investments
Equity Securities: These financial instruments represent ownership in a company and can vary significantly in their characteristics and rights associated with them.
Common Stocks: Represent partial ownership in a company and typically entitle the holder to one vote per share. While dividends may be issued, they are contingent upon the profitability of the company, meaning they are not guaranteed.
Preferred Stocks: These stocks promise a fixed income each year but the company is not obligated to pay this income annually. They have priority over common stocks when it comes to unpaid dividends and during liquidation, although they do not offer voting rights.
American Depositary Receipts (ADRs): Internationally traded financial instruments that represent shares in foreign companies.
Common Stocks Characteristics: Detailing the specific features and rights of common stock ownership.
Ownership and Claims: Common stocks entail residual claims, meaning stockholders are last in line to receive assets and income during liquidation. Stockholders only receive operating income after all other obligations to creditors, employees, etc., have been met.
Limited Liability: Stockholders are protected by limited liability; thus, their maximum loss is confined to their original investment, and they are not personally responsible for the company's debts.
Quick Tests: These encompass test questions that assess understanding related to stock ownership and the investment potential of different equity securities.
Preferred Stocks Characteristics: Examining the defining attributes of preferred stocks.
Income and Claims: Preferred stocks provide fixed dividends that accumulate if unpaid. They take precedence over common stockholders for dividend payments and during liquidation processes. Notably, payments are categorized as dividends, which are not tax-deductible for the issuing firm.
Valuation of Stocks: The process of determining the intrinsic value of stocks is based on expected future cash flows, particularly anticipated dividends, while analysis techniques differ; top-down analysis involves a broader examination that includes:
Global and Domestic Economics
Demand and supply shocks
Federal government policies
Business cycles
Performance within the industry itself.
Industry Analysis: A comprehensive evaluation of industry health as it is frequently linked to firm performance.
Importance of Industry Analysis: There is a strong correlation between firm health and the overall wellness of the industry in which it operates, illustrated by comparative performance between sectors, such as the retail industry experiencing a growth of +42% while the coal industry faces a decline of -34%.
Defining an Industry: This can be a challenging task with various methods for classification including:
NAICS codes, which have replaced traditional SIC codes,
Classifications provided by Standard & Poor's.
Business Cycles: Understand the natural ebb and flow in economies, characterized by recurring patterns of recession and recovery, with critical transition points being Peaks (signaling the end of an expansion) and Troughs (indicating the start of recovery).
Industry Sensitivity: This details how certain sectors react to changes in the economy:
Cyclical Industries: These industries display high sensitivity to economic fluctuations (for instance, sectors associated with durable goods).
Defensive Industries: These sectors are less sensitive and tend to maintain stable performance regardless of economic conditions (an example being food production).
Factors Influencing Sensitivity: Several key factors contribute to an industry's sensitivity to economic changes, including:
Sales Sensitivity: Differentiate between necessities versus non-essential goods, where necessities may demonstrate steadier sales during economic downturns.
Operating Leverage: Consider the ratio of fixed to variable costs; industries with high operating leverage are more sensitive to economic cycles due to substantial fixed costs relative to variable costs.
Financial Leverage: The degree of reliance on debt also impacts sensitivity; higher debt levels increase vulnerability due to mandatory interest payments influencing profitability.
Sector Rotation Strategy: This investment strategy involves adjusting portfolios in response to the various phases within business cycles to capitalize on industries that are projected to outperform during certain economic conditions.
Challenges: Recognize that the duration and intensity of business cycles are highly unpredictable, presenting difficulties when attempting to implement such strategies.
Industry Life Cycles: Understand the distinct stages that industries typically progress through:
Start-up: Characterized by rapid growth in market acceptance and development.
Consolidation: Growth rates in this phase are faster than the broader economy as the industry matures.
Maturity: Growth stagnates, aligning with the overall performance of the general economy.
Relative Decline: This stage consists of slower growth rates or even contraction when compared to overall economic performance.
