Equity

Front 1

Main Functions of A Financial System

Back 1

• (Peoples uses for financial system) Allows entities to borrow, save, issue equity, manage risk, exchange assets, and utilize information
• Determines the returns that equate savings and borrowing across the economy
• Allocate capital efficiently to its highest valued uses.

Front 2

Financial vs. Real Assets

Back 2

Financial: stocks, bonds, contracts

Real Assets: PP&E, Real estate

Front 3

Physical Derivatives vs. Financial Derivatives

Back 3

Physical: Underlying is something real like wheat to oranges.

Financial: Underlying is a financial item like interest rates or exchange rates.

Front 4

Spot vs. Future Markets

Back 4

Same for forwards

Spot: market for immediate delivery

Futures: agree to buy and sell in the future at a price determined now

Front 5

Primary vs. Secondary Markets

Back 5

Primary: Initial Issuance

Secondary: Traded in between investors. Provide liquidity and information about value to investors.

Front 6

Money Markets vs. Capital Markets

Back 6

Money Market: Securities have maturity of less than one year

Capital Markets: Maturity of one year or greater.

Front 7

Traditional vs. Alternative Markets

Back 7

Traditional: All publically traded debts and equities, and pools of publically traded debts and equities

Alternative: hedge funds, private equities, commodities, real estate securities, real estate properties, securitized debts, operating leases, machinery, collectables and precious metals. Because they are difficult to value, they sometimes trade far off from intrinsic values.

Front 8

Call vs. Continuous Assets

Back 8

Call: Trades only at a specific points in time. All bids and asks are accumulated and then price is set that clears the market. Price is normally what maximizes volume.

Continuous: Trades constantly while market is open.

Front 9

Describe Brokers/Exchanges and the role they provide

Back 9

Connects buyers and sellers together at the same time with no stake in underlying, traded asset.

Front 10

Describe Dealers and the role they provide

Back 10

Match byers and sellers of the same security at differnet points in time by holding inventory. Has stake in value of underlying, traded asset.

Front 11

Arbitrageurs

Back 11

Transact between buyers and sellers of the same security, at the same time, on different markets

Front 12

Securitizers (Depository Institutions)

Back 12

Sells diversified pool of assets. Think Sears selling securitys on $1 billion of their credit card debt

Front 13

Insurance Companies

Back 13

Manage a diversified pool of risks

Front 14

Clearinghouses

Back 14

Reduce counterparty risk and promote market integerity. They facilitate the transfer of assets from one investor to another.

Front 15

Selling Short Rules

Back 15

• Sell share high, buy it back at lower price
  
• Short position pays dividends out.
  
• Must meet maintainence margin equity percentage. Calculated as (Stock value - loan)/Stock value
  

Front 16

Buying on Margin Rules

Back 16

• Must meet "Initial Margin Requirement"
  
• Must maintain minimum equity percentage or get margin called. Calculated as (Stock value - loan)/stock value

Front 17

Leverage Ratio of Margin

Back 17

(1/% of margin used in transaction)

Ex. 50% margin would yield a financial leverage ratio of 2. This means for a 10% fluctuation in asset value, you would receive a 20% return.

Front 18

Investor's Return on Margin

Back 18

Net Proceeds (Sales Proceeds - Loan Amount - Interest on Loans - Commision on sale + Dividends Received)

/

Total Intital Investment (Cash you put up + any commision on purchase)

Front 19

Margin Call

Back 19

If Equity < Maintainence margin, investor must deposit more cash or be force closed out of their position.

Trigger Price = Initial Price[(1 - Initial Margin)/(1 - Maintainence Margin)]

Front 20

Limit Order

Back 20

Buy at limit price or lower, sell at limit price or higher. Different types are

• Good Till Cancel
• Immediate or Cancel
• Day Order

Front 21

Stop (loss) Order

Back 21

Once the price reaches a "trigger price", it turns into a market order

• Trader whos long a stock trading at 35 could put a stop sell at 31.50
• Trader whos short a stock trading at 35 could put a stop buy at 39
• Technician who thinks a big move will come when/if the price reaches 60, might put a stop buy at 60

Front 22

Underwritten Offer vs. Best Efforts Offer

Back 22

Underwritten: Investment bank gaurantees the securities sale, or they will purchase.

