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Topic Weightings in CFA Level I

Session NO. Content Weightings
Study Session 1-2 Quantitative Methods 8-12
Study Session 3-4 Economics 8-12
Study Session 5-8 Financial Reporting and Analysis 13-17
Study Session 9-10 Corporate Issuers 8-12
Study Session 11-12 Equity 10-12
Study Session 13-14 Fixed Income 10-12
Study Session 15 Derivatives 5-8
Study Session 16 Alternative Investments 5-8
Study Session 17-18 Portfolio Management 5-8
Study Session 19 Ethical and Professional Standards 15-20
Framework ¾ SS11 Equity Investment (1)
• R33 Market Organization and
Structure
Equity Investments • R34 Security Market Indexes
• R35 Market Efficiency
¾ SS12 Equity Investment (2)

• R36 Overview of Equity
Securities
• R37 Introduction to Industry
and Company Analysis
• R38 Equity Valuation:
Concepts and Basic Tools
Reading
33
Market Organization and Structure
1. Markets, Assets, and Intermediaries
Framework • Main Functions of the Financial System

• Different Types of Financial
Intermediaries
• Classification of Assets
• Classification of Markets
2. Positions and Leverage
3. Order Execution and Validity
The Main Functions of
The Financial System &
Market Regulation
1-7
Main Functions of the Financial Market

¾ Main Functions of the Financial Market (Totally Three Functions)
z Achievement of Purposes in the Financial System
9 Allow entities to save and borrow money, raise equity capital,
manage risks, trade assets currently or in the future, and trade based
on their estimates of asset values.
z Return Determination
9 Determine the returns (i.e., interest rates) that equate the total
supply of savings with the total demand for borrowing.
z Allocation of Capital
9 The financial system allows the transfer of assets and risks from one
entity to another as well as across time.
2-7

¾ First function: Achievement of Purposes in the Financial System
z Savings: savers buy stocks, bonds, certificates of deposit, real assets,
and other assets.
z Borrowing: borrow money from lenders who require collateral, take an
equity position, or investigate the credit risk of the borrower to protect
themselves in case of borrower defaults.
z Issuing equity: another method of raising capital is to issue equity,
where the capital providers will share in any future profits
z Risk management: entities face risks from changing interest rates,
currency values, commodities values, and defaults on debt, among other
things. So they would like to find a way to manage these risks.
z Exchanging assets: the financial system also allows entities to exchange
assets.
z Utilizing information: investors with information expect to earn a
return on that information in addition to their usual return.
9 Information-motivated traders: trade to profit from information
that they believe allows them to predict future prices.
3-7
¾ Second function: Return Determination
z Determine the rate of return that equates the amount of borrowing with
the amount of lending (saving) in an economy. Low rates of return
increase borrowing but reduce saving (increase current consumption).
z Equilibrium Interest Rate:
9 The rate at which the amount individuals, businesses, and
governments desire to borrow is equal to the amount that
individuals, businesses, and governments desire to lend.
9 Equilibrium rates for different types of borrowing and lending will
differ due to differences in risk, liquidity, and maturity.
4-7

¾ Third function: Allocation of Capital
z Investors have to weigh the expected risks and returns of different
investments to determine their most preferred investments due to
limited availability of capital.
z This would result in an allocation to capital to its most valuable uses.
5-7
Well Functioned Financial Market

¾ A well functioned financial market:
z allows entities to achieve their purposes.
¾ Characteristics of a well functioned financial Market
z Complete markets: savers receive a return, borrowers can obtain capital.
hedgers can manage risks, and traders can acquire needed assets.
z Operational efficiency: trading costs are low.
z Informational efficiency: prices reflect fundamental information
quickly.
z Allocational efficiency: capital is allocated to its most productive use.
6-7
Well Functioned Financial Market
¾ Market Regulation
Problems when there are no regulations Objectives of market regulations
Fraud and theft: the potential for theft and Protect unsophisticated investors.
fraud increases because investment managers Require minimum standards of
take advantage of unsophisticated investors. competency to make it easier to
perform valuation.
Insider trading: Investors would exit the market Prevent insiders from exploiting
and thus reduced liquidity if they believe traders other investors.
with inside information will exploit them.
Costly information: If obtaining information is Require common financial reporting
relatively expensive, markets will not be as requirements.
informational efficient and investors will not
invest as much.
Defaults: Parties might not honor their Require minimum levels of capital
obligations in markets. so that participants will honor long-
term commitments.
7-7
Types of Financial
Intermediaries and
Services
1-9
Intermediaries of Financial Market

¾ Intermediaries of Financial Market (Summary)
z Brokers, Dealers and Exchange
z Securitizers
z Depository Institutions
z Insurance Companies
z Arbitrageurs
z Clearinghouses and Custodians
2-9
¾ Brokers, Dealers and Exchange
z Brokers: Brokers help their clients buy and sell securities by finding
counterparties to trades in a cost efficient manner.
z Block Brokers: Help with the placement of Large trades. Typically, large
trades are difficult to place without moving the market.
z Investment Banks: Help corporations sell common stock, preferred
stock, and debt securities to investors.
3-9

¾ Brokers, Dealers and Exchange (Cont.)
z Dealers: Facilitate trading by buying for or selling from their own
inventory. Dealers provide liquidity in the market and profit primarily
from the spread (difference) between the price at which they will buy
(bid price) and the price at which they will sell (ask price) the security or
other asset.
9 Dealers that trade with central banks to affect the money supply are
referred to as primary dealers.
9 Broker-dealers: Some dealers also act as brokers. Broker-dealers
have an inherent conflict of interest.
Brokers: should seek the best prices for their clients;
Dealers: are to profit through prices or spreads.
4-9

¾ Brokers, Dealers and Exchange
z Exchanges:
9 Provide a venue for traders.
9 Now arrange trades on the basis of orders placed by brokers and
traders.
z Alternative Trading Systems (ATS):
9 ATSs are trading places where traders arrange their trades.
9 However, the trade has a lack of regulatory authority.
Many ATSs are known as dark pools because they do not
display the orders that their clients send to them.
9 This also known as electronic communications networks (ECNs) or
multilateral trading facilities (MTFs).
5-9
¾ Securitizers
z Securitizers pool large amounts of securities or other assets together
and sell interests in the pool to other investors.
9 By securitizing the assets, the securitizer creates a diversified pool
of assets with more predictable cash flows than the individual
assets in the pool.
9 This creates liquidity in the assets, because the ownership interests
are more easily valued and traded.
9 There are also economies of scale in the management costs of
large pools of assets and potential benefits from the manager’s
selection of assets.
6-9

¾ Securitizers (Cont.)
z Assets that are often securitized include mortgages, car loans, credit
card receivables, bank loans, and equipment leases.
z A firm may set up a special purpose vehicle (SPV) or special purpose
entity (SPE) to buy firm assets, which removes them from the firm’s
balance sheet and may increase their value by removing the risk that
financial trouble at the firm will give other investors a claim to the
assets’ cash flows.
¾ Depository Institutions
z Absorb deposits by paying interest on customer deposits
z Provide transaction services on one hand, and then make loans with the
deposits on the other hand.
7-9

¾ Insurance Companies
z Insurance companies collect insurance premiums in return for providing
risk reduction to the insured.
z Such intermediaries are able to do this by pooling policyholders with
uncorrelated risk of losses.
z Insurance firms also provide a benefit to investors by managing the
risks:
9 Moral hazard occurs because the insured may take more risks
once they are protected against losses.
9 Adverse selection those who purchase insurance against risk are
more likely than the general population to be at risk..
9 In fraud, the insured purposely cause damage or claim fictitious
losses so they can collect on their insurance policies.
8-9
¾ Arbitrageurs
z Arbitrageurs are intermediaries who seek to gain certain return without
bearing any risk.
z In markets with good information, pure arbitrage is rare because
traders will favor the markets with the best prices.
¾ Clearinghouses and Custodians
z Clearinghouses: Act as buyers when customers want to sell assets and
as sellers when customers want to buy assets, and thus limit
counterparty risk.
z Custodians: Also improve market integrity by holding client securities
and preventing their loss due to fraud or other events that affect the
broker or investment manager.
9-9
Classification of
Assets
1-9
Classification of Assets
¾ Classification of assets (Summary)
z Financial Assets
9 Security
Fixed income vs. Equity securities
Public vs. Private
9 Currency
9 Derivative contracts
Financial derivative contracts
Physical derivative contracts
z Real Assets
9 Commodity
9 Real Estate
2-9
¾ Classification of Assets-financial Assets
z Security (Fixed income vs. Equity Securities )
9 Fixed Income Securities: Make sure the borrowed funds can be repaid.
Bonds With longer maturities (with maturity longer than 10 years)