Investment Considerations: High-growth industries, while appearing attractive, often come with increased competition and the risk of market saturation, which may deter investment despite high potential returns.
Fundamental Analysis:
Definition: Fundamental analysis refers to the process of assessing a company’s intrinsic value through a comprehensive evaluation of its financial health and potential for future profitability.
Purpose: The main goal of fundamental analysis is to identify stocks that are mispriced either as undervalued or overvalued, enabling informed investment decisions.
Steps:
Measure the intrinsic value based on financial data that includes balance sheets, income statements, and cash flow statements.
Compare the calculated intrinsic value with the current market price to determine investment opportunities.
Fundamental Analysis Techniques:
Balance Sheet Models: Utilize methods that involve the assessment of various indicators such as book value per share and liquidation value per share, helping investors understand the company’s financial stability.
Holding-Period Return (HPR): Calculate the total return on an investment over a specific period to gauge performance.
Dividend Discount Models (DDM): Pricing stocks based on expected future dividends to derive their intrinsic value.
Free Cash Flow Models: Analyze cash flows generated by the company to assess overall value and sustainability.
Holding-Period Return (HPR):
Expected HPR Formula:
The expected holding-period return is calculated as follows: Expected HPR = Expected Dividend + Expected Price Appreciation, where one-year expected HPR is denoted as Er = ED + [EP - P].
Required Rate of Return:
Capital Asset Pricing Model (CAPM): A model that determines the required rate of return (k) based on the risk-free rate of return, investment beta, and the expected market return by utilizing the formula k = r_f + β[E_r - r_f].
Where:
r_f = Risk-free rate;
β = Investment beta;
E_r = Expected market return.
Trading Signals based on HPR:
If the calculated holding-period return exceeds the required return, the stock is considered underpriced and is a buy recommendation.
Conversely, if the holding-period return falls short of the required return, the stock is viewed as overpriced, leading to sell or short-sell recommendations.
Dividend Discount Models (DDM):
The intrinsic value (V) can be computed as the sum of the present value of expected dividends and the anticipated stock price, represented mathematically as V_0 = D_1/(1+k) + P_1/(1+k).
Future price estimation (P_1) can be determined through the formula P_1 = V_1 = D_2/(1+k) + P_2/((1+k)^2).
When evaluating over a holding period of H years, the value can be expressed as V_t = D_1/(1+k) + ... + (D_H + P_H)/(1+k)^H.
Constant Growth DDM:
The model assumes a stable growth rate (g), providing a more simplified calculation for intrinsic value as V_0 = D_0(1+g)/(k-g).
A key assumption made in this model is that stock prices move in line with dividend growth.
Estimating Dividend Growth Rate (g):
Dividend growth rates can be estimated using the formula g = ROE × b, where (b) represents the plowback ratio calculated as (1 - Dividend Payout Ratio).
Present Value of Growth Opportunities (PVGO):
The overall value of a firm is comprised of:
No-growth value: This represents the value derived solely from existing assets.
PVGO: This is the net present value of opportunities available for future investments, calculated as P_0 = E_1/k + PVGO.
Valuation by Comparable:
Valuation Ratios: These ratios assist in comparing firm valuation metrics within the industry setting and include measures such as P/E ratio, price-to-book ratio, and price-to-cash-flow ratio.
Price-to-Earnings (P/E) Ratio:
Defined as the ratio of the price per share to the earnings per share, this ratio indicates the growth expectations of the company.
Conversion to assess value can be expressed as P/E = 1/k (1 + PVGO/k), where a high P/E ratio signifies high growth expectations.
P/E Ratios and Risk:
An increase in perceived risk, referenced through a higher beta (β), causes an uptick in the required return (k) and subsequently decreases the P/E ratio of the stock.
Pitfalls in P/E Analysis:
P/E ratios may exhibit fluctuations in response to changes in earnings driven by differing accounting regulations.