Best Efforts: Investment bank acts as a broker and holds stake.

Front 23

Private Placements

Back 23

Securities are sold directly to qualified investors, less restriction since investors are considered "qualified".

Front 24

Shelf Registration

Back 24

Company makes all public disclosures it would if it was selling new shares, but does not sell the securities immediately. Instead, they sell them when they are in need of additional capital.

Front 25

Dividend Reinvestment Plan

Fix me

Back 25

Issue New Share to shareholders who reinvest dividends, sometimes at a slight discount.

Front 26

Rights Offering

Back 26

Corporation distributes rights to buy stock at a fixed price to exisint shareholders in proportion to their current holdings. Can be sold or traded. Shareholders must exercise to avoid dillution of shares.

Front 27

How Securities Are Traded on Quote-Driven, Order-Driven, and Brokered Markets.

Back 27

Quote Drive: Trades take place at quotes set buy dealers. Dealers supply liquidity.

Order-Driven: Buyers and sellers are matched. First priority goes to the lowest seller and the highest bidder. Second priority for a set price is who is showing the quantity being traded. If it is kept private it is a lower priority. Last precedence is time. First come first serve. Traders supply liquidity.

Brokered: Brokers find buyers for a seller. More common with hard to trade securities and large blocks of regular securities.

Front 28

Objectives of Market Regulation

Back 28

1. Control Fraud
2. Control Agency Problems
3. Promote Fairness
4. Set mutually beneficial standards
5. Prevent undercapitalized financial firms from exploiting their investors by making excessively risk investments
6. Ensure that long-term liabilites are funded

Front 29

Charactersitics of a Well-Functioning Financial System

Back 29

1. Complete Markets: existence of well-developed markets that trade instruments that help people solve their financial problems.
2. Operationally Efficient: Liquid markets in which costs of trading are low.
3. Informationally (Market) Efficient: Prices reflect fundamental values
4. Financial Intermediares facilitate transactions and file timely financial disclosures.

Front 30

Transparent vs. Opaque Transaction Costs

Back 30

Lower in transparent because traders can more easily determine market value and more easily manage.

Front 31

Investor vs. Information Trader

Back 31

Investor: Expects equilibrium (fair) returns over time.

Information trade: Expects a positive risk adjusted return (active management)

Front 32

Open vs. Closed End Funds

Back 32

Open: sell shares back to the fund (TRP)

Closed: Sell on market

Front 33

Forward vs. Futures Contracts

Back 33

Forwards: Unregulated, between two parties.

Futures: Traded, no counterparty risk because it goes through clearinghouse

Front 34

Validity Instruction

Back 34

Instruction regarding when to fill an order

Front 35

Make The Market vs. Take The Market, vs. Make A New Market

Back 35

Make the Market: Bid at the best bid. Offer to trade.

Take the Market: Selling at bid or buying at ask. Accepting a trade.

Make a New Market: Bidding higher than the higest bid but lower than the ask.

Front 36

Security Market Index

Back 36

Represents value of a set of assets. Calculated from market prices of indexes constituent securities. Can represent a security market, market segment, or asset class.

Front 37

Price Return on an Index vs. Total Return on An Index

Back 37

Price Return: (Ending Price/ Beginning Price) - 1

Total Return: [(Ending Price + Cash Flows)/ Beginning Price] - 1

Front 38

Index Constructors Must Decide

Back 38

1. What market it represents (what universe of investments to pick from)
2. What securities will be included
3. What weighting scheme
4. When it will rebalanced
5. When securities will be re-examined

Front 39

Different Weighting Methods Used in Index Constructio, as they relate to Market Cap Weighting

Back 39

Price-Weighted: Factors higher priced stocks and is more affected by stock splits

Equal Weighted: Places more weight on small cap stocks and less on large cap. More frequent rebalancing is necessary.

Float-Adjusted: More closely matches investable shares proportion.

Fundamental Weigted: More suseptable to value tilt (favoring of one particular parameter)

Front 40

Price Weighted Index

Back 40

Equal number of shares of each stock. Percentage change in high price stock effects more than a percentage change in a lower priced stock.

ex. DIJA

PWI = (Sum of stock prices)/(Number of stocks, adjusted for stock splits)

Front 41

Market-Cap Weighted Index

Back 41

Matches portfolio weights to each stock's percentage of total market value of index stocks. Larger market caps have more influence. Prone to Momentum Tilt (overpriced have higher weights in value weighted index). S&P 500.

Calculate market cap of stock as a proportion to market cap of total index to determine weightings.

Front 42

Float-Adjusted Market Capitalization Weighting

Back 42

Adjustment to market capitalization model to only include share that are market float (available to the investing public).

Free Float: Excludes any shares not offered internationally.

Front 43

Fundamental Weighting

Back 43

Weightings in index are based upon proporiton to total value of a fundamental factor (revenue, earnings, cash flow, etc.)

Prone to value tilt (overvaluing one parameter)

Front 44

Equal-Weighted Index

Back 44

Same weight of each index stock. Often times rebalances more regularly than other weightings.

Front 45

Rebalancing vs. Reconstitution

Back 45

Rebalancing: Updating the index weights on a periodic basis.

Reconstitution: process of chaning the constituent securities in an index. Part of rebalancing cycle.

Front 46

Uses of Market Indices

Back 46

• gauges market setiment
• Proxies for measuring and modeling returns, systematic risk, and risk-adjusted performance
• proxies for asset classes in asset allocation models
• benchmarks for actively managed portfolios
• model portfolios for such investment products as index funds and ETFs
• Calculating Beta

Front 47

Types of Indexes

Back 47

Broad Market: Represents an entire given equity market.

Multi-Market Market-Cap: Represent several markets. (Can be done with GDP weighting)

Sector: represent and track different sectors

Style: Classified by market capitalization, value, growth, or a combination of these characteristics.

Front 48

Fixed Income Indexes Can Be Sorted By

Back 48

Can be sorted by:

• Type of issuer (gov, corporate etc.)
• Type of financing (collaterized, general obligation)
• Currency of Payments
• Credit quality
• Inflation protection

Front 49

Alternative Investment Indexes

Back 49

Commodity Indexes: Index for futures contracts, prices can vary from underlying.

Real Estate Indexes: Apprasials, repeat sales, REITS

Hedge Fund Selection: self-selection and survivorship bias are likely.

Front 50

Aggregate Fixed Income Indices fix me

Back 50

Can be divided by market sector, style, economic sector, or another characteristic that to narrow the style.

Front 51

Market Efficiency

Back 51

Also called informational efficiency. Security prices quickly and fully reflect all available information in a statistical sense. Investors cannot use information to earn positive abnormal (risk-adjusted) returns on average. If an efficient market, any changes are based upon new information.

Front 52

Market vs. Intrinsic Value

Back 52

Market: Value at which an asset can be bought or sold.

Intrinsic Value: Value a rational investor would place on an asset with full view of its characteristics

Front 53

Factors that Affect a Market's Efficiency

Back 53

1. Number of Market participants (more participants, more efficient)
2. Availability of information (more available, more efficient)
3. Impediments on Trading (less impediments, more efficency. Example, you can't hold a short position in real estate.
4. Transaction and Information Acquiring Costs (lower costs, more efficient)

Front 54

Forms of Market Efficiency

Back 54

Weak Form: Efficient to market information (price and volume). Disagrees with technical analysis.

Semi-Strong Form: Efficient to all publically known and available information. Disagrees with both technical and fundamental analysis.

Strong: Market is strong to all information, including private information.

Front 55

Active Management's Role in Efficient Markets

Back 55

• Establish portfolio risk/returns
• Diversification
• Implement asset allocation based on risk/return objectives
• Minimize Tax Burdens

Front 56

Market Anomalies

Back 56

A change in the price of an asset or secuirty that cannot directly be linked to current relevant information known in the market. If you cannot put an economic basis behind it, you should not trade on it. Does not necessarily mean market inefficiency.