Notes Intermediate term (with maturity between 2 to 10 years)
Bills Short term (with maturity less than 1 year)
Commercial paper Short term issued by firms (with maturity less than 1-2 years)
Certificates of
Certificates of deposit issued by banks
deposit
Borrower sells a high quality asset and has both the right and
Repurchase
obligation to repurchase it (at a higher price) in the future.
agreements
Repurchase agreements can be for terms as short as one day.
Convertible debt are typically convertible into stock, usually
Convertible debt
at the option of the holder after some period.
3-9
¾ Classification of Assets-financial Assets-security
z Security (Fixed Income vs. Equity Securities )
9 Equity Securities: Represent ownership in a firm.
y Own residual rights to the assets of the company;

y Right to receive any dividends declared by the boards of
Common stock
directors, and in the event of liquidation, any assets
remaining after all other claims are paid.
y Preferred rights (relative to common shares) to the cash
flows and assets of the company;
Preferred stock y A specific dividend on a regular basis;
y Higher claims to assets relative to common shareholders in
the event of corporate liquidation.
y Securities issued by a corporation that allow the warrant
Warrants holders to buy a security issued by that corporation, if they
so desire, usually at any time before the warrants expire.
4-9
z Security
9 Pooled Investment Vehicles:
Individual securities can be combined in pooled investment
vehicles.
The securities created by mutual funds, trusts, depositories, and
hedge fund are respectively called shares, units, depository
receipts, and limited partnership interests.
Include mutual funds, depositories, and hedge funds.
5-9
z Security
9 Pooled Investment Vehicles:
y Investment vehicles that pool money from many investors for
Mutual funds investment in a portfolio of securities;
y May be open-ended or closed-ended.
Exchange-traded
y Open-ended funds: investors can trade in secondary markets;
funds (ETFs) &
y The market price and net asset values of ETFs tend to converge
exchange-traded
by authorized participant’s operation.
notes (ETNs)
Asset-backed y Pooling the asset deriving from assets’ values and income
securities payments, e.g., mortgage bonds, credit card debt, or car loans.
y Organized as limited partnerships( investors Æ limited partners;
fund manager Ægeneral partner);
Hedge funds y Hedge funds often use leverage;
y Funds pay their managers with proportional of their assets and
with a contingent incentive fee.
6-9
z Security (Public vs. Private)
9 Public Securities: trade in liquid markets in which sellers can easily
find buyers for their securities.
9 Private Securities: are not traded in public markets which are often
illiquid and not subject to regulation.
z Currency:
9 Issued by national monetary authorities.
9 Some of these currencies are regarded as reserve currencies.
Reserve currencies are currencies that national central banks and
other monetary authorities hold in significant quantities.
7-9
¾ Classification of Assets-financial Assets
z Contract:
9 Are agreements between two parties that require some action in the
future, such as exchanging an asset for cash.
Is an agreement to trade the underlying asset in the future at a
Forward contract
price agreed upon today.
Is a standardized forward contract for which a clearinghouse
Futures contract guarantees the performance of all traders.
Swap contract Is a series of forward contracts.
Allows the holder of the option to buy or sell an underlying
Option contract instrument at a specified price at or before a specified date in
the future.
Insurance contract Pays their beneficiaries a cash benefit if some event occurs.
Credit default Are insurance contracts that promise payment of principal in
swaps the event that a company defaults on its bonds.
8-9
¾ Classification of Assets-real Assets
z Commodity:
9 Commodities are goods like precious metals, industrial metals,
agricultural products, energy products, and credits for carbon
reduction that are traded in spot, forward, and futures markets.
9 Note: spot markets are for immediate delivery while forwards,
futures, and options markets are for the future delivery of physical
and financial assets.
z Real Assets:
9 Real assets include such tangible properties as real estate, airplanes,
machinery, or lumber stands.
9 Characteristics:
Provide income, tax advantage, diversification benefits
Entail substantial management costs
Require substantial due diligence before investing
9-9
Classification of
Markets
1-21
Classification of Markets
¾ Classification of markets
z Money vs. Capital markets
z Traditional vs. Alternative markets
z Primary vs. Secondary markets
2-21
z Money vs. Capital markets
9 Money markets: the market for short-term debt instruments (one-
year maturity or less).
9 Capital markets: financial markets that trade securities of longer
duration, such as bonds and equities.
z Traditional vs. Alternative markets
9 Traditional investment markets: markets for traditional
investments, include all publicly traded debts and equities and
shares in pooled investment vehicles that hold publicly traded debts
and/or equities.
9 Alternative markets: market for investments other than traditional
securities investments.
3-21
z Primary vs. Secondary markets
9 Primary market: the market where newly issued securities are sold.
Newly issued securities involve:
IPO (initial public offerings): first-time issues by firms whose
shares are not currently publicly traded.
Seasoned offerings (secondary issues): new shares issued by
firms whose shares are already trading in the marketplace.
4-21
¾ How securities are sold through primary market
z Sold Publicly
9 Underwritten Offering (the most common way)
9 Best Efforts
9 Indications of Interest
9 Book building
z Sold Privately
9 Private placement
z Other transaction methods
9 Shelf registration
9 Dividend Reinvestment Plan
9 Rights Offering
5-21
¾ How securities are sold through primary market- Sold Publicly :
z Underwritten Offering (the most common way )
9 Investment bank purchases the entire issue at a price that is
negotiated between the issuer and bank.
9 Investment bank bears the risk of buying the unsold portion of
securities if the target number of shares to be issued does not meet.
z Best Efforts
9 Unlike underwriting offering, the investment bank doesn’t purchase
the whole issue.
9 Bank is not obligated to buy the unsold portion if the issue is
undersubscribed.
z Indications of Interest
6-21
z Difference between underwritten offering and best efforts.
Underwritten offering Best Efforts

Obligated to buy the unsold portion Not obligated to buy the unsold portion
Investment bank would prefer that Investment bank sets the issue price as
the price be set low enough to gain high as possible to raise the most funds
more profit for the issuer
7-21
z Underwritten Offering
z Best Efforts
z Indications of Interest
9 Indications of interest: the investment bank finds investors who
agree to buy part of the issue.
9 This process of gathering indications of interest is called book
building, and the investment bank during this process is called book
builder or book runner.
9 If securities must be issued quickly, the process is called accelerated
book building.
8-21
¾ How securities are sold through primary market- Sold Privately and
Other transaction methods:
z Private Placement
9 Securities are sold directly to qualified investors, typically with the
assistance of an investment bank.
z Shelf Registration
9 Type of public offering that allows the issuer to file a single, all-
encompassing offering circular that covers a series of bond issues.
z Dividend Reinvestment Plan
9 A dividend reinvestment plan (DRP or DRIP) allows existing
shareholders to use their dividends to buy new shares from the firm
at a slight discount.
z Rights Offering
9 In rights offering, existing shareholders are given the right to buy
new shares at a discount to the current market price.
9-21
¾ Secondary Capital Markets
z The secondary market is the place where securities are traded after
their initial offerings.
z The secondary market supports the primary market by providing:
9 Liquidity
Investors who buy stocks in the primary markets want to sell
then again to acquire other securities such as risk free bonds
and cash.
9 Price discovery
New issues of stocks and bonds are based on prices in the
secondary markets.
10-21
z When securities are traded in a secondary market.
9 Call Markets
Trading for individual stocks occurs at specific times.
All bids and asks are gathered and then a negotiated price is
produced to make the demand quantity as close as possible to
the supply quantity.
9 Continuous Markets
Trades occur at any time when market is open.
The price is determined either by an auction process or
through a dealer bid-ask process. There are differences
between dealer markets and an auction market in continuous
markets.
11-21
z How securities are traded in Secondary Markets
9 Order-Driven Market
9 Quote-Driven Market
9 Brokered Markets
12-21
In order-driven market, orders are executed using trading rules,
which are necessary because traders are usually anonymous.
Exchanges and automated trading systems are examples of
order-driven markets.
9 Brokered Markets
13-21
14-21
z How securities are traded in Secondary Markets- Order-Driven
Market.
z Two sets of rules are used in these markets:
9 Order matching rules: establish an order precedence hierarchy.
Price priority: trades with the highest bid (buy) and lowest
ask (sell) prices are traded first, this is so-called price priority.
Time precedence: if orders are at the same prices, the earliest
arriving orders are traded first.
15-21
Quote-driven market is also referred to as a dealer market, a
price-driven market or an over-the-counter market.
Individual dealers provide liquidity for investors by buying and
selling the shares of stock for themselves.
Numerous dealers compete against each other to provide the
highest bid prices when investors are selling and the lowest
asking price when investors are buying stock.
9 Brokered Markets
16-21
9 Brokered Markets
In brokered markets, brokers trade with the counterparty they
find.
This service is especially valuable when the trader has a
security that is unique or illiquid.
Examples are large blocks of stock, real estate, and artwork.
17-21
9 Comparison between Quote-Driven Market and Order-Driven
Market.
Quote-Driven Market Order-Driven Market