Additionally, reported earnings can be impacted by inflation, which should be considered in valuation assessments.
Comparing Valuation Models:
It is important to recognize that estimated values derived from various models may demonstrate discrepancies due to simplifying assumptions employed in calculations, including but not limited to, constant-growth rates, chosen depreciation methods, and estimates concerning return on equity (ROE).
Financial Statement Analysis
The primary purpose of financial statement analysis is to identify mispriced securities in the market.
Equity Valuation Models are largely based on estimated economic earnings, which include dividends as a key metric.
Financial statement analysis often relies on readily available accounting earnings, particularly financial ratios.
Accounting vs. Economic Earnings
Economic Earnings: Represent real cash flow that is available for payout without impairing the productive capacity of the business, prominently including dividends.
Accounting Earnings: These earnings can be influenced by various conventions regarding asset valuation, which include methods such as LIFO and FIFO for inventory accounting.
Financial Statements Overview
Income Statement: This statement summarizes the profitability of a company over a specific period of time.
Balance Sheet: Provides a snapshot of the financial condition of a firm at a particular moment, displaying assets, liabilities, and equity.
Statement of Cash Flows: This statement tracks the cash implications of transactions, showing how cash is generated and used in operations, investments, and financing.
Income Statement Breakdown (Target, Year Ending January 2021)
Operating Revenues: $93,561 Million, representing net sales.
Operating Expenses totaled $87,022 Million, which included:
Cost of Goods Sold: $66,177 Million
Selling, General & Administrative Expenses: $18,615 Million
Depreciation: $2,230 Million
Operating Income amounted to $6,539 Million, reflecting a margin of 7.0%.
Net Income was reported at $4,368 Million, with a margin of 4.7%.
Dividends distributed were $1,343 Million, with an addition to retained earnings of $3,025 Million.
Balance Sheet Overview (Target, Year Ending January 2021)
Assets: Total assets stood at $51,248 Million, comprised of:
Current Assets: $51,248 Million
Cash and Marketable Securities: $8,511 Million (16.6% of total assets)
Inventories: $10,653 Million (20.8% of total assets)
Liabilities and Shareholders' Equity:
Total Liabilities were $36,808 Million (71.8% of total).
Total Shareholders' Equity amounted to $14,440 Million (28.2% of total).
Statement of Cash Flows (Target)
Cash provided by Operations totaled $10,525 Million.
Adjustments made to this cash flow indicated $6,157 Million.
Cash Flows from Investments reported outflows of ($2,591 Million).
Cash Flows from Financing Activities recorded outflows of ($2,000 Million).
The Net Increase in Cash was $5,934 Million.
Measuring Firm Performance
Key Ratios to Evaluate: Various ratios to measure different aspects of performance including:
Profitability Ratios such as Return on Assets (ROA), Return on Equity (ROE), and Economic Value Added.
Leverage Ratios including debt ratios and interest coverage ratios.
Liquidity Ratios which consist of current, quick, and cash ratios.
Efficiency Ratios focusing on turnover ratios and profit margins.
Important Financial Ratios
Return on Assets (ROA): This ratio is defined as EBIT divided by total assets, measuring operating income per dollar deployed in the firm.
Return on Equity (ROE): Defined as the ratio of net income to equity, focusing on the profitability of equity investments and influenced by financial leverage.
Financial Leverage and ROE
The formula expressing ROE is:
ROE = (1 - Tax rate) [ROA + (ROA - Interest rate) \times Debt/Equity]
Key consideration: Debt will boost ROE only if the Return on Assets (ROA) exceeds the Interest rate.
DuPont Method for Decomposing ROE
The ROE formula is:
ROE = Net Profit Margin \times Total Asset Turnover \times Leverage Ratio
For ROA, the formula is:
ROA = Profit Margin \times Total Asset Turnover
Key Financial Ratios Summary
Leverage ratios include: Leverage ratio = Debt/Equity.