Examples include:

• Calendar Affects
• Overreactions
• Momentum
• IPOs

Front 57

Behavioral Finance

Back 57

Investors do not always act rational, and have cognitive biases.

Markets can still be efficient even if investors exhibit irrational behavior.

Front 58

Loss Aversion

Back 58

Investors dislike losses more than they like gains

Front 59

Information Cascading

Back 59

Uninformed investors follow the lead of informed investors, and the trickle down decreases any possiblity for growth.

Front 60

Size Effect Anomaly

Back 60

Small cap companies out perform large caps on a risk adjusted basis. Has since been relatively disproved

Front 61

Value Effect Anomaly

Back 61

Companies with below average P/E and market to book ratios, and pay above average dividends, out performed growth stocks over long periods of time.

Front 62

Characteristics of Common Stock

Back 62

• Dividends are variable with no obligation to be paid
  
• Have residual claim to firm assets
• Vote for board of directors
• Different classes of common shares have different voting rights
• Can be callable by the firm, or putable by the investor.

Front 63

Characteristics of Preferred Stock

Back 63

• Dividends are fixed, but are not an obligation
• Can be callable by the firm, or putable by the investor.
• Rank above common stock and below debt during liquidation.
• Do not share in operating performance
• Mostly do not have voting rights

Less risky than common shares because of fixed dividends, earlier claims to distributions, earlier claims during liquidation.

Front 64

Cumulative vs. Statutory Voting

Back 64

Example: 3 board positions up for vote, shareholder has 100 shares

Cumulative: Shareholder can give a maximum of 300 votes to one candidate. Favors minority investors

Statutory (non-cumulative): shareholder can give a maximum of 100 votes to each of the 3 candidates.

Front 65

Cumulative Preferred Stock

Back 65

Any unpaid dividends to preferred shareholders must be caught up before any dividend payments to common shareholders can be made.

Front 66

Participating Preferred Stock

Back 66

Allows shareholder to receive fixed dividend payment, plus a potential bonus if the firm performs over a specified level.

Front 67

Convertible Preferred Stock

Back 67

Can be converted into common stock shares at a given conversion ratio. Less risky than common stock while still maintaining some growth potential.

Front 68

Callable and Putable Shares

Back 68

For both common and preferred stock.

Callable: give the firm the right to repurchase shares at the call price - more risk than regular shares

Putable: gives shareholders the right to sell the share back to the firm at put price - less risky than regular shares

Front 69

Private Equity

Back 69

Not available to the public. Requires less financial reporting, no obligations for quarterly reports, has potential for greater returns once it does go public.

Disadvantages: Less liquid, less disclosure, may less ability to raise capital

Front 70

Venture Capital

Back 70

Provides financing for early stages of firm development

Front 71

Leverage Buyout (LBO)

Back 71

uses debt to buy all outstanding stock. If led by management, called a Management buyback (MBO)

Front 72

Private Investment in Public Entity (PIPE)

Back 72

Public firm raises capital from selling equity in a private placement. Quicker, less regulations since you are going to experienced investors.

Front 73

Direct Investing in Foreign Entities

Back 73

Investors buy and sell securities directly in foreign market. Denominated in foreign currency. Often less liquid and transparent. Regulations may be different.

Front 74

Sponsored vs. Unsponsored Depository Receipts

Back 74

Sponsored: firm is involved with issue of depository reciept. Voting and dividend privledges pass on to investor.

Unsponsored: depository buys and holds the shares, maintaining their rights. Less regulation.

Front 75

Depository Receipts

Back 75

Trades like an ordinary share on a local exchange and represents an economic interest in a foriegn company. Allows securities to be traded outside of their market.

Front 76

Global vs. American Depository Receipts

Back 76

Global: Issued outside U.S. and firm's home country. Most are denominated in USD. Cannot be listed on US exchanges, but can be sold in private placements.