Dealers make a market in the stock, Enough buyers and sellers are
which means that they are willing to trading to allow the market to be
buy or sell for their own account at a continuous
specified bid-and-ask price.
18-21
Example
¾ A financial intermediary buys a stock and then resells it a few days later
at a higher price. Which intermediary would this most likely describe?
A. Broker.
B. Dealer.
C. Arbitrageur.
¾ Correct answer: B
¾ An investor who buys a government bond from a dealer’s inventory is

said to obtain:
A. a real asset in a primary market transaction.
B. a financial asset in a primary market transaction.
C. a financial asset in a secondary market transaction.
¾ Correct answer: C
19-21
Example
¾ New issues of securities are transactions in:
A. the primary market.
B. the secondary market.
C. the seasoned market.
¾ Correct answer: A
¾ Daniel Ferramosco is concerned that a long-term bond he holds might

default. He therefore buys a contract that will compensate him in the
case of default. What type of contract does he hold?
A. Physical derivative contract.
B. Primary derivative contract.
C. Financial derivative contract.
20-21
Example
¾ A market is said to be informationally efficient if it features:
A. market prices that reflect all available information about the value
of the securities traded.
B. timely and accurate information about current supply and demand
conditions.
C. many buyers and sellers that are willing to trade at prices above
and below the prevailing market price.
¾ Which of the following would least likely be an objective of market

regulation?
A. Reduce burdensome accounting standards.
B. Make it easier for investors to evaluate performance.
C. Prevent investors from using inside information in securities trading.
21-21
Positions and
Leverage
1-11
Positions in an Asset
¾ Positions an investor can take in an asset
z Long Position
z Short Position
z Leveraged Position
¾ Long Position
z An investor who owns an asset, or has the right or obligation under a
contract to purchase an asset, is said to have a long position.
z Benefit form an increase in the price
2-11
¾ Short Position
z For a short-sale, the procedure is as below:
9 Borrow the stock through your broker and simultaneously sell it in
the market.
9 Return the stocks upon your brokers request
9 Maintain the proceeds of short-sales as collateral.
z Benefit from a decrease in the price
z Unlike a long position, the potential loss of a short sale is unlimited
3-11
¾ Short Position
z Payment-in-lieu: the received dividends and interests must be paid
back to the investor who lent the stock
ʏ Lend securities ʑ Deposit cash and margin

ʕ ʓ
Security lender Short seller Broker
Pay interest minus

Paying dividends servicing fee and invest
interest paid to
ʒ
lender
ʐ ʔ
Sell securities Buy securities T-bill
Stock
Markets
4-11
¾ Short Position
z Short Rebate Rate
9 The short seller must deposit the proceeds of the short sale as
collateral.
9 The broker earns interest on these funds and may return a portion
of this interest to the short seller at a rate referred to as the short
rebate rate.
9 If the security is difficult to borrow, short rebate rate may be lower
or negative.
5-11
¾ Leveraged Positions
z Definition: An investor is said to be take leveraged positions if he
borrowed funds to purchase an asset.
z Buy on margin: Investors who use leverage to buy securities by
borrowing from their brokers are said to buy on margin and the
borrowed funds are referred to as a margin loan.
z The interest rate paid on the funds is the call money rate.
z Leverage ratio:
9 The leverage ratio of a margin investment is the value of the asset
divided by the value of the equity position.
6-11
z Margin Requirement: the required equity position is called the margin
requirement.
9 Initial Margin: a minimum amount of equity at the time of a new
margin purchase.
9 Maintenance Margin: the investor’s required equity position in
the account.
9 Margin Call: if an investor’s margin account balance falls below the
maintenance margin, the investor will receive a margin call and will
be required to either liquidate the position or bring the account
back to its maintenance (minimum) margin requirement.
7-11
z Computation of the Price Triggering a Margin Call.
9 Margin Call Price for a Leverage Position.
§ 1-IM ·
PL' =P0 ¨ ¸
© 1-MM ¹
8-11
Example
¾ If an investor purchases a stock for $40 per share with an initial margin
requirement of 50% and the maintenance margin requirement is 25%,
at what price will the investor get a margin call?
¾ Answer:
૝૙ሺ૚ െ ૙Ǥ ૞ሻ
ൌ ૛૟Ǥ ૟ૠ
૚ െ ૙Ǥ ૛૞
z A margin call is triggered at a price below $26.67.
9-11
Example
¾ An investor buys 1,000 shares of a stock on margin at a price of $50 per
share. The initial margin requirement is 40% and the margin lending
rate is 3%. The investor’s broker charges a commission of $0.01 per
share on purchases and sales. The stock pays an annual dividend of
$0.30 per share. One year later, the investor sells the 1,000 shares at a
price of $56 per share. The investor’s rate of return is closest to:
A. 12%.
B. 27%.
C. 36%.
10-11
Example
z The total purchase price is 1,000 Ø $50 = $50,000. The investor
must post initial margin of 40% Ø $50,000 = $20,000. The
remaining $30,000 is borrowed. The commission on the purchase is
1,000 Ø $0.01 = $10. Thus, the initial equity investment is $20,010.
In one year, the sales price is 1,000 Ø $56 = $56,000. Dividends
received are 1,000 Ø $0.30 = $300. Interest paid is $30,000 Ø 3% =
$900. The commission on the sale is 1,000 Ø $0.01 = $10. Thus, the
profit is $56,000 − $50,000 + $300 − $900 − $20 = $5380. The
return on the equity investment is $5380 / $20,010 = 26.89%.
11-11
Order
Execution and
Validity
1-10
Instructions of Transaction Processes

¾ When investors want to buy or sell, they must enter orders that specify the
size of the trade and whether to buy or sell.
z Execution instructions: that specify how to trade;
z Validity instructions: that specify when the order can be filled;
z Clearing instructions: that specify how to settle the trade.
2-10

¾ Execution instructions
z The most common orders
9 Market orders: orders are the orders to buy or sell a security at the
best current price, is the most frequent type of order.
9 Limit orders: orders specify the buy or sell order. Limit orders
waiting to execute are called standing limit orders.
Make the market: a limit buy order at best bid or a limit sell
order at the best.
Make a new market: a limit buy order placed above best bid
but below best ask order.
Take the market: those who trade with them at posted prices
are said to.
Behind the market: a buy order placed below the best bid or a
sell order placed above the best offer.
Far from the market: a behind the market order whose price is
far from their best ask/bid.
3-10
¾ Execution Instructions
z Instructions concern the volume of the trade:
9 All-or-nothing orders execute only if the whole order can be filled.
z Instructions concern the visibility of the trade:
9 Hidden orders are those for which only the broker or exchange
knows the trade size.
9 Iceberg orders are orders that traders can also specify certain
aspects of the trade so that only part of the trade is visible to the
market.
4-10
5-10

¾ Validity Instructions:
z Validity instructions specify when an order should be executed.
9 Day orders: means the orders expire if unfilled by the end of the
trading day.
9 Good-till-cancelled orders(GTC): In practice, most brokers limit
how long they will manage an order to ensure that they do not fill
orders that their clients have forgotten
9 Immediate or cancel orders: are cancelled unless they can be filled
immediately. They are also known as fill or kill orders.
9 Good-on-close orders: are only filled at the end of the trading day.
If they are market orders, they are referred to as market-on-close
orders.
9 Good-on-open orders: are only filled at the open of the trading
day.
6-10
¾ Validity Instructions:
z Validity instructions specify when an order should be executed.
9 Stop orders: are those that are not executed unless the stop price
has been met. They are often referred to as stop loss orders because
they can be used to prevent losses or to protect profits.
Stop-sell order: If the investor wants to sell out of the position
if the price falls 10% to $45, he can enter a stop-sell order at
$45. If the stock trades down to $45 or lower, this triggers a
market order to sell.
Stop-buy: is entered with at stop (trigger) above the current
market price. Two primary reasons are: (1) A trader with short
position; (2)an investor who believes a stock is undervalued, but
does not wish to own it until there are signs.
Stop orders reinforce market momentum.
7-10

¾ Clearing Instructions
z Clearing instructions tell the trader how to clear and settle a trade.
z They are usually standing instructions and not attached to an order.
8-10
Example
¾ A stock is selling at $50. An investor’s valuation model estimates its
intrinsic value to be $40. Based on her estimate, she would most likely
place:
A. a short-sale order.
B. a stop order to buy.
C. a market order to buy.
¾ Which of the following limit buy orders would be the most likely to go
unexecuted?
A. A marketable order.
B. An order behind the market.
C. An order making a new market.
9-10
Example
¾ In which of the following types of markets do stocks trade any time the
market is open?
A. Exchange markets.
B. Call markets.
C. Continuous markets.
10-10
Reading
34
Security Market Indexes
1. Weighting Schemes for Stock Indexes
Framework • Price-Weighted Index

• Equal-Weighted Index
• Market Capitalization-Weighted Index
• A Float-Adjusted Market Capitalization-
Weighted Index
• Fundamental Weighting
2. Uses and Types of Indexes
Security Market
Indexes
1-3
Definitions about Market Indexes

¾ Definitions about Market Indexes
z A security market index: is used to represent the performance of an
asset class, security market, or segment of a market.
9 Price index:
A price index uses only the prices of the constituent securities
in the return calculation.
A rate of return that is calculated based on a price index is
referred to as a price return.
9 Return index:
A return index includes both prices and income from the
constituent securities.
A rate of return that is calculated based on a return index is
called a total return.
2-3
How an Index is Constructed

¾ How an index is constructed
z What is the target market the index is intended to measure?
z Which securities from the target market should be included in the index?
z How should the securities be weighted in the index?
z How often should the index be rebalanced?
z When should the selection and weighting of securities be re-examined?
3-3
Price Weighting
and
Equal Weighting
1-4
Weighting Schemes for Stock Indexes:

¾ Weighting schemes for stock indexes:
z Price-Weighted Index
z Equal-Weighted Index
z Market Capitalization-Weighted Index
z A Float-Adjusted Market Capitalization-Weighted Index
z Fundamental weighting
2-4
Methods of Index Construction

¾ Weighting schemes for stock indexes: Price-Weighted Index
z A price-weighted index is an arithmetic average of current security
prices, which means that indexes movements are influenced by the
differential prices of the components. The price-weighted index
assumes you purchase an equal number of shares (one) of each stock
represented in the index.
sum of stock prices

price-weighted index=
number of stocks in index adjusted for splits
z Two major price-weighted indexes are the Dow Jones Industrial

Average (DJIA) and the Nikkei Dow Jones Stock Average.
z Features: simple, high priced stocks tilted.
3-4
¾ Weighting schemes for stock indexes: Equal-Weighted Index
z The arithmetic average return of the index stocks for a given time
period. Places an equal weight on the returns of all index stock,
regardless of their price or market value.
z Two averaging methodologies to the calculation of an un-weighted
index:
9 Arithmetic mean: Xi is the return on each stock
change in average index value=

¦x i
n
9 Geometric mean: Xi=1+HPRi
change in average index value=n x1x 2 Ăxn -1
9 The geometric-averaged index value is always less than the

arithmetic-averaged index value.
z Features: small cap stocks tilted.
4-4
Market Capitalization
Weighting and
Fundamental Weighting
1-9

¾ Weighting schemes for stock indexes: Market Capitalization-Weighted
Index (or value-weighted index)
z A market capitalization-weighted index (or value-weighted index): the
weight on each constituent security is determined by dividing its
market capitalization by the total market capitalization (the sum of the
market capitalization) of all the securities in the index.
z Current index value =
current total market value of index stocks

u base year index value
base year total market value of index stocks
z Features: large cap stocks tilted, momentum effect
2-9
¾ Weighting schemes for stock indexes: A Float-Adjusted Market
Capitalization-Weighted Index
z The construction method is just like a market capitalization-weighted
index.
z The weight on each constituent security is determined by adjusting its
market capitalization for the number of shares of the constituent
security that are available to the investing public.
3-9

¾ Weighting schemes for stock indexes: Fundamental weighting
z Weighting by using measures of a company’s size that are independent
of its security price to determine the weight on each constituent
security.
z Advantage: It addresses the disadvantage of market-capitalization
weighting method by putting more weights undervalued constituents.
z Features: value-tilted, contrarian-style
4-9
Example
¾ Use the information in the following table
¾ The 1-year return on a price-weighted index of these three stocks is

closest to:
A. 12.5%.
B. 13.5%.
C. 18.0%.
5-9
Example
z (22+40+34)/3=32
z (28+50+30)/3=36
z 36/32-1=0.125
6-9
Example
¾ The 1-year return on an equal-weighted index of these three stocks is
closest to:
A. 12.0%.
B. 12.5%.
C. 13.5%.
(28/22−1)+(50/40−1)+(30/34−1)
z =13.5%
3
7-9
Example
¾ The 1-year return on a market capitalization-weighted index of these
stocks is closest to:
A. 12.5%.
B. 13.5%.
C. 18.0%.
z Total portfolio value January 1:
22 ൈ (1,500)+40 ൈ (10,000)+34 ൈ (3,000) = 535,000
z Total portfolio value December 31:
28 ൈ (1,500)+50 ൈ (10,000)+30 ൈ (3,000) = 632,000
632/535-1=0.18
z From a base value of 100, the December 31 index value would be
632/535*100=118.13
8-9
Example
¾ Market float of a stock is best described as its:
A. total outstanding shares.
B. shares that are available to domestic investors.
C. outstanding shares, excluding those held by controlling
shareholders.
9-9
Rebalancing and
Reconstitution of an
index
1-3
Rebalancing and Reconstitution

¾ Rebalancing and Reconstitution
z Rebalancing
9 Used to adjusting the weights of securities in a portfolio to their
target weights since price changes may affect the weights of
securities used to calculate the indexes.
9 Rebalancing is done on a periodic basis, usually quarterly.
z Reconstitution
9 Index reconstitution refers to periodically adding and deleting
securities that make up an index.
9 Securities are deleted if they no longer meet the index criteria and
are replaced by other securities.
2-3
Uses of Security-Market Indexes
¾ Uses of Security-Market Indexes
z Reflection of investor confidence.
z Benchmark of manager performance.
z Proxies for measure of market return and risk.
z Proxies for measure of beta and risk-adjusted return.
z Model portfolio for index funds.
3-3
Other Investment
Indexes
1-9
Other Investment Indexes

¾ Characteristics of Equity Indexes (Summary)
z Broad market index
z Multi-market index
z Multi-market index with fundamental weighting
z Sector Index
z Style index
2-9
¾ Broad Market Index
z Provides a measure of a market’s overall performance and usually
contains more than 90% of the market’s total value.
¾ Multi-market Index
z Typically constructed from the indexes of markets in several countries
and is used to measure the equity returns of a geographic region,
markets based on their stage of economic development, or the entire
world.
¾ Multi-market Index with Fundamental weighting
z Uses market capitalization weighting for the country indexes, and uses
fundamental factor (e.g., GDP) to weights the country index returns in
the global index.
¾ Sector Index
¾ Style Index
3-9

¾ Broad market index
¾ Multi-market index
¾ Multi-market index with fundamental weighting
¾ Sector Index
z Measures the returns for an industry sectors such as health care,
financial, or consumer goods firms.
¾ Style index
z Measures the returns to market capitalization and value or growth
strategies
4-9

¾ Several issues with the construction of fixed income indexes:
z Large universe of securities:
9 The fixed income security universe is much broader than the
universe of stocks.
9 Are issued not just by firms, but also by governments and
government agencies.
9 Turnover is high in fixed income indexes since bond may mature
and be replaced in the index.
z Dealer markets and infrequent trading:
9 Fixed income securities are primarily traded by dealers, so index
providers must depend on dealers for recent prices.
5-9
¾ Alternative Investment Indexes- Commodity Indexes
z Commodity indexes represent futures contracts on commodities such
as grains, livestock, metals, and energy.
z There are several issues relevant to commodity indexes:
9 A variety of weighting schemes.
9 Based on futures contracts
9 Compositions are changed over time,
¾ Alternative Investment Indexes- Real Estate Indexes
z Real estate indexes can be constructed using returns based on
appraisals of properties, repeat property sales, or the performance of
Real Estate Investment Trusts (REITs).
¾ Alternative Investment Indexes- Hedge Fund Indexes
z Underlying assets are usually nontraditional assets with high leverage.
z Hedge funds are largely unregulated.
z Performance of different indexes are vary substantially.
6-9
Example
¾ For which of the following indexes will rebalancing occur most
frequently?
A. A price-weighted index.
B. An equal-weighted index.
C. A market capitalization-weighted index.
¾ The publisher of an index that includes 50 corporate bonds removes

from the index three bonds that are nearing maturity and one whose
issuer has defaulted and selects four actively traded bonds to replace
them in the index. This bond index is said to have been:
A. redefined.
B. rebalanced.
C. reconstituted.
7-9
Example
¾ Which of the following would most likely represent an inappropriate
use of an index?
A. As a reflection of market sentiment.
B. Comparing a small-cap manager against a broad market.
C. Using the CAPM to determine the expected return and beta.
¾ An index of 200 mid-cap growth stocks is best described as:

A. a style index.
B. a sector index.
C. a broad market index.
8-9
Example
¾ Which of the following is least accurate regarding fixed-income indexes?
A. Replicating the return on a fixed-income security index is difficult for
investors.
B. There is a great deal of heterogeneity in the composition of fixed
income security indexes.
C. Due to the large universe of fixed-income security issues, data for
fixed-income securities are relatively easy to obtain.
¾ Which of the following indexes of alternative investments is most likely to

be calculated from derivatives prices?
A. Real estate index.
B. Commodity index.
C. Hedge fund index.
9-9
Reading
35
Market Efficiency
1. Three Forms of Market Efficiency
Framework • The Weak-form EMH

• The Semi-strong Form EMH
• The Strong-form EMH
2. Tests, Implications and Conclusions of
EMH
3. Market Anomalies
4. Behavior Finance
Introduction of
market efficiency
1-4
Efficient Capital Market

¾ Efficient capital market and the assumptions
z An informationally efficient capital market is one in which the current
price of a security fully, quickly, and rationally reflects all available
information about that security.
z The time frame for an asset’s price to incorporate information can be
used to measure a market’s efficiency.
9 If the time frame of price adjustment allows many traders to earn
profits with little risk, then the market is relatively inefficient.
z An informational efficient capital market is where security prices adjust
rapidly to the infusion of new information.
z Prices should be expected to react only to the elements of information
releases that are not anticipated fully by investors.
2-4
Efficient Capital Market

¾ In markets that are highly efficient, investors can typically expect
market values to reflect intrinsic values.
z The market value of an asset is its current price.
z The intrinsic value or fundamental value of an asset is the value that
a rational investor with full knowledge about the asset’s characteristics
would willingly pay.
z In markets that are highly efficient, investors can typically expect market
values to reflect intrinsic values.
z If markets are not completely efficient, active managers will buy assets
for which they think intrinsic values are greater than market values and
sell assets for which they think intrinsic values are less than market
values.
3-4
Factors Affect the Degree of Market Efficiency
¾ Factors affect the degree of market efficiency
Number of market • The larger the number of investors, analysts, and
participation traders who follow an asset market, the more
efficient market.
Availability of • The more information is available to investors, the

information more efficient the market.
Impediments to • Impediments to arbitrage, such as lack of

trading information, will limit arbitrage activity and allow
inefficiency to persist.
Transaction and • Higher costs of information, analysis, and trading,

information costs more inefficient of the market.
4-4
Contrast weak
form,semi-strong form,
strong form market
efficiency
1-4
Three Forms of Market Efficiency

Weak-Form Semi-Strong Strong-Form
Market info Public info All info available
Price Market info Public info
Volume Non-market info Private info
Types Assumption Implication

Weak-Form EMH Market info. Technical Analysis h
Semi Strong-Form Technical Analysis h
Public info.
EMH Fundamental Analysis h
Technical Analysis h
Strong-Form EMH All info. Fundamental Analysis h
Nobody can win the market h
2-4
Tests, Implications and Conclusions of EMH
¾ Test of EMH
z Abnormal profit (or risk-adjusted returns) calculations are often used
to test market efficiency. If returns are ,on average, greater than
equilibrium expected returns, we can reject the hypothesis of efficient
prices with respect to the information on which the strategy is based.
9 Technical analysis seeks to earn positive risk-adjusted returns by
using historical price and volume data.
9 Fundamental analysis is base on public information such as
earnings, dividends, and various accounting rations and estimates.
9 One method of testing the semi-strong form is an event study,
examining abnormal returns before and after the release of new
information that affects intrinsic value.
3-4
Tests, Implications and Conclusions of EMH

¾ Conclusions of EMH
z If markets are semi-strong form efficient, investors should invest
passively (i.e., invest in an index portfolio that replicates the returns on
a market index).
z Indeed, the evidence shows that most mutual fund managers can not
outperform a passive index strategy over time.
z Even if markets are efficient, portfolio managers can add value by
establishing and implementing portfolio risk and return objectives and
by assisting clients with portfolio diversification, asset allocation, and tax
management.
4-4
Market Anomalies
1-6
Market Anomalies
¾ Market Anomalies
z Definition: something deviates and helps to disprove the EMH
z 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.
2-6
Market Anomalies
¾ Market Anomalies-Anomalies in Time-series data
z Calendar anomalies
9 The January effect is the finding that during the first five days of
January, stock returns, especially for small firms, significantly higher
than the rest of the year.
9 Explanations for January effect are͹
Tax-loss selling, as investors sell losing positions in December
to realize losses for tax purposes and repurchase stocks in
January; and
Window dressing, as portfolio managers sell risky stocks in
December to remove them from year-end statements and
repurchase them in January.
3-6
Market Anomalies
¾ Market Anomalies-Anomalies in Time-series data
z The overreaction effect: refers to the finding that firms with poor
stock returns over the previous three or five years (losers) have better
subsequent returns than firms that had high stock returns over the prior
period.
z Momentum anomalies: High short-term returns are followed by
continued high returns
z Both the overreaction effect and momentum effects violate the weak
form of market efficiency.
4-6
Market Anomalies
¾ Anomalies in cross-sectional data
z Size effect: This test indicates that stocks of small-sized firms tend to
outperform stocks of large-sized firms.
z Value effect: refers to the finding that value stocks [those with lower
price-to-earnings (P/E), lower market-to-book (M/B), and higher
dividend yields] have outperformed growth stocks (those with higher
P/E, higher M/B, and lower dividend yields).
¾ Other identified anomalies
z Closed-end investment funds: The shares of closed-end investment
funds trade at prices that sometimes deviate from the net asset value
(NAV) of the fund shares, often trading at large discounts to NAV.
5-6
Market Anomalies
¾ Market Anomalies-Anomalies in time-series data
¾ Anomalies in cross-sectional data
¾ Other identified anomalies
z Earnings announcements: The anomaly is that the adjustment
process does not occur entirely on the announcement day.
z Initial public offerings: the long-term performance of IPO shares as a
group is below average.
z Economic fundamentals: Research has found that stock returns are
related to known economic fundamentals such as dividend yields, stock
volatility, and interest rates. However, we would expect stock returns to
be related to economic fundamentals in efficient markets.
¾ The majority of the evidence suggests that reported anomalies are not
violations of market efficiency but are due to the methodologies used in
the tests of market efficiency.
¾ Investment management based solely on anomalies has no sound
economic basis.
6-6
Behavior Finance
1-7
Behavioral Finance
¾ Behavioral finance:
z Concerns about to what extent the psychological characteristics affect
investments either by individuals or groups.
¾ Behavioral biases that have been identified include
z Loss aversion: refers to the tendency for investors to be more risk
averse when faced with potential losses and less risk averse when faced
with potential gains.
z Overconfidence: explains that investors or analysts are overconfident
in their earning forecasts which result in the overestimation of growth,
good news.
z Herding: trading that occurs in clusters and is not necessarily driven by
information.
z Information Cascades: is the transmission of information from those
participants who act first and whose decisions influence the decisions of
others.
2-7
Behavioral Finance
¾ Rational vs. Irrational
z Efficient market hypothesis that only market is rational.
z Behavioral finance is used to explain some of the market anomalies as
irrational decisions.
¾ Behavioral biases that have been identified include
z Representativeness: Investors assume good companies or good
markets are good investments.
z Mental accounting: Investors classify different investments into
separate mental accounts instead of viewing them as a total portfolio.
z Conservatism: Investors react slowly to changes.
z Narrow framing: Investors view events in isolation.
3-7
Example
¾ In an informationally efficient capital market:
A. active managers can generate abnormal profits.
B. security prices quickly reflect new information.
C. investors react to all information releases rapidly.
¾ The intrinsic value of an asset:

A. changes through time as new information is released.
B. is the price at which the asset can be bought or sold at a given
point in time.
C. can be easily determined with a financial calculator, given investor
risk preferences.
4-7
Example
¾ In terms of market efficiency, short selling most likely:
A. leads to excess volatility, which reduces market efficiency.
B. promotes market efficiency by making assets less likely to become
overvalued.
C. has little effect on market efficiency because short sellers face the
risk of unlimited losses.
¾ The weak-form EMH asserts that stock prices fully reflect which of the
following types of information?
A. Market only.
B. Market and public.
C. Public and private.
5-7
Example
¾ Research has revealed that the performance of professional portfolio
managers tends to be:
A. equal to the performance of a passive investment strategy.
B. inferior to the performance of a passive investment strategy.
C. superior to the performance of a passive investment strategy.
¾ Which of the following best describes the majority of the evidence

regarding anomalies in stock returns?
A. Weak-form market efficiency holds, but semi-strong form efficiency
does not.
B. Neither weak-form nor semi-strong form market efficiency holds.
C. Reported anomalies are not violations of market efficiency but are
the result of research methodologies.
6-7
Example
¾ Investors who exhibit loss aversion most likely:
A. have symmetric risk preferences.
B. are highly risk averse.
C. dislike losses more than they like equal gains.
7-7
Reading
36
Overview of Equity Securities
1. Types of Equity Investments

Framework • Public Equity Securities
• Private Equity Securities
2. Foreign Equities and Equity Risk
Types of Equity
Investments
1-10
Classification of Public Equity Securities
¾ Classification of Equity Securities
z Common Shares:
9 Common shares are the most common form of equity and
represent an ownership interest. Common shareholders have a
residual claim (after the claims of debt holders and preferred
stockholders) on firm assets if the firm is liquidated and govern the
corporation through voting rights.
9 Common stockholders are able to vote for the board of directors,
on merger decisions, and on the selection of auditors.
In a statutory voting system, each share held is assigned one
vote in the election of each member of the board of directors.
Under cumulative voting, shareholders can allocate their votes
to one or more candidates as they choose. Cumulative voting
makes it possible for a minority shareholder to have more
proportional representation on the board.
2-10

z Callable common shares
9 Callable common shares give the firm the right to repurchase the
stock at a pre-specified call price. Investors receive a fixed amount
when the firm calls the stock.
z Putable common shares
9 Putable common shares give the shareholder the right to sell the
shares back to the firm at a specific price. A put option on the
shares benefits the shareholder because it effectively places a floor
under the share value.
Callable common share Advantage to firm

Putable common share Advantage to shareholder
3-10

z Preference shares
9 Preference shares (or preferred stock) have features of both
common stock and debt.
Features of common stock: do not mature
Features of debt: fixed dividend payment, but dividends are
not contractual obligation and do not usually have voting
rights.
Preferred shares have less risk than common shares because
the dividend is stable and they have priority over common
stock in receiving dividends and in the event of liquidation of
the firm.
4-10
z Cumulative preference shares
9 Usually promised fixed dividends and any dividends that are not
paid must be made up before common shareholders can receive
dividends.
z Investors in participating preference shares receive extra dividends if
firm profits exceed a predetermined level.
5-10

z Convertible preference shares
9 Convertible preference shares can be exchanged for common stock
at a conversion ratio determined when the shares are originally
issued.
9 It has the following advantages:
The preferred dividend is higher than a common dividend.
If the firm is profitable, the investor can share in the profits by
converting their shares into common stock.
Turns more valuable when the common stock price increases.
Preferred shares have less risk than common shares.
6-10
Private Equity Securities

¾ Private equity
z Private equity is usually issued to institutional investors via private
placements.
¾ Private equity has the following characteristics:
z Less liquidity because no public market for the shares exists.
z Share price is negotiated between the firm and its investors, not
determined in a market.
z More limited firm financial disclosure because there is no
government or exchange requirement to do so.
z Lower reporting costs because of less onerous reporting requirements.
z Potentially weaker corporate governance because of reduced
reporting requirements and less public scrutiny.
z Greater ability to focus on long-term prospects because there is no
public pressure for short-term results.
z Potentially greater return for investors once the firm goes public.
7-10
Private Equity Securities
¾ The three main types of private equity investments are:
• The capital provided to firms early in their life
Venture capital cycles to fund their development and growth.
• Venture capital financing at various stages of a
firm’s development is referred to as seed or start-
up, early stage, or mezzanine financing.
• Investors buy all of a firm’s equity using debt

Leveraged buyout(LBO) financing. If the buyers are the firm’s current
management, the LBO is referred to as a
management buyout(MBO)
Private investment in • A public firm that needs capital quickly sells

private equity to investors. The firm may have
public equity(PIPE) growth opportunities, be in distress, or have large
amounts of debt.
8-10
Example
¾ The advantage of participating preferred shares versus non-
participating preferred shares is that participating preferred shares can:
A. obtain voting rights.
B. receive extra dividends.
C. be converted into common stock.
¾ Which of the following best describes the benefit of cumulative share

voting?
A. It provides significant minority shareholders with proportional
representation on the board.
B. It prevents minority shareholders from exercising excessive control.
C. If cumulative dividends are not paid, preferred shareholders are
given voting rights.
9-10
Example
¾ Compared to public equity, which of the following is least likely to
characterize private equity?
A. Lower reporting costs.
B. Potentially weaker corporate governance.
C. Lower returns because of its less liquid market.
10-10
Investment in
non-domestic equity
securities
1-5
Non-domestic Equity Securities

¾ Trends in the international market
z An increasing number of companies have issued shares in markets
outside of their home country.
z the number of companies whose shares are traded in markets outside
of their home has increased.
z An increasing number of companies are dual listed, which means that
their shares are simultaneously issued and traded in two or more
markets.
¾ Companies located in emerging markets have particularly benefited
from these trends.
z These companies no longer have to be concerned with capital
constraints or lack of liquidity in their domestic markets.
z These companies have found it easier to raise capital in the markets of
developed countries because these markets generally have higher levels
of liquidity and more stringent financial reporting requirements and
accounting standards.
2-5

¾ Direct investing
z Buying a foreign firm’s securities in foreign markets directly. Some
obstacles to direct foreign investment are that:
9 Investment and return are denominated in a foreign currency.
9 The foreign stock exchange may be illiquid.
9 Reporting requirements may be less strict, impeding analysis.
9 Investors must be familiar with the regulations and procedures.
¾ Global registered shares
z Global registered shares (GRS) are traded in different currencies on
stock exchanges around the world.
3-5
¾ Depository receipts
z Depository receipts (DRs) represent ownership in a foreign firm and are
traded in the markets of other countries in local market currencies.
z A bank deposits shares of the foreign firm and then issues receipts
representing ownership of a specific number of the foreign shares. The
depository bank acts as a custodian and manages dividends, stock
splits, and other events.
9 Sponsored DR: the firm is involved with the issue. A sponsored DR
provides the investor voting rights.
9 Unsponsored DR: the firm is not involved with the issue. The
depository bank retains the voting rights.
4-5

¾ Depository receipts
z Depository receipts (DRs) represent ownership in a foreign firm and are
traded in the markets of other countries in local market currencies.
9 Global depository receipts (GDRs) are issued outside the U.S. and
the issuer’s home country. Most GDRs are traded on the London
and Luxembourg exchanges.
9 American depository receipts (ADRs) are denominated in U.S.
dollars and trade in the United States.
z Basket of listed depository receipts
9 A basket of listed depository receipts (BLDR) is an exchange-traded
fund (ETF) that is a collection of DRs.
5-5
Risk and return

characteristics of
equity securities
1-7
Risk and Return of Equity Securities
¾ Equity returns:
z Dividends
9 Gains from dividends and the reinvestment of dividends have been
an important part equity investors’ long-term returns.
z Capital gains or losses from changes in share prices
z Foreign exchange gains or losses.
9 For investors who purchase depository receipts or foreign shares
directly also subject foreign exchange gains (or losses)
2-7

¾ Equity risk:
z Most commonly measured as the standard deviation of returns.
z Preferred stock is less risky than common stock
9 preferred stock pays a known, fixed dividend
9 preferred stockholders receive their distributions before common
shareholders
9 have a claim in liquidation priority over the claims of common
stock.
z Putable shares are less risky for investor (for both common and
preferred shares)
9 if the market price drops, the investor can put the shares back to
the firm at a fixed price
z Callable shares are more risky for investor (for both common and
preferred shares)
9 if the market price rises, the firm can call the shares, limiting the
upside potential of the shares.
3-7

¾ The risk is most commonly measured as the standard deviation of
returns (‫ߗࣩ࣮ݗ‬Ӕٚ).
Low risk High
Preferred stock < Common stock
Putable stock < Callable stock
Cumulative preferred stock < Non-cumulative preferred stock
4-7
¾ The book value of equity
z The book value is shareholders’ equity on a company’s balance sheet.
¾ The market value of equity
z The market value of equity reflects the collective and differing
expectations of investors concerning the amount, timing, and
uncertainty of the company’s future cash flows.
¾ Return on Equity
z Return on equity is the primary measure that equity investors use to
determine whether the management of a company is effectively and
efficiently using the capital they have provided to generate profits.
NI t NI t
ROEt = =
average BV BVt +BVt-1 /2
୲
୲ ൌ
୲ିଵ
5-7

¾ Cost of equity:
z The expected equilibrium total return (including dividends) on its shares
in the market.
9 At any point in time, a decrease in share price will increase the
expected return on the shares and an increase in share price will
decrease expected returns, other things equal.
9 A firm’s cost of equity can be interpreted as the minimum rate of
return required by investors (in the aggregate) to compensate
them for the risk of the firm’s equity shares.
6-7
Example
¾ Global depository receipts are most often denominated in:
A. the currency of the country where they trade and issued outside
the United States.
B. U.S. dollars and issued in the United States.
C. U.S. dollars and issued outside the United States.
¾ Which of the following types of preferred shares has the most risk for
investors?
A. Putable shares.
B. Callable shares.
C. Non-putable, non-callable shares.
7-7
Reading
37
Introduction to Industry and company Analysis
1. Industry Analysis
Framework • The Uses of Industry Analysis
• Approaches to Identifying Similar

Companies
• Strategic Analysis of an Industry
2. External Influences and Company

analysis
Current industry
classification
systems
1-10
The Uses of Industry Analysis
¾ Understanding a company’s business and business environment
z Industry analysis is often a critical early step in stock selection and
valuation because it provides insights into the issuer’s growth
opportunities, competitive dynamics, and business risks .
¾ Identifying active equity investment opportunities
z Industry valuation can be used in an active management strategy to
determine which industries to overweight or underweight in a portfolio.
Some investors engage in industry rotation, which is overweighting or
underweighting industries based on the current phase of the business
cycle.
¾ Portfolio performance attribution.
z Performance attribution, which addresses the sources of a portfolio’s
returns, usually in relation to the portfolios benchmark, includes
industry or sector selection. Industry classifications chemes play a role
in such performance attribution.
2-10
Industry Classification
¾ The major approaches to industry classification
z Products and services they offer;
z Sensitivity to business cycles;
z Statistical methods, such as cluster analysis;
z Commercial industry classification;
z Peer group;
3-10
¾ One way to group companies into an industry is by the products and
services they offer.
z Systems that are grouped by products and services usually use a firm’s
principal business activity (the largest source of sales or earnings)
to classify firms.
z Examples of these systems are discussed in the following and include
the Global Industry Classification Standard (GICS) and Industry
Classification Benchmark (ICB).
4-10
¾ Firms can also be classified by their sensitivity to business cycles. This
system has two main classifications: cyclical and non-cyclical firms.
z Cyclical firm: highly dependent on the stage of the business cycle.
9 High earnings volatility
9 high operating leverage
9 Includes: basic materials and processing, consumer discretionary,
energy, financial services, industrial and producer durables, and
technology.
9 A cyclical company is one whose profits are strongly correlated with
the strength of the overall economy.
5-10
¾ Firms can also be classified by their sensitivity to business cycles. This
system has two main classifications: cyclical and non-cyclical firms.
z Non-cyclical firm: demand is relatively stable over the business cycle.
9 Examples include: Health care, utilities, telecommunications, and
consumer staples.
9 Defensive industries: least affected by the stage of the business
cycle and include utilities, consumer staples (such as food
producers), and basic services (such as drug stores).
9 Growth industries: demand so strong they are largely unaffected
by the stage of the business cycle.
6-10
¾ Statistical methods, such as cluster analysis, can also be used.
z This method groups firms that historically have had highly correlated
returns. The groups (i.e., industries) formed will then have lower returns
correlations between groups.
z This method has several limitations:
9 Historical correlations may not be the same as future correlations.
9 The groupings of firms may differ over time and across countries.
9 The grouping of firms is sometimes non-intuitive.
9 The method is susceptible to statistical error (i.e., firms can be
grouped by a relationship that occurs by chance, or not grouped
together when they should be).
7-10
¾ Commercial industry classification system
z Global Industry Classification StandardͧGICSͨ
9 Designed to facilitate global comparisons of industries. It classifies
companies in both developed and developing economies.
9 GICS classification structure comprised four levels of detail
consisting of 11 sectors, 24 industry groups, 69 industries, and 158
sub-industries.
z Industry Classification Benchmark (ICB)
9 The Industry Classification Benchmark uses a four-tier structure to
categorize companies globally on the basis of the source from
which a company derives the majority of its revenue.
8-10
¾ Strengths and Weaknesses of Current Systems (Commercial vs.
Governmental)
z Unlike commercial classification systems, most government systems do
not disclose information about a specific business or company, so an
analyst cannot know all of the constituents of a particular category.
z Generally, commercial classification systems are adjusted more
frequently than government classification systems, which may be
updated only every five years or so.
z Government classification systems generally do not distinguish between
small and large businesses, between for-profit and not-for-profit
organizations, or between public and private companies.
z Many commercial classification systems have the ability to distinguish
between large and small companies by virtue of association with a
particular equity index, and these systems include only for-profit and
publicly traded organizations.
9-10
¾ Peer Group
z A peer group is a set of similar companies an analyst will use for valuation
comparisons.
z The following are steps an analyst would use to form a peer group:
9 Examine commercial classification systems if available. These systems
often provide a useful starting point for identifying companies
operating in the same industry.
9 Review the subject company’s annual report for a discussion of the
competitive environment. Companies frequently cite specific
competitors.
9 Review competitors’ annual reports to identify other potential
comparables.
9 Review industry trade publications to identify additional peer
companies.
9 Confirm that each comparable or peer company derives a significant
portion of its revenue and operating profit from a business activity
similar to that of the subject company.
10-10
Industry life cycle
models
1-8
¾ Industry Classification System (Cont.)
z Industry Life Cycle
9 Embryonic stage
9 Growth stage
9 Shakeout stage
9 Mature stage
9 Decline stage
2-8
9 Embryonic stage: the industry has just started
Slow growth: customers are unfamiliar with the product.
High prices: the volume necessary for economies of scale has
not been reached.
Large investment required. to develop the product.
High risk of failure: most embryonic firms fail.
3-8
9 Growth stage (industry growth is rapid )
Rapid growth: new consumers discover the product.
Limited competitive pressures: The threat of new firms coming
into the market peaks during the growth phase, but rapid
growth allows firms to grow without competing on price.
Falling prices: economies of scale are reached and distribution
channels increase.
Increasing profitability: due to economies of scale.
4-8
9 Shakeout stage : industry growth and profitability are slowing due
to strong competition.
Growth has slowed: demand reaches saturation level with few
new customers to be found.
Intense competition: industry growth has slowed, so firm
growth must come at the expense of competitors.
Increasing industry overcapacity: firm investment exceeds
increases in demand.
Declining profitability: due to overcapacity.
Increased cost cutting: firms restructure to survive and attempt
to build brand loyalty.
Increased failures: weaker firms liquidate or are acquired.
5-8
9 Mature stage: there is little industry growth and firms begin to
consolidate
Slow growth: market is saturated and demand is only for
replacement.
Consolidation: market evolves to an oligopoly,
High barriers to entry: surviving firms have brand loyalty and
low cost structures.
Stable pricing: firms try to avoid price wars, although periodic
price wars may occur during recessions.
Superior firms gain market share: the firms with better
products may grow faster than the industry average.
6-8
9 Decline stage: industry growth is negative.
Negative growth: due to development of substitute products,
societal changes, or global competition.
Declining prices: competition is intense and there are price
wars due to overcapacity.
Consolidation: failing firms exit or merge.
7-8
Industry Life Cycle Model

Sales
Time
Embryonic Growth Shakeout Mature Decline
8-8
Strategic analysis of
an industry
1-6
Strategic Analysis of an Industry
¾ Competitive Advantage
z Analysis framework developed by Michael Porter delineates five
forces that determine industry competition:
9 Rivalry among existing competitors. Rivalry increases when many
firms of relatively equal size compete within an industry.
9 Threat of new entrants. Industries that have significant barriers to
entry will find it easier to maintain premium pricing.
9 Threat of substitute products. Substitute products limit the profit
potential of an industry.
9 Bargaining power of buyers. Buyers’ ability to bargain for lower
prices or higher quality influences industry profitability.
9 Bargaining power of suppliers. Suppliers’ ability to raise prices or
limit supply influences industry profitability.
2-6
Strategic Analysis of an Industry

¾ Pricing power
z Barriers to entry
9 low barriers to entry->little pricing power
9 high barriers to entry do not necessarily mean high pricing power
(Overcapacity)
9 Low barriers to exit may have higher pricing power
z Industry concentration
9 High Industry concentration does not guarantee pricing power
z Industry capacity
9 Undercapacity->higher pricing power and higher return on capital
9 Overcapacity->lower pricing power and lower return on capital
z Market share stability
9 More stable market shares likely indicate less intense competition.
3-6
Example
¾ Firms and industries are most appropriately classified as cyclical or non-
cyclical based on:
A. their stock price fluctuations relative to the market.
B. the sensitivity of their earnings to the business cycle.
C. the volatility of their earnings relative to a peer group.
¾ An analyst should most likely include two firms in the same peer group
for analysis if the firms:
A. are both grouped in the same industry classification.
B. are similar in size, industry life-cycle stage, and cyclicality.
C. derive their revenue and earnings from similar business activities.
4-6
Example
¾ Two of the five competitive forces in the Porter framework are:
A. threat of entry and barriers to exit.
B. power of suppliers and threat of substitutes.
C. rivalry among competitors and power of regulators.
¾ Which of the following statements best describes the relationship

between pricing power and ease of entry and exit? Greater ease of
entry:
A. and greater ease of exit decrease pricing power.
B. and greater ease of exit increase pricing power.
C. decreases pricing power and greater ease of exit increases pricing
power.
5-6
Example
¾ Industry overcapacity and increased cost cutting characterize which
stage of the industry life cycle?
A. Growth.
B. Shakeout.
C. Maturity.
¾ In which of these characteristics is the oil producing industry most

likely similar to the home building industry?
A. Industry concentration.
B. Demographic influences.
C. Business cycle sensitivity.
6-6
External Influences
and Company
Analysis
External Influences
¾ The external influences on industry growth, profitability, and risk
z Macroeconomic factors
9 Can be cyclical or structural (longer-term) trends, most notably
economic output as measured by GDP or some other measure,
such as interest rates, inflation and education level.
z Technology
9 Change an industry dramatically through the introduction of new
or improved products.
z Demographics
9 The demographics includes not only the population growth and
the age distributions, but also the geographical distribution of
people, the changing ethnic mix in a society, and changes in
income distribution.
External Influences
¾ The external influences on industry growth, profitability, and risk
z Governments
9 Today’s social trend may be tomorrow’s law, regulation, or tax
z Social influence
9 How people work, play, spend their money, and conduct their lives.
z Environmental influences
9 Consumer perception for certain brands, products, and services
9 Increased government regulations and protections
9 Potential disruptions to supply chains and the ability to operate,
such as an increase in natural disasters or resource shortages in
water or energy
Company Analysis
¾ A company analysis should include the following elements
z Firm overview, including information on operations, governance, and
strengths and weaknesses.
z Industry characteristics.
z Product demand.
z A product costs.
z Pricing environment.
z A financial ratios, with comparisons to other firms and over time.
z Projected financial statements and firm valuation.
3-6
Company Analysis
¾ Three generic competitive strategies
z Cost leadership: With the same product, the firm seeks to a lower cost.
z Differentiation: With the same cost, the firm seeks to provide product
benefits that other firms do no provide.
z Focus: The firm targets a niche with either a cost or a differentiation
focus.
Low-cost strategy Product differentiation strategy

• Seek to have the lowest costs of • The firm’s products and services should
production in its industry. be distinctive in terms of type, quality,
• In predatory pricing, the firm hopes to or delivery.
drive out competitors and later increase • The price premium should also be
prices. sustainable over time.
• A low-cost strategy firm should have • Successful differentiators will have
managerial incentives that have outstanding marketing research teams
toward improving operating efficiency and creative personnel.
4-6
Company Analysis
¾ Analysts often use spreadsheet modeling to analyze and forecast company
fundamentals.
¾ The problem with this method is that the models’ complexity can make their
conclusions seem precise, and the estimation is performed with error that
can compound over time.
5-6
Example
¾ Which of the following is least likely a significant external influence on
industry growth?
A. Social influences.
B. Macroeconomic factors.
C. Supplier bargaining power.
¾ Which of the following best describes a low-cost competitive strategy?

A. Volume sold is typically modest.
B. Managerial incentives promote operational efficiency.
C. Success depends heavily on creative marketing and product
development.
6-6
Reading
38
Equity Valuation: Concept and Basic Tool
1. Discounted Cash Flow Models

Framework • Dividends, Splits, and Repurchases
• Dividend Discount Models
• Free Cash Flow Models
2. Multiplier models
• Price Multiples Based on Fundamentals
• Price Multiples Based on Fundamentals
2. Asset-based models
Equity valuation
models
1-6
Evaluate a Security
¾ Intrinsic value vs. Market price
z Analysts use valuation models to estimate the intrinsic values of stocks
and compare them to the stocks’ market prices to determine whether
individual stocks are overvalued, undervalued, or fairly valued.
z Market price is assumed to move toward intrinsic value.
z Things to consider when deciding whether to invest based on estimated
intrinsic value:
9 Percentage difference between market prices and estimated values.
9 Confidence of the appropriateness of the valuation model.
9 Confidence of the inputs used in the valuation model.
9 Reasons why stock is mispriced.
9 Assume that market price will actually move toward estimated
intrinsic value and that it will do so to a significant extent within
the investment time horizon.
2-6
Major Categories of Equity Valuation Models

¾ Major categories of equity valuation models
z Discounted cash flow models (or present value models)
9 dividend discount models
9 free cash flow to equity models
z Multiplier models (market multiple models)
9 the ratio of stock price to fundamentals
9 the ratio of enterprise value to fundamentals
z Asset-based models
3-6
Background for DDM: Stock Dividends

¾ Dividend
z A dividend is a distribution paid to shareholders based on the number
of shares owned, and a cash dividend is a cash distribution made to
company’s shareholders.
¾ Extra dividend or special dividend
z The dividends paid by a company that does not pay dividends on a
regular schedule or a dividend that supplements regular cash dividend
with an extra payment.
¾ Stock dividends
z Stock dividends is a type of dividend in which a company distributes
additional shares of its common stock to shareholders instead of cash.
¾ Stock split/ Reverse stock split
4-6
Background for DDM: Share Repurchase
¾ Definition
z A share repurchase is a transaction in which a company uses cash to buy
back its own shares.
z Shares that have been repurchased are not considered for dividends,
voting, or computing earnings per share.
¾ Key reasons for engaging in share repurchases
z Signaling a belief that their shares are undervalued;
z Flexibility in the amount and timing of distributing cash to shareholders;
z Tax efficiency in markets where tax rates on dividends exceed tax rates
on capital gains;
z The ability to absorb increase in outstanding shares because of the
exercise of employee stock options.
5-6
Dividend Payment Chronology

The ex-dividend date Holