macroeconomic, governmental, social and technological influences
ª Examine the forces that determine industry competition
LOS f Porter’s five forces

Œ Rivalry among existing competitors
Threat of entry
Ž Threat of substitutes
Power of buyers
LOS g
Power of suppliers
e
re
Barriers to Industry Industry Market share
entry concentration capacity stability
Capacity can be
High industry physical or non-physical Highly variable shares
concentration does indicate a highly
Benefit existing
nT
not guarantee pricing Undercapacity - competitive industry

industry because they power Demand > Supply in which firms have
prevent new little pricing power
competitors from Industries with Overcapacity -
taking away market greater product Demand < Supply Switching costs -
share differentiation will Costs that customers
have greater pricing Capacity is fixed in face when changing
High barriers to entry power short run and variable from one firm’s
do not necessarily in long run products to another
Fi
mean firm pricing market fragmentation

power is high results in strong Non-physical capacity High switching costs -
competition and low can be reallocated more market share stability
return on capital quickly than physical and pricing power
capacity
LOS h Industry life cycle
Demand
Mature
Decline
Shakeout
Growth
Embryonic
Time
Embryonic Growth stage Shakeout

Mature stage Decline stage
stage stage
Slow growth - Rapid growth - Slowing growth - Slow growth - Negative growth -
Customers are New consumers Demand reaches Saturation of Due to substitutes,
unfamiliar with the
product
High prices -
discover the
product
Little competition -
with new
customers
e
saturation level market. Demand
is only for
replacement
societal changes or
global competition
Declining prices -
re
Volume required Threat of new Intense Consolidation - Intense
for economies of entrants but firms competition - Market evolves competition and
scale is not yet still grow without Industry growth to an oligopoly price wars due to
reached competing on price gets slowed. So overcapacity
firm growth comes High barriers to
Large investment - Falling prices - at the expense entry - Consolidation -
To develop the Economies of scale of competitors Firms have brand Failing firms exit or
product are reached and loyalty and low merge
nT
distribution Industry cost structures

High risk - channels increase overcapacity -
Most embryonic Supply > demand Stable pricing -
firms fail Increasing Firms try to
profitability - Declining avoid price wars
Due to economies profitability -
of scale Due to Superior firms
overcapacity gain market
Fi
share -
Cost cutting - Firms with better
Firms restructure products may
to survive and try grow faster than
to build brand industry average
loyalty
Increased failures -
Weaker firms
liquidate or are
acquired
LOS i Elements of industry strategic analysis
è Major firms
è Barriers to entry and success
è Industry concentration
è Influence of industry capacity on pricing
è Industry stability
è Life cycle
è Competition
è Demographic influences
è Government influence
è Social influence
è Technological influence
è Business cycle sensitivity
LOS j External influences on industry growth, profitability and risk
Macroeconomic Technological Demographic Governmental Social
Includes tax rates, Relate to how
Can be cyclical or
structural
Technology can
dramatically
change an e
Includes size and
age distribution of
the population
regulations,
empowerment of
self-regulatory
organizations,
people work, play,
spend their money
and conduct their
lives
re
industry through and government
Include long-term the introduction of Eg. Aging of the purchases of Eg. When women
trends in factors new or improved overall population goods and started getting
such as GDP products. can mean services jobs, restaurant
growth, interest significant growth industry
rates and inflation Eg. Computer for the health care Eg. Ban on benefitted
hardware industry tobacco because there was
production less cooking at
nT
home
LOS k Elements that should be covered in a thorough company analysis

Competitive strategy - How firms responds to opportunities and threats
Cost leadership - Low cost, low price, superior return
Used to protect market share (defensive) or to
Fi
gain market share (offensive)

Product differentiation - Firm’s products/services are distinctive
in terms of type, quality or delivery
Company analysis involves analyzing firm’s financial condition, products

and services, and competitive strategy. It includes following elements
Ÿ Firm overview
Ÿ Industry characteristics
Ÿ Product demand
Ÿ Product costs
Ÿ Pricing environment
Ÿ Financial ratios
Ÿ Projected financial statements and firm valuation
Equity Valuation: Concepts And Basic Tools
LOS a Determine whether stocks are overvalued, undervalued, or fairly valued

Fairly valued - Market price = Intrinsic value
Undervalued - Market value < Intrinsic value
Overvalued - Market value > Intrinsic value
For security valuation to be profitable, the security must be mispriced now and price
must converge to intrinsic value over time
More investors after a security, more likely it is to be fairly valued
LOS b Major categories of equity valuation models
Discounted cash flow model Multiplier model

Asset-based model
(Present value model) (Market multiple models)
Value is estimated as PV of Two types Total Assets - Total Liabilities

cash distributed to No of shares
shareholders (DDM) or PV of Œ Ratio of stock price to
cash available to shareholders
after fixed and working capital
expenses (FCFE) ratio
e
fundamentals (earnings,
sales, BV, CF etc.) Eg. P/E
Ratio of Enterprise Value

(EV) to EBITDA or sales
re
LOS c Describe DDM & FCFE
1 DDM
D1 P1
One-year holding period DDM = +
(1 + Ke)1 (1 + Ke)1
nT
D1 D2 P2
Two-year holding period DDM = + +
(1 + Ke)1 (1 + Ke)2 (1 + Ke)2
Eg. P1 = 15 P2 = 21 D0 = 1.5 Expected dividend growth = 5% Required rate of return = 13.5%
D1 1.5 x (1 + 0.05) 1.575

One-year holding period DDM = = = = 1.39
(1 + Ke)1 (1 + 0.135)1 (1.135)
+
Fi
P1 15 15
= = = 13.215
(1 + Ke)1 (1 + 0.135)1 (1.135)
14.605
D1 1.5 x (1 + 0.05) 1.575 1.39

Two-year holding period DDM = = = =
(1 + Ke)1 (1 + 0.135)1 (1.135)
+ D2 1.5 x (1 + 0.05)2 1.65
= = = 1.28
(1 + Ke)2 (1 + 0.135)2 (1.288)
+ P2 21 21
= = = 16.3
(1 + Ke)2 (1 + 0.135)1 (1.288)
18.97
2 FCFE Free Cash Flow to Equity
Free Cash Flow to Firm (FCFF) = Net income + Non cash
charges(depreciation) + Interest x (1 − tax rate) +/− Working
capital investment +/− Fixed capital investment
FCFE = FCFF − Interest (1 − tax rate) +/− Net borrowing

FCFEt
PV of FCFE =
(1 + Ke)t
LOS d Intrinsic value of non-callable, non-convertible preferred stock

Dividend
Value (Infinite maturity) =
Kp
Dividend Face value

Value (Finite maturity) = +
Kp Kp
LOS e Gordon growth model
D1
V0 =
Ke − g
Dividend displacement effect
Assumptions of GGM (DDM)
g = Vo
Ÿ ROE is constant
Ÿ Dividend payout ratio is constant
Ÿ Therefore growth ‘g’ will remain constant
(g = ROE x Retention ratio)
Ÿ To keep ROE constant capital structure e Ke = Vo ¯
D = Vo
If D then retention ratio ¯, g ¯, Vo ¯

re
should be constant
Ÿ Ke > g
Eg. Expected dividend growth (For 4 years) = 20% Expected dividend growth (after 4 years) = 5%
D0 = 2 Ke = 13% Calculate the value of stock
D0 = Given = 2
nT
D1 = 2 x (1+ 0.2)1 = 2.4

D2 = 2 x (1+ 0.2)2 = 2.88
D3 = 2 x (1+ 0.2)3 = 3.456
D4 = 2 x (1+ 0.2)4 = 4.1472
D4 4.1472
P3 = = = 51.84
Fi
Ke - g 0.13 - 0.05
2.4 2.88 3.456 51.84 = 38.57

Value of stock - + + +
1.13 1.132 1.133 1.133
LOS f Appropriateness of constant growth and multistage dividend discount model

ª Constant growth model - Firms that pay dividends that grow at a constant rate (stable/mature
firms or noncyclical firms)
ª 2-stage DDM - Firm with high current growth that will drop to a stable rate in the future (firm
experiencing temporary high growth phase)
ª 3-stage DDM - Young firm that is still in its high growth phase
LOS g & h Valuation based on multiples
Price-Earning multiple (P/E)
Based on MPS Based on fundamentals
Leading Trailing Leading Trailing
Po Po Vo Vo
E1 E0 E1 E0
Vo D1/(Ke - g) Vo D0(1 + g) / Ke - g
= =
E1 E1 E0 E0
Payout ratio Payout ratio x (1+ g)
= =
Ke - g Ke - g
P/E - MPS/EPS P/S - MPS/Sales per share P/B - MPS/BVPS P/CF - MPS/CF per share
LOS i Enterprise value
e
Measures total company value
EV = MV of equity + MV of debt + MV of preferred stock − Cash − Short term investments

re
Appropriate when firms have significant differences in capital structure
EBITDA is most frequently used denominator for EV multiples (EV/EBITDA)
LOS j Asset-based valuation models

Equity value = MV of Assets − MV of Liabilities
nT
Appropriate for a firm whose assets are largely tangible and have fair values that
can be established easily
LOS k Advantages and disadvantages of each category of valuation model

DCF (PV) model Multiplier model Asset-based models
Fi
Advantages Disadvantages Advantages Disdvantages Advantages Disdvantages

Ÿ Mvs are difficult
Ÿ Sensitive to to obtain
Ÿ Widely used inputs Ÿ Inaccurate
Ÿ Readily Ÿ Negative Ÿ Can provide when firm has a
Ÿ Inputs must be available denominator floor values large amount of
Ÿ Easy to
estimated Ÿ Useful for results in a Ÿ Useful for intangible
calculate
predicting stock meaningless valuing public assets or future
Ÿ Estimates are returns ratio (P/E) firms that CFs not
Ÿ Widely
very sensitive Ÿ Can be used in Ÿ May not be report fair reflected in
accepted
to input values time series and comparable values (MV) asset value
cross-sectional across firms, Ÿ difficult to
comparisons especially value during
internationally hyperinflation

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Market Organization and Structure

LOS a Main functions of ﬁnancial system

ª To allocate capital to its most efﬁcient uses

LOS b Classiﬁcation of assets

Financial assets Real assets

Securities Derivatives Currencies Real estate Equipment Commodities Others

ª Equity securities - Represent ownership in a company

ª Publicly traded securities - Traded on exchanges or through securities dealers

Derivatives - Value is derived from the value of underlying asset

Primary Secondary Money Capital

Markets for longer-

Markets for immediate delivery are referred to as spot markets

Fixed income Equity

Intermediate Common Preferred

Maturity of Maturity is in Maturity Variable Fixed dividend Similar to

ª Issued by a government’s central bank

ª Reserve currencies - Currencies held by governments and central banks worldwide.

Forward Futures Option Insurance

Agreements to Used to hedge

ª Include precious metals, industrial metals, agricultural products, energy

ª Real assets include real estate, equipment, machinery etc.

ª There is substantial management cost involved

have large ownership of real assets

LOS d Types of ﬁnancial intermediaries and their services

1 Opening price 1 100

Margin call price - S0

ª Appropriate when the trader wants to execute quickly

Limit order - ª Used to avoid price execution uncertainty

Best bid Best ask

Limit orders waiting to execute are called standing limit orders

ª Good-till-cancelled - They last until they are ﬁlled

By an investor who believes a stock is

it until he thinks the market agrees with

ª Retail trades - settled by the broker

ª Institutional trades - settled by a custodian or another broker

LOS i Primary and secondary markets

ª Indications of interest - Investors who agree to buy part of the issue

ª Oversubscribed IPO is referred to as a hot issue

Importance of secondary market

LOS j Quote-driven, order-driven and brokered markets

Call markets Securities are only traded at speciﬁc times

Quote driven Order driven Brokered

Traders transact with dealers who

ª Post-trade transparent market - Investors obtain post-trade information regarding completed

LOS k Characteristics of a well-functioning ﬁnancial system

Operational efﬁciency - Trading costs are low

Allocational efﬁciency - In informationally efﬁcient markets capital is directed to its most

LOS l Objectives of market regulation

ª Protect unsophisticated investors

LOS a What is a security market index ?

è An index is a hypothetical portfolio

LOS b Price return and total return of an index

LOS c Choices and issues in index construction and management

Ê The target market the index will measure

Ê Securities to be include from the target market

Ê How frequently to rebalance the index to its target weights

Ê How frequently to re-examine the selection and weighting of securities

Œ Average Price Œ % Change Œ Market capital

 % Change  Average Price  % Change

These index returns Uses weights based

Constituent P0 P1 DPS1 Quantity %∆P %∆P Market Market Dividend

% Change Average Price % Change

Total return - Total return - Total return -