The three main functions of the financial system are to:

1. Allow entities to save, borrow, issue equity capital, manage risks, exchange assets, and utilize information.
2. Determine the return that equates aggregate savings and borrowing.
3. Allocate capital efficiently.

Assets and markets can be classified as:

• Financial assets (e.g., securities, currencies, derivatives) versus real assets (e.g., real estate, equipment).
• Debt securities versus equity securities.
• Public securities that trade on exchanges or through dealers versus private securities.
• Physical derivative contracts (e.g., on grains or metals) versus financial derivative contracts (e.g., on bonds or equity indexes).
• Spot versus future delivery markets.
• Primary markets (issuance of new securities) versus secondary markets (trading of previously issued securities).
• Money markets (short-term debt instruments) versus capital markets (longer-term debt instruments and equities).
• Traditional investment markets (bonds, stocks) versus alternative investment markets (e.g., real estate, hedge funds, fine art).

The major types of assets are securities, currencies, contracts, commodities, and real assets.

Securities include fixed income (e.g., bonds, notes, commercial paper), equity (common stock, preferred stock, warrants), and pooled investment vehicles (mutual funds, exchange-traded funds, hedge funds, asset-backed securities).

Contracts include futures, forwards, options, swaps, and insurance contracts.

Commodities include agricultural products, industrial and precious metals, and energy products and are traded in spot, forward, and futures markets.

Most national currencies are traded in spot markets and some are also traded in forward and futures markets.

Financial intermediaries perform the following roles:

• Brokers, exchanges, and alternative trading systems connect buyers and sellers of the same security at the same location and time. They provide a centralized location for trading.
• Dealers match buyers and sellers of the same security at different points in time.
• Arbitrageurs connect buyers and sellers of the same security at the same time but in different venues. They also connect buyers and sellers of non-identical securities of similar risk.
• Securitizers and depository institutions package assets into a diversified pool and sell interests in it. Investors obtain greater liquidity and choose their desired risk level.
• Insurance companies create a diversified pool of risks and manage the risk inherent in providing insurance.
• Clearinghouses reduce counterparty risk and promote market integrity.

A long position in an asset represents current or future ownership. A long position benefits when the asset increases in value.

A short position represents an agreement to sell or deliver an asset or results from borrowing an asset and selling it (i.e., a short sale). A short position benefits when the asset decreases in value.

When an investor buys a security by borrowing from a broker, the investor is said to buy on margin and has a leveraged position. The risk of investing borrowed funds is referred to as financial leverage. More leverage results in greater risk.

The leverage ratio is the value of the asset divided by the value of the equity position. Higher leverage ratios indicate greater risk.

The return on a margin transaction is the increase in the value of the position after deducting selling commissions and interest charges, divided by the amount of funds initially invested, including purchase commissions.

The maintenance margin is the minimum percentage of equity that a margin investor is required to maintain in his account. If the investor’s equity falls below the maintenance margin, the investor will receive a margin call. The stock price that will result in a margin call is:

[image]

where:
P₀ = initial purchase price

Execution instructions specify how to trade. Market orders and limit orders are examples of execution instructions.

Validity instructions specify when an order can be filled. Day orders, good-til-cancelled orders, and stop orders are examples of validity instructions.

Clearing instructions specify how to settle a trade.

A market order is an order to execute the trade immediately at the best possible price. A market order is appropriate when the trader wants to execute a transaction quickly. The disadvantage of a market order is that it may execute at an unfavorable price.

A limit order is an order to trade at the best possible price, subject to the price satisfying the limit condition. A limit order avoids price execution uncertainty. The disadvantage of a limit order is that it may not be filled. A buy (sell) order with a limit of $18 will only be executed if the security can be bought (sold) at a price of $18 or less (more).

New issues of securities are sold in primary capital markets. Secondary financial markets are where securities trade after their initial issuance.

In an underwritten offering, the investment bank guarantees that the issue will be sold at a price that is negotiated between the issuer and bank. In a best efforts offering, the bank acts only as a broker.

In a private placement, a firm sells securities directly to qualified investors, without the disclosures of a public offering.

A liquid secondary market makes it easier for firms to raise external capital in the primary market, which results in a lower cost of capital for firms.

There are three main categories of securities markets:

1. Quote-driven markets: Investors trade with dealers that maintain inventories of securities, currencies, or contracts.
2. Order-driven markets: Order-matching and trade-pricing rules are used to match the orders of buyers and sellers.
3. Brokered markets: Brokers locate a counterparty to take the other side of a buy or sell order.

In call markets, securities are only traded at specific times. In continuous markets, trades occur at any time the market is open.

A well-functioning financial system has the following characteristics:

• Complete markets: Savers receive a return, borrowers can obtain capital, hedgers can manage risks, and traders can acquire needed assets.
• Operational efficiency: Trading costs are low.
• Informational efficiency: Prices reflect fundamental information quickly.
• Allocational efficiency: Capital is directed to its highest valued use.

The objectives of market regulation are to:

• Protect unsophisticated investors.
• Establish minimum standards of competency.
• Help investors to evaluate performance.
• Prevent insiders from exploiting other investors.
• Promote common financial reporting requirements so that information gathering is less expensive.
• Require minimum levels of capital so that market participants will be able to honor their commitments and be more careful about their risks.

A price index uses only the prices of the constituent securities in the return calculation. The rate of return is called a price return.

A total return index uses both the price of and the income from the index securities in the return calculation.

Decisions that index providers must make when constructing and managing indexes include:

• The target market the index will measure.
• Which securities from the target market to include.
• The appropriate weighting method.
• How frequently to rebalance the index to its target weights.
• How frequently to re-examine the selection and weighting of securities.

A price-weighted index is the arithmetic mean of the prices of the index securities. The divisor, which is initially equal to the number of securities in the index, must be adjusted for stock splits and changes in the composition of the index over time.

An equal-weighted index assigns the same weight to each of its constituent securities.

A market capitalization-weighted index gives each constituent security a weight equal to its proportion of the total market value of all securities in the index. Market capitalization can be adjusted for a security’s market float or free float to reflect the fact that not all outstanding shares are available for purchase.

A fundamental-weighted index uses weights that are independent of security prices, such as company earnings, revenue, assets, or cash flow.

[image]

Market capitalization-weighted index =

[image]

Equal-weighted index = (1 + average percentage change in index stocks) × initial index value.

Index providers periodically rebalance the weights of the constituent securities. This is most important for equal-weighted indexes.

Reconstitution refers to changing the securities that are included in an index. This is necessary when securities mature or when they no longer have the required characteristics to be included.

Indexes are used for the following purposes:

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

Broad market equity indexes represent the majority of stocks in a market.

Multi-market equity indexes contain the indexes of several countries. Multi-market equity indexes with fundamental weighting use market capitalization weighting for the securities within a country’s market but then weight the countries within the global index by a fundamental factor.

Sector indexes measure the returns for a sector (e.g., health care) and are useful because some sectors do better than others in certain business cycle phases. These indexes are used to evaluate portfolio managers and as models for sector investment funds.

Style indexes measure the returns to market capitalization and value or growth strategies. Stocks tend to migrate among classifications, which causes style indexes to have higher constituent turnover than broad market indexes.

Fixed income indexes can be classified by issuer, collateral, coupon, maturity, credit risk (e.g., investment grade versus high-yield), and inflation protection. They can be delineated as broad market, sector, style, or other specialized indexes. Indexes exist for various sectors, regions, and levels of development.

The fixed income security universe is much broader than the equity universe, and fixed income indexes have higher turnover. Index providers must depend on dealers for fixed income security prices, and the securities are often illiquid. Fixed income security indexes vary widely in their numbers of constituent securities and can be difficult and expensive to replicate.

Indexes have been developed to represent markets for alternative assets such as commodities, real estate, and hedge funds.

Issues in creating commodity indexes include the weighting method (different indexes can have vastly different commodity weights and resulting risk and return) and the fact that commodity indexes are based on the performance of commodity futures contracts, not the actual commodities, which can result in different performance for a commodity index versus the actual commodity.

Real estate indexes include appraisal indexes, repeat property sales indexes, and indexes of real estate investment trusts.

Because hedge funds report their performance to index providers voluntarily, the performance of different hedge fund indexes can vary substantially and index returns have an upward bias.

Security market indexes available from commercial providers represent a variety of asset classes and reflect target markets that can be classified by:

• Geographic location, such as country, regional, or global indexes.
• Sector or industry, such as indexes of energy producers.
• Level of economic development, such as emerging market indexes.
• Fundamental factors, such as indexes of value stocks or growth stocks.

In an informationally efficient capital market, security prices reflect all available information fully, quickly, and rationally. The more efficient a market is, the quicker its reaction will be to new information. Only unexpected information should elicit a response from traders.

If the market is fully efficient, active investment strategies cannot earn positive risk-adjusted returns consistently, and investors should therefore use a passive strategy.

An asset’s market value is the price at which it can currently be bought or sold.

An asset’s intrinsic value is the price that investors with full knowledge of the asset’s characteristics would place on the asset.

Large numbers of market participants and greater information availability tend to make markets more efficient.

Impediments to arbitrage and short selling and high costs of trading and gathering information tend to make markets less efficient.

The weak form of the efficient markets hypothesis (EMH) states that security prices fully reflect all past price and volume information.

The semi-strong form of the EMH states that security prices fully reflect all publicly available information.

The strong form of the EMH states that security prices fully reflect all public and private information.

If markets are weak-form efficient, technical analysis does not consistently result in abnormal profits.

If markets are semi-strong form efficient, fundamental analysis does not consistently result in abnormal profits. However, fundamental analysis is necessary if market prices are to be semi-strong form efficient.

If markets are strong-form efficient, active investment management does not consistently result in abnormal profits.

Even if markets are strong-form efficient, portfolio managers can add value by establishing and implementing portfolio risk and return objectives and assisting with portfolio diversification, asset allocation, and tax minimization.

A market anomaly is something that deviates from the efficient market hypothesis. Most evidence suggests anomalies are not violations of market efficiency but are due to the methodologies used in anomaly research, such as data mining or failing to adjust adequately for risk.

Anomalies that have been identified in time-series data include calendar anomalies such as the January effect (small firm stock returns are higher at the beginning of January), overreaction anomalies (stock returns subsequently reverse), and momentum anomalies (high short-term returns are followed by continued high returns).

Anomalies that have been identified in cross-sectional data include a size effect (small-cap stocks outperform large-cap stocks) and a value effect (value stocks outperform growth stocks).

Other identified anomalies involve closed-end investment funds selling at a discount to NAV, slow adjustments to earnings surprises, investor overreaction to and long-term underperformance of IPOs, and a relationship between stock returns and prior economic fundamentals.

Common shareholders have a residual claim on firm assets and govern the corporation through voting rights. Common shares have variable dividends which the firm is under no legal obligation to pay.

Callable common shares allow the firm the right to repurchase the shares at a pre-specified price. Putable common shares give the shareholder the right to sell the shares back to the firm at a pre-specified price.

Preferred stock typically does not mature, does not have voting rights, and has dividends that are fixed in amount but are not a contractual obligation of the firm.

Cumulative preferred shares require any dividends that were missed in the past (dividends in arrears) to be paid before common shareholders receive any dividends. Participating preferred shares receive extra dividends if firm profits exceed a pre-specified level and a value greater than the par value if the firm is liquidated. Convertible preferred stock can be converted to common stock at a pre-specified conversion ratio.

Investors who buy foreign stock directly on a foreign stock exchange receive a return denominated in a foreign currency, must abide by the foreign stock exchange’s regulations and procedures, and may be faced with less liquidity and less transparency than is available in the investor’s domestic markets. Investors can often avoid these disadvantages by purchasing depository receipts for the foreign stock that trade on their domestic exchange.

Global depository receipts are issued outside the United States and outside the issuer’s home country. American depository receipts are denominated in U.S. dollars and are traded on U.S. exchanges.

Global registered shares are common shares of a firm that trade in different currencies on stock exchanges throughout the world.

Baskets of listed depository receipts are exchange-traded funds that invest in depository receipts.

Equity investor returns consist of dividends, capital gains or losses from changes in share prices, and any foreign exchange gains or losses on shares traded in a foreign currency. Compounding of reinvested dividends has been an important part of an equity investor’s long-term return.

Preferred stock is less risky than common stock because preferred stock pays a known, fixed dividend to investors; preferred stockholders must receive dividends before common stock dividends can be paid; and preferred stockholders have a claim equal to par value if the firm is liquidated. Putable shares are the least risky and callable shares are the most risky. Cumulative preferred shares are less risky than non-cumulative preferred shares, as any dividends missed must be paid before a common stock dividend can be paid.

The book value of equity is the difference between the financial statement value of the firm’s assets and liabilities. Positive retained earnings increase the book value of equity. Book values reflect the firm’s past operating and financing choices.

The market value of equity is the share price multiplied by the number of shares outstanding. Market value reflects investors’ expectations about the timing, amount, and risk of the firm’s future cash flows.

The accounting return on equity (ROE) is calculated as the firm’s net income divided by the book value of common equity. ROE measures whether management is generating a return on common equity but is affected by the firm’s accounting methods.

The firm’s cost of equity is the minimum rate of return that investors in the firm’s equity require. Investors’ required rates of return are reflected in the market prices of the firm’s shares.

Industry analysis is necessary for understanding a company’s business environment before engaging in analysis of the company. The industry environment can provide information about the firm’s potential growth, competition, risks, appropriate debt levels, and credit risk.

Industry valuation can be used in an active management strategy to determine which industries to overweight or underweight in a portfolio.

Industry representation is often a component in a performance attribution analysis of a portfolio’s return.

Firms can be grouped into industries according to their products and services or business cycle sensitivity, or through statistical methods that group firms with high historical correlation in returns.

Industry classification systems from commercial providers include the Global Industry Classification Standard (Standard & Poor’s and MSCI Barra), Russell Global Sectors, and the Industry Classification Benchmark (Dow Jones and FTSE).

Industry classification systems developed by government agencies include the International Standard Industrial Classification (ISIC), the North American Industry Classification System (NAICS), and systems designed for the European Union and Australia/New Zealand.

A cyclical firm has earnings that are highly dependent on the business cycle. A non-cyclical firm has earnings that are less dependent on the business cycle. Industries can also be classified as cyclical or non-cyclical. Non-cyclical industries or firms can be classified as defensive (demand for the product tends not to fluctuate with the business cycle) or growth (demand is so strong that it is largely unaffected by the business cycle).

Limitations of descriptors such as growth, defensive, and cyclical include the facts that cyclical industries often include growth firms; even non-cyclical industries can be affected by severe recessions; defensive industries are not always safe investments; business cycle timing differs across countries and regions; and the classification of firms is somewhat arbitrary.

A thorough industry analysis should:

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

An asset is fairly valued if the market price is equal to its estimated intrinsic value, undervalued if the market price is less than its estimated value, and overvalued if the market price is greater than the estimated value.

For security valuation to be profitable, the security must be mispriced now and price must converge to intrinsic value over the investment horizon.

Securities that are followed by many investors are more likely to be fairly valued than securities that are neglected by analysts.

Discounted cash flow models estimate the present value of cash distributed to shareholders (dividend discount models) or the present value of cash available to shareholders after meeting capital expenditures and working capital expenses (free cash flow to equity models).

Multiplier models compare the stock price to earnings, sales, book value, or cash flow. Alternatively, enterprise value is compared to sales or EBITDA.

Asset-based models define a stock’s value as the firm’s total asset value minus liabilities and preferred stock, on a per-share basis.

The dividend discount model is based on the rationale that a corporation has an indefinite life, and a stock’s value is the present value of its future cash dividends. The most general form of the model is:

[image]

Free cash flow to equity (FCFE) can be used instead of dividends. FCFE is the cash remaining after a firm meets all of its debt obligations and provides for necessary capital expenditures. FCFE reflects the firm’s capacity for dividends and is useful for firms that currently do not pay a dividend. By using FCFE, an analyst does not need to project the amount and timing of future dividends.

Preferred stock typically pays a fixed dividend and does not mature. It is valued as:

[image]

The Gordon growth model assumes the growth rate in dividends is constant:

[image]

The sustainable growth rate is the rate at which earnings and dividends can continue to grow indefinitely:

g = b × ROE

where:
b	= earnings retention rate = 1 − dividend payout rate
ROE	= return on equity

A firm with high growth over some number of periods followed by a constant growth rate of dividends forever can be valued using a multistage model:

[image]

where:
Pn	= [image]
gc	= constant growth rate of dividends
n	= number of periods of supernormal growth

The constant growth model is most appropriate for firms that pay dividends that grow at a constant rate, such as stable and mature firms or noncyclical firms such as utilities and food producers in mature markets.

A 2-stage DDM would be most appropriate for a firm with high current growth that will drop to a stable rate in the future, an older firm that is experiencing a temporary high growth phase, or an older firm with a market share that is decreasing but expected to stabilize.

A 3-stage model would be appropriate for a young firm still in a high growth phase.

The P/E ratio based on fundamentals is calculated as:

[image]

If the subject firm has a higher dividend payout ratio, higher growth rate, and lower required return than its peers, it may be justified in having a higher P/E ratio.

Price multiples are widely used by analysts, are easily calculated and readily available, and can be used in time series and cross-sectional comparisons.

The price-earnings (P/E) ratio is a firm’s stock price divided by earnings per share.

The price-sales (P/S) ratio is a firm’s stock price divided by sales per share.

The price-book value (P/B) ratio is a firm’s stock price divided by book value per share.

The price-cash flow (P/CF) ratio is a firm’s stock price divided by cash flow per share. Cash flow may be defined as operating cash flow or free cash flow.

Enterprise value (EV) measures total company value:

EV = market value of common and preferred stock + market value of debt − cash and short-term investments

EBITDA is frequently used as the denominator in EV multiples because EV represents total company value, and EBITDA represents earnings available to all investors.

• Easy to calculate.
• Widely accepted in the analyst community.
• FCFE model is useful for firms that currently do not pay a dividend.
• Gordon growth model is useful for stable, mature, noncyclical firms.
• Multistage models can be used for firms with nonconstant growth.

• Inputs must be forecast.
• Estimates are very sensitive to inputs.
• For the Gordon growth model specifically:
  • Very sensitive to the k − g denominator.
  • Required return on equity must be greater than the growth rate.
  • Required return on equity and growth rate must remain constant.
  • Firm must pay dividends.

• Often useful for predicting stock returns.
• Widely used by analysts.
• Easily calculated and readily available.
• Can be used in time series and cross-sectional comparisons.
• EV/EBITDA multiples are useful when comparing firm values independent of capital structure or when earnings are negative and the P/E ratio cannot be used.

• P/E ratio based on fundamentals will be very sensitive to the inputs.
• May not be comparable across firms, especially internationally.
• Multiples for cyclical firms may be greatly affected by economic conditions. P/E ratio may be especially inappropriate. (The P/S multiple may be more appropriate for cyclical firms.)
• A stock may appear overvalued by the comparable method but undervalued by the fundamental method or vice versa.
• Negative denominator results in a meaningless ratio; the P/E ratio is especially susceptible to this problem.
• A potential problem with EV/EBITDA multiples is that the market value of a firm’s debt is often not available.

• Can provide floor values.
• Most reliable when the firm has mostly tangible short-term assets, assets with a ready market value, or when the firm is being liquidated.
• May be increasingly useful for valuing public firms if they report fair values.

• Market values of assets can be difficult to obtain and are usually different than book values.
• Inaccurate when a firm has a large amount of intangible assets or future cash flows not reflected in asset value.
• Asset values can be difficult to value during periods of hyperinflation.