Asset Utilization includes metrics like total asset turnover and inventory turnover ratios.
Liquidity ratios comprise current ratio, quick ratio, and cash ratio.
Profitability metrics include return on assets, return on equity, and margin percentages.
Comparability Problems
Various factors affecting comparability include accounting differences like those between GAAP and IFRS, inflation consideration, the impact of fair value accounting, and differing international conventions.
Earnings vs. Cash Flows
Cash flow from operations serves as a significant indicator of the quality of earnings as well as actual cash generation capabilities of a firm.
Efficient Market Hypothesis (EMH) Overview
Learning Objectives:
Understand the principles of the Efficient Market Hypothesis (EMH).
Evaluate empirical evidence to determine the validity of market efficiency.
Random Walk Hypothesis:
Definition: Stock price changes are random and unpredictable.
Empirical Evidence by Kendall (1953):
No predictable pattern in stock prices was found.
Prices are equally likely to rise or fall on any given day, regardless of past information.
Exploration: Raises the question of how random stock price changes can be explained.
Efficient Market Hypothesis:
Definition: Stock prices already reflect all available information.
New information leads to unpredictable price changes.
Predictable information is incorporated into current prices.
Examples of EMH in Action:
Takeover Announcement:
Leads to a jump in the target firm's stock price as new information is released.
No further price drift occurs after the announcement because prices reflect the new information.
CNBC Midday Call:
Positive Reports: Stocks rise and stabilize within approximately 5 minutes.
Negative Reports: Stocks drop and stabilize within about 12 minutes.
Versions of EMH:
Weak-form efficiency: All past market trading data is reflected in prices.
Semistrong-form efficiency: All public information is incorporated into stock prices.
Strong-form efficiency: Includes all information, both public and private.
Implications of EMH:
Technical Analysis:
Predicts future prices based on past trading data and is effective under weak-form EMH.
Example: The Relative Strength approach identifies resistance levels (limits on price rises) and support levels (price floors).
Fundamental Analysis:
Analyzes economic and accounting earnings to find mispriced stocks and works under semistrong-form EMH.
Examples include Industry Analysis, Equity Valuation Models, and Financial Statement Analysis.
Active vs. Passive Portfolio Management:
Active Management:
Based on the manager’s expertise to find mispriced securities.
Generally more expensive due to frequent trading and higher fees.
Suitable for large portfolios.
Passive Management:
Based on the belief that EMH is true; therefore, active management is unnecessary.
Involves tracking indices like the S&P 500, minimizing transaction fees and focusing on risk characteristics.
Event Studies and Abnormal Returns:
Event Study:
Assesses the impact of events (e.g., dividends) on stock prices.
Abnormal Return (𝑒!):
Defined as the difference between actual return (𝑟!) and expected return calculated using a single-index model.
Cumulative Abnormal Return:
Sum of abnormal returns over a period of interest.
Evaluating Market Efficiency:
Queries if active managers consistently identify mispriced stocks.
Magnitude Issue:
Profits from minor mispricing may be insufficient for smaller managers.
Selection Bias Issue:
Unsuccessful strategies often become public, whereas successful strategies tend to remain private.
Lucky Event Issue:
Some outcomes might arise purely from chance.
Empirical Tests of EMH:
Weak-Form Tests:
Examine patterns in stock returns using market trading data; includes momentum effects.
Semistrong-Form Tests:
Analyze the market's response to fundamental information; includes notable effects like P/E Ratio and Size Effect.
Strong-Form Tests:
Investigate insider trading and the profitability of executives trading on inside information.
Notable Anomalies in EMH:
P/E Effect:
Stocks with low Price-to-Earnings ratios tend to yield higher returns compared to high P/E stocks.
Size Effect:
Smaller firms typically yield higher annual returns than larger firms.
Book-to-Market Ratios Effect:
Returns depend heavily on the book-to-market ratio, suggesting market inefficiencies.
Post-Earnings Announcement Drift:
Contrary to EMH principles, stock prices do not adjust rapidly to earnings announcements, revealing a gradual adjustment leading to prolonged abnormal returns.
Conclusion: Are Markets Efficient?
While some anomalies indicate inefficiencies, the overall market tends toward efficiency.
Competitive environments mean that only those with exceptionally superior information can regularly earn higher returns.
Most portfolio managers do not outperform passive strategies, although a few, like Peter Lynch and Warren Buffett, have demonstrated consistent success.
· Issuers in the U.S. Bond Market:
o Treasury Notes and Bonds: These are debt instruments issued by the U.S. government that provide a way for the government to finance its activities.
o Federal Agency Debt: This category includes bonds issued by federally related institutions and government-sponsored enterprises, which serve to fund specific government functions.
o Municipal Bonds: These are bonds issued by state and local governments, often used to fund public projects such as infrastructure improvements.
o Corporate Bonds: These are issued by both U.S. and foreign corporations to raise capital for business operations.
· Quick Test:
o Identify the least risky investment among options: A. Corporate bonds, B. U.S. Agency issues, C. Treasury bonds, D. Common stocks.
· Bond Characteristics:
o Bonds are defined as debt obligations where the issuer (borrower) agrees to pay back the bondholder (creditor).
o Par Value (Face Value): This is the amount paid to the bondholder when the bond matures, which is typically around $1,000.
o Coupon Rate: This represents the interest payments made per dollar of par value, typically distributed semiannually, although some bonds may feature zero coupon rates known as zero-coupon bonds.
o Indenture: This is a legal contract between the bond issuer and the bondholder outlining essential details such as the coupon rate, maturity date, and par value of the bond.
· Treasury Bonds and Notes:
o Maturity: Treasury Notes have maturities ranging from 1 to 10 years, while Treasury Bonds mature in 10 to 30 years.
o These securities can be purchased directly from the U.S. Treasury, with denominations starting at $100 and commonly at $1,000.
· U.S. Treasury Quotes:
o Interest payments for Treasury bonds are distributed semiannually, with an example payment of $11.25 in February and August.
o Bid refers to the price at which the investor can sell the bond, while Ask indicates the price at which the investor can buy the bond.
o The Bid-Ask Spread represents the profit margin from this transaction, and prices are quoted as percentages of the par value.
· Bond Pricing:
o The intrinsic value (P0) of a bond is calculated as the sum of the present value of both the coupon payments and the par value at maturity.
o The formula used for this calculation is: [ P_0 = \sum_{t=1}^{T} \frac{C}{(1+r)^t} + \frac{Par \ Value}{(1+r)^T} ], where T is the total number of periods until maturity and r is the current interest rate.
· Example of Bond Pricing:
o This includes calculating the value of an 8% semiannual coupon bond over a duration of 2 years with a par value of $1,000 at a prevailing interest rate of 10%, in addition to calculating for a 30-year bond under similar conditions.
· Bond Prices:
o The Invoice Price consists of both the stated price (flat price), which reflects the price listed online or in financial media, and the accrued interest related to the upcoming semiannual coupon payment, if applicable.
o The accrued interest can be computed using the formula: [ Accrued \ Interest = \frac{Annual \ coupon \ payment}{2} \times \frac{Days \ since \ last \ coupon}{Days \ separating \ coupon \ payment} ].
· Example of Accrued Interest:
o For a bond with a par value of $1,000, an annual coupon rate of 8%, and 30 days since the last payment, if the flat price is $990, the accrued interest helps determine the final transaction cost.
· Bond Values and Interest Rate Relationship:
o There exists an inverse relationship between the price of bonds and their yields, meaning that as interest rates increase, bond prices typically decrease, which is a principal risk associated with bond investments.
o The price curve is convex and becomes flatter at higher interest rates, indicating that bonds with longer maturities are more sensitive to changes in interest rates.
· Bond Yields Overview:
o Different types of bond yields include Yield to Maturity (YTM), Current Yield, Yield to Call, and Realised Compound Return, each providing insights into the potential returns from bond investments.
· Yield to Maturity (YTM):
o This yield is defined as the interest rate that equalizes the present value of a bond’s anticipated payments to its current price, allowing investors to understand what returns they could expect if they held the bond to maturity.
o The formula for YTM is: [ P_0 = \frac{C}{(1+r)^{0.5}} + \frac{C}{(1+r)^{1}} + \frac{Par \ Value}{(1+r)^{T}} ].
· Current Yield:
o This yield, derived from dividing the annual coupon payment by the current bond price, indicates the expected income relative to the bond's market price.
o The formula is: [ Current \ Yield = \frac{Annual \ coupon}{Price} ].
· YTM vs. Current Yield:
o Yield to Maturity provides a more comprehensive measure of a bond's internal rate of return and is a proxy for the average return assuming reinvestment of coupon payments.
o Conversely, Current Yield only provides a ratio of the annual coupon payment to the market price, which can vary for premium and discount bonds. Premium bonds feature a coupon rate greater than the current yield and YTM, while discount bonds have a coupon rate that is lower than the current yield and YTM.
· Yield to Call (YTC):
o This measure applies to callable bonds, which give issuers the option to repurchase the bonds before their maturity date, often at a premium, potentially leading to bondholders losing long-term income.
o The computation of YTC follows a process similar to YTM, replacing maturity with the time remaining until the call date.
· Other Types of Corporate Bonds:
o Putable Bonds grant the bondholders the option to sell the bond back at par or extend the maturity, providing an element of flexibility in times of rising interest rates.
o Convertible Bonds allow holders to convert their bonds into a specified number of shares of the issuing company's stock, offering the potential for capital appreciation.
o Floating-rate Bonds have coupon rates that reset based on market interest rates, thus protecting investors from fixed-rate bond risks.
· Realised Compound Return:
o This return refers to the compound rate of return assuming that all coupon payments are reinvested until maturity, allowing for growth of the initial investment through reinvestment.
o The formula used for this calculation is: [ V_m(1 + r)^{T} = V_0 ], where V_m is the current price, V_0 is the par value plus the total value of reinvested coupon payments.
· Compounding Examples:
o Examples include calculating the growth of invested funds based on different reinvestment rates, such as 10% and 8%, showcasing how reinvestment can significantly affect total returns.
· Comparative Analysis of Returns:
o This analysis highlights the important relationship between reinvestment rates and the realised compound return in relation to the YTM, showcasing the impacts of different rates on overall returns from bond investments.
Here are some multiple choice questions based on the content in the notes:
What do common stocks typically entitle the holder to?A) Fixed dividendsB) Voting rightsC) Priority in liquidationD) Tax-exempt statusAnswer: B) Voting rights
What is a characteristic of preferred stocks?A) They entitle the holder to voting rights.B) They provide fixed dividends but are not guaranteed annually.C) They are always riskier than common stocks.D) They have the same claims as common stocks during liquidation.Answer: B) They provide fixed dividends but are not guaranteed annually.
What does the Capital Asset Pricing Model (CAPM) help determine?A) The intrinsic value of stocksB) The required rate of return based on riskC) The total cash flow of a companyD) The financial leverage of a firmAnswer: B) The required rate of return based on risk
Which statement is true regarding bond pricing?A) Bond prices are directly proportional to interest rates.B) Bond prices and yields have an inverse relationship.C) The par value is determined by the bondholder.D) The intrinsic value of a bond is always fixed.Answer: B) Bond prices and yields have an inverse relationship.
What is the purpose of fundamental analysis?A) To assess market trendsB) To find securities that are mispricedC) To analyze market psychologyD) To minimize tax liabilitiesAnswer: B) To find securities that are mispriced.
Feel free to ask for clarification or additional questions!