Equity Investments

Study Guide

Market Organization and Structure

• Primary vs. Secondary Markets:
  • Primary Market: Where securities are first issued (e.g., Initial Public Offerings - IPOs).
  • Secondary Market: Where existing securities are traded among investors. Provides liquidity.
• Key Market Functions:
  • Provide liquidity for investors.
  • Enable price discovery through supply and demand interactions.
  • Reduce transaction costs.
• Order Types:
  • Market Order: Execute immediately at the best available price. Prioritizes speed over price.
  • Limit Order: Execute at a specific price or better. Prioritizes price over speed.
  • Stop Order (Stop-Loss): A trigger order that becomes a market order when a specific price (the stop price) is reached or passed. Used to limit losses or protect profits.
• Market Structures:
  • Quote-Driven Markets (Dealer Markets): Investors trade with dealers who maintain inventories of securities. Prices are quoted as bid and ask.
  • Order-Driven Markets: Orders from buyers (bids) and sellers (asks) are matched directly. Rules determine trade priority (e.g., price, then time).
  • Brokered Markets: Brokers act as agents to find counterparties for large or unique trades.

Security Market Indexes

• Purpose: Track the performance of a specific market, sector, or asset class. Used as a benchmark for portfolio performance and as a basis for index funds and ETFs.
• Index Weighting Methods:
  • Price-Weighted Index: The weight of each stock is its price as a percentage of the sum of all prices.
    • Formula: $\text{Index Value} = \frac{\sum \text{Component Stock Prices}}{\text{Divisor}}$
    • Bias: Higher-priced stocks have a greater impact.
  • Value-Weighted (Market-Cap Weighted) Index: The weight of each stock is its market capitalization as a percentage of the total market capitalization of all stocks in the index.
    • Formula: $\text{Index Value}_t = \text{Index Value}_{t-1} \times \frac{\sum \text{Current Market Cap}}{\sum \text{Base Period Market Cap}}$
    • Bias: Large-cap stocks have a greater impact. Most common method.
  • Equal-Weighted Index: Each stock has the same weight in the index, regardless of its price or market cap.
    • Bias: Smaller-cap stocks have a greater impact than in a value-weighted index. Requires frequent rebalancing.

Market Efficiency

The Efficient Market Hypothesis (EMH) states that asset prices fully reflect all available information.

• Forms of Market Efficiency:

  Form	Information Reflected	Implications for Analysis
  Weak	Past market data (price, volume)	Technical analysis is not profitable.
  Semi-Strong	All publicly available information	Fundamental analysis is not profitable.
  Strong	All public and private information	Even insiders cannot earn abnormal returns.

• Market Anomalies: Seemingly persistent abnormal returns that challenge the EMH.

  • Size Effect: Small-cap stocks have historically outperformed large-cap stocks on a risk-adjusted basis.
  • Value Effect: Value stocks (low P/B, low P/E) have historically outperformed growth stocks.
  • January Effect: Returns are higher in January, particularly for small-cap stocks.

• Behavioral Finance: Explains anomalies through investor psychology and biases (e.g., loss aversion, overconfidence).

Overview of Equity Securities

• Common Stock vs. Preferred Stock:

• Types of Preferred Stock:
  • Cumulative: Unpaid dividends (dividends in arrears) must be paid before any common dividends can be paid.
  • Participating: Allows preferred shareholders to receive extra dividends if company profits exceed a certain level.
  • Convertible: Can be converted into a specified number of common shares.
• Depository Receipts (DRs): Securities representing ownership in a foreign company's shares.
  • American Depository Receipt (ADR): Traded in the United States.
  • Global Depository Receipt (GDR): Traded outside the U.S. and the issuer's home country.

Industry and Competitive Analysis

• Purpose: To understand the industry's structure and competitive environment to forecast industry trends and a company's potential for profitability.
• Porter's Five Forces: A framework for analyzing industry competition.
  1. Threat of New Entrants: How easily can new firms enter the industry?
  2. Bargaining Power of Buyers: How much power do customers have to drive down prices?
  3. Bargaining Power of Suppliers: How much power do suppliers have to raise input costs?
  4. Threat of Substitute Products: How likely are customers to switch to alternatives?
  5. Intensity of Rivalry: How intense is the competition among existing firms?
• Industry Life Cycle:
  • Embryonic: Slow growth, high prices, high investment.
  • Growth: Rapidly increasing demand, improving profitability, falling prices.
  • Shakeout: Slower growth, intense competition, declining profitability.
  • Mature: Little or no growth, industry consolidation, high barriers to entry.
  • Decline: Negative growth, excess capacity, high competition.

Company Analysis: Past and Present

• Focus: Using financial ratios to evaluate a company's historical performance and financial health.
• DuPont Analysis: Decomposes Return on Equity (ROE) into its key components.
  • 3-Part DuPont: $\text{ROE} = (\frac{\text{Net Income}}{\text{Revenue}}) \times (\frac{\text{Revenue}}{\text{Total Assets}}) \times (\frac{\text{Total Assets}}{\text{Equity}})$ $\text{ROE} = \text{Net Profit Margin} \times \text{Asset Turnover} \times \text{Financial Leverage}$
  • 5-Part DuPont: Further breaks down the Net Profit Margin. $\text{ROE} = (\frac{\text{Net Income}}{\text{EBT}}) \times (\frac{\text{EBT}}{\text{EBIT}}) \times (\frac{\text{EBIT}}{\text{Revenue}}) \times (\frac{\text{Revenue}}{\text{Assets}}) \times (\frac{\text{Assets}}{\text{Equity}})$ $\text{ROE} = \text{Tax Burden} \times \text{Interest Burden} \times \text{EBIT Margin} \times \text{Asset Turnover} \times \text{Financial Leverage}$

Company Analysis: Forecasting

• Objective: To project a company's future earnings and cash flows for use in valuation models.
• Forecasting Approaches:
  • Top-Down: Start with macroeconomic forecasts, then industry forecasts, and finally company-specific forecasts.
  • Bottom-Up: Start with company-level forecasts (e.g., product lines) and aggregate them to create a total company forecast.
• Process: Typically involves forecasting the income statement (revenues, expenses) and then the balance sheet and cash flow statement. The percentage-of-sales method is a common technique.

Equity Valuation: Concepts and Basic Tools

• Intrinsic Value: The "true" or fundamental value of an asset based on analysis. An investor's goal is to compare intrinsic value to market price.
  • If Intrinsic Value > Market Price, the stock is undervalued.
  • If Intrinsic Value < Market Price, the stock is overvalued.
• Valuation Models:
  1. Discounted Cash Flow (DCF) Models: Value is the present value of future cash flows.
     • Dividend Discount Model (DDM): Values a stock as the present value of its future dividends.
     • Gordon Growth Model (Constant Growth DDM): Assumes dividends grow at a constant rate, g. $V_0 = \frac{D_1}{r - g}$ Where:
       • $V_0$ = Intrinsic value per share today
       • $D_1$ = Expected dividend one year from now ($D_0 \times (1+g)$)
       • $r$ = Required rate of return on equity
       • $g$ = Constant dividend growth rate
  2. Multiplier Models (Relative Valuation): Compares a stock's price multiple to a benchmark (e.g., industry average or its own historical average).
     • Price-to-Earnings (P/E): $\frac{\text{Price per Share}}{\text{Earnings per Share}}$
     • Price-to-Book (P/B): $\frac{\text{Price per Share}}{\text{Book Value per Share}}$
     • Price-to-Sales (P/S): $\frac{\text{Price per Share}}{\text{Sales per Share}}$
  3. Asset-Based Valuation: Values a company based on the market value of its assets minus its liabilities. Often used for companies with significant tangible assets or for liquidation analysis.