American Depository Receipts: Denominated in USD. Traded on U.S. exchanges. Oldest and most common type. American Depository Shares are underlying asset that receipts are based off.

Front 77

Global Registered Shares

Back 77

Traded on stock exchanges throughout the world, denominated in different currencies. Shares are identical.

Front 78

Baskets of Listed Depository Receipts

Back 78

ETFs of depository receipts.

Front 79

Return Characteristics of Equity Securities

Back 79

• Dividends
  
• Capital Gains and losses
• share repurchases
• possible foreign exchange gain or loss (for some depository receipts)

Historically, compounding of reinvested dividends has been 2/3+ investors' compound returns.

Front 80

Role of Equity Securities in Financing Assets

Back 80

Provides funds to buy the assets. Decreases firm's reliance on debt. Can be used to buy other companies or for employee incentives. Raise capital and increase liquidity

Front 81

Book Value of A Security vs. Market Value

Back 81

Book Value: value of firm's balance sheet assets - its liabilities. Based upon accounting numbers.

Market Value: Normally referenced unless otherwise specified. Reflects investor expectations regarding firm risk and the amount and timing of future cash flows. Based on expectations.

Front 82

Cost of Equity vs. Accounting Return on Equity vs. Investors' Required Rate of Return fix me

Back 82

Cost of Equity: Minimum return equity holders will accept before pulling their money and putting it elsewhere. If not met, you will lose investors over time.

ROE: (Net Income/Average Book Equity) measures the return managment is generating on equity capital. Good reflection of management's performance.

Investors' Required Rate of Return: The minimum return investors will accept before pulling their money out.

Front 83

Level I, II, and III, and Rule 144A American Depository Reciepts

Back 83

Listed: Level II and III

Can Raise Capital in US markets: III and 144A

High Listing Fees and Size/Earnings Requirements: II and III

Level I: traded OTC

Level II and III: Traded on big exchanges

144A: Privately traded.

Front 84

Uses of Industry Analysis

Back 84

• Understanding a company's business and business enviroment (growth, competition, risks)
• Identifying active equity investment opportunities. Used to help weight profiles and rotate among industries
• Portfolio Attribution to determine where returns originate.
• Lays foundation for company analysis.

Front 85

Major Categories For Grouping

Back 85

1. Product or sevices supplied: health care, automotive.
2. Business Cycle Sensitivity. Cyclical or Non-Cyclical. Cycical company's profits corelate heavily with overall economy, whereas non-cyclical does not have that correlation.
3. Statistical Grouping: Groups built by a computer for company's with highly correlated historical returns.

Front 86

Cyclical vs. Non-Cyclical

Back 86

Cyclical: Very heavily correlated to the business cycle.

Non-Cyclical: Not affected by business cycle.

Front 87

Growth Stocks

Back 87

Demand for the firms products is so high, it is largely unaffected by business cycle.

Front 88

Defensive Stocks

Back 88

Basic goods and services that have stable enough to demand to normally avoid business cycle fluctuations.

Front 89

Consumer Staples

Back 89

Consumer-related companies whose business tends to exhibit less economic sensitivity than other companies

Front 90

Consumer Discretionary

Back 90

Companies that derive a majority of revenue from the sale of consumer related products or services for which demand tends to have a relatively high correlation to economic sensitivity.

Front 91

Industrial/Producer Durables

Back 91

Manufacterers of capital goods and providers of commerical services. (ex. heavy machineary, transportation services etc.)

Front 92

Global Industry Classification Standard

Back 92

Compares industries globally. Classifies developing and developed countries. Classifies by primary business activity. 4 Tiers

Front 93

Russel Global Sectors

Back 93

Contains 9 sectors compared to Global Industry Classification Standard's 10. 3 Tiers

Front 94

Industry Classification Benchmark

Back 94

Breaks down into both goods and services whereas Russel Global Sectors and Global Industry Classification Standards lumps goods and services together. 4 Tiers

Front 95

Government Industry Classification Systems

Back 95

International Standard Industrial Classification of All Economic Activities (ISIC): United Nations

Statistical Classification of Economic Activities in Eurpoean Community (NACE): Europe

Australian and New Zealand Classification: Australia and New Zealand

North American Industry Classifciation System: (NAICS) north america.

Front 96

Steps To Identifying Peer Group

Back 96

1. Examine classification systems.
2. Review annual report for competitor analysis
3. Review competitor's annual reports
4. Review industry trade publications
5. Confirm comparable companies drive revenue from similar business activities.

Front 97

Elements of Thorough Industry Analysis

Back 97

• Evaluate relatioships between macroeconomic variables and the industry
• Estimate industry projections using multiple approaches and scenarios
• Cross-Check anaylsis with other analysts
• Analyze Prospects using stratgic groups (groups sharing distinct business models or catering to similar market segments)
• Classify Industries by life cycle stage
• Position on experience curve
• Consider demographic, macroeconomic, governmental, social, and technological influences
• Examine forces that determine industry competition

Front 98

Experience Curve

Back 98

Cost per output of unit has been shown to decrease with each output. As you gain more experience, you become more efficient. Fixed costs are also spread more.

Front 99

Porter's Five Forces for Industry Competition Analysis

Back 99

1. Rivarly among existing competitors
2. Threat of new entrents
3. Threat of substitute products
4. Bargaining power of suppliers
5. Bargaining power of buyers

Front 100

Barriers To Entry

Back 100

High barriers limit new competitors. This allows for more pricing power for firms, due to less pricing competition.

Front 101

Industry Concentration

Back 101

How many players are in the particular market. As the number of firms decreases, typically they gain more purchasing power from less price competition, however, relative market position tends to effect more than absolute market position.

Front 102

Industry Capacity

Back 102

The maximum amount of a good or service that can be supplied at any given time. Fixed short term, variable long term. If it is at tight capacity and still does not meet demand, pricing power is high, pricing competition is low. If it is at overcapacity (supply is greater than demand) pricing power is low and price competition is high.

Front 103

Market Stability

Back 103

What percentage of firm's that were "top players" last year, are "top players" this year. If market stability is high, pricing power is high and price competition is low. If market stability is low, top firms are always changing, so pricing power is low and price competition is high.

Front 104

Life Cycle Model

Back 104

Continuous cycle. Model is a graph of demand and time.

1. Embryonic Stage: Slow growth, low competition, high prices, large investment required. High risk of failure, no established market yet.
   
2. Growth Stage: Rapid development, low competition, falling prices, increasing profitability.
3. Shakeout (Stabilization) Stage: growth slows, intense competition, increased overcapacity chances, cost cutting is frequent. Risk of failure increases again.
4. Mature Stage: Slow growth, Industry consolidation, high barriers including brand loyalty. Economic downturn can cause price cutting.
5. Decline Stage: Negative Growth, excess capacity leads to still price competition.

Front 105

Embryonic Stage

Back 105

Slow growth, low competition, high prices, large investment required. High risk of failure, no established market yet.

Front 106

Growth Stage

Back 106

Rapid development, low competition, falling prices, increasing profitability.

Front 107

Shakeout (Stabilization) Stage

Back 107

growth slows, intense competition, increased overcapacity chances, cost cutting is frequent. Risk of failure increases again.

Front 108

Mature Stage

Back 108

Slow growth, Industry consolidation, high barriers including brand loyalty. Economic downturn can cause price cutting.

Front 109

Decline Stage

Back 109

Negative Growth, excess capacity leads to stiff price competition.

Front 110

Limitations to Life Cylce Model

Back 110

• More useful during stable periods
• Stages can have different legnths than anticipated or can be skipped all together
• Firms experience dissimilar growth

Front 111

Macroeconomic Factors That Can Influence Industry Growth, Profitability, and Risk

Back 111

• Economic Output
• GDP
• Credit Availability
• Inflation

Front 112

Technology Factors That Can Influence Industry Growth, Profitability, and Risk

Back 112

New or Improved products/processes

Front 113

Demographic Factors That Can Influence Industry Growth, Profitability, and Risk

Back 113

• changes in population size
• distributions of age and gender

Front 114

Govermental Factors That Can Influence Industry Growth, Profitability, and Risk

Back 114

• Tax rates
  
• business regulations
• government purchases

Front 115

Social Factors That Can Influence Industry Growth, Profitability, and Risk

Back 115

Social trends on how people live their lives and spend their outcomes.

Front 116

Company Analysis Should Include Analysis Of

Back 116

Analysis of Company's financial position, products/services, and competitive strategy (plan to respond to threats and opportunities in the external environment).

Should Investigate

• corporate profile
• industry characteristics
• demand for services/goods
• supply for goods and services
• pricing
• financial ratios

Front 117

Competitive Advantages

Back 117

What the company does to differentiate itself from its competitors. Can be:

1. Cost Leaders: Lowest costs of production translates to lowest costs to consumers. Sell high volume to earn superior return.
2. Product Differentiation: distinctive in terms of type, features, quality, or delivery. Achieve price premium for differentation.

Front 118

Tactical Asset Allocation

Back 118

The decision to deliberately deviate from the strategic asset allocation in an attempt to add value based on the forecast of the near-term relative performance of asset classes. Not involved in industry analysis.

Front 119

Strategic Asset Allocation

Back 119

The set of exposures to IPS-permissable asset classes that is expected to achieve the client's long-term objectives, given the client's restraints.

Front 120

Security Valuation

Back 120

Market Price > estimated value: overpriced

Market Price < estimated value: under priced

For valuation to be profitable, market price must converge with intrinsic value in the future. The more analysts covering a security, the more likely and quickly the catch up.

If current multiples are below average historical multiples, all else constant, security is undervalued,

Front 121

Asset-Based Equity Valuation Model

Back 121

Equity value is simply Assets minus (Liabilities + Preferred Stock Values) to find the book value of the common shares. Works well for firms with few "off the books" items and high current asset and current liability proportions.

Does not work well with intangibles, since they are hard to value. Work well with private companies.

Front 122

Enterprise Value Multiplier Model

Back 122

Have the form of enterprise value to the value of a fundamental variable. Can be either EV over EBITDA or total revenue. Useful for companies with negative earnings (P/E cannot be use) or firms with different capital structures.

If multiplier is below industry average, firm is undervalued.

Front 123

Present Value Models

Back 123

Also Called Discounted Cash Flow models. Estimates the intrinsic value as the present value of all cash flows to be received from a security. Least likely to use book value.

Can be either:

• Future cash distributed to shareholders (dividend discount models)
• Future cash flow available to shareholders (free cash flow to equity models)

Front 124

Price Multiplier

Back 124

Estimates intrinsic value of a common share from a price multiple for some fundamental variable such as revenues, earnings, cash flows, or book value. ex. P/E or P/S.

Values are relative

Useful because

• Widely Used
• Readily available
• Easy to Calculate
• Can be used across industry
• Have correlation with equity returns.

Front 125

Dividend Discount Model

Back 125

Value of any asset is equal to the present value of its future cash flows and future sales price. Take note of the phrase "last year's dividend", because that phrase means you must grow it by one year to get this year's dividend. If you have no plans for selling the security, you are measuring the PV of every future dividend payment. Value of P2 is the intrinsic value of all future dividends from period 3 to infinity.

Front 126

Free-Cash-Flow-To-Equity Model

Back 126

For analysts who want to see dividend paying capacity as opposed to expected dividends, FCFE shows is the cash available to be paid as dividends without impacting business model. Useful for firms who do not currently pay dividends or for analysts who don't want to estimate dividends.

FCFE: Cash Flow from Operations - FC Inventory + Net borrowing

Front 127

Gordon (Constant) Growth Model

Back 127

Useful for estimating intrinsic value of security that is paying indefinite dividends, at an expected growth rate. Calculated as

Price at Period 0 = (Dividend at year 1)/ (required return - growth rate)

Growth Rate: Earnings Retention Rate * Return on Equity

Front 128

Earnings Retention Rate

Back 128

Used in calculating constant growth. Will either be stated or will be calculated as (1 - dividend payout ratio)

Front 129

Preferred Stock Valuation

Back 129

pays fixed dividend and has no maturity date.

Vo = Preferred Divided / required rate of return (k)

Front 130

Multistage Dividend Discount Model

Back 130

Useful if growth rate is not constant forever, ex. company is experiencing large, temporary growth, but growth is expected to be constant at some point in the future. Can be more than 2 stages. 3 Stage is often used for companies just entering the growth stage.

1. Estimate Dividends during rapid growth period.
2. Use gordon growth to find the terminal value of the the firm when the growth is constant.
3. Discount it all back to today.

Will be on the exam multiple times.

Front 131

When to Use Gordon Growth vs. Multistage growth

Back 131

Gordon:

• Stable, mature firms
• Noncyclical

Multistage:

• firms with high growth that will fall in the future.
• Older firms that were in constant growth phase, but will change in the future.

Front 132

Price to Earnings

Back 132

Market value per share divided by earnings per share. This relates to the gordon growth model becasue the same rate of return required and growth rate that affect the stocks price affect its P/E ratio.

Divide each side of gordon growth model by expected earnings and you have P0/E1 = (D1/E1)/ (k -g)

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Dividend Payout Ratio

Back 133

Calculated as Dividend1/Earnings1

Front 134

Price Multiples List

Back 134

P/E= Stock Price/ Earnings Per Share

P/S= Stock Price/ Sales Per Share

P/B = Stock Price/ Book Value Per Share

P/CF = Stock Price/ Cash Flow Per Share (operating or free cash flow)

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Law of One Price

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Two COMPARABLE assets with the same price multiples should sell for the same price.

If P/E, P/S, P/B or P/CF ratio is lower than industry average, security is undervalued

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Enterprise Value

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Total Market Value of the Firm

EV = Market Value of Common Stock(or total equity - preferred shares) + Market Value of Debt - Cash and Short term investments

To calculate Market Value of Debt given book value of debt, assume short term debt is equal in both market and book value.

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Determining Market Value of Short-Term Debts and Liabilities

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Assume it is the same as the Book value for short term.

Book Value of Total Debt - Book Value of Long term Debt = both Book and market value of short term debt.

Front 138

Present Value Model Advantages and Disadvantages

Back 138

Advantages:

• Theoretically Sound
• Widely Accepted

Disadvantages:

• Inputs must be estimated
• Valuation is very sensitive to inputs

Front 139

Multiplier Models Advantages and Disadvantages

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Advantages:

• Widely Used
• Proven correlation with returns
• Easily Calculated
• Good for identifying attractive companies
• Useful for times-seris or cross-sectional analysis

Disadvantages:

• Differencesin accounting methods make comparisons difficult
• Multiples for cyclical companies are highly variable

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Asset Based Models Advantages and Disadvantages

Back 140

Advantages:

• Can provide floor values (lowest level value can fall to)
• Work well in short term

Disadvantages:

• Ongoing firm value may be greater than asset value
• Fair values require estimation.

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Price/Earnings as it Relates to Dividend Growth Model

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Price/Earnings: Market Price Per Share/Earnings Per Share

Dividend Growth Model: P0=(D1)/(r-g)

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Beta's Effect On Price, Holding All Else Constant

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When the beta of a stock increases, its required return will increase. This increases the discount rate investors use to estimate the present value of the stock's future cash flows, which decreases the value of the stock.

Front 143

Equity Securities Normally Finance

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Long-lived assets, such as equipment, or long lived projects, like research and development.

Front 144

Growth Rate Calculation For Gordon Growth Model

Back 144

Gordon Growth:

Price at 0 = (Dividend 1)/(required return - growth rate)

Growth Rate = Retention Rate * Return on Equity

Retention Rate = 1 - Dividend Payout Ratio

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The Overreaction Effect

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refers to stocks with poor returns over three to five-year periods that had higher subsequent performance than stocks with high returns in the prior period. The result is attributed to overreaction in stock prices that reverses over longer periods of time. Stocks with high previous short-term returns that have high subsequent returns show a momentum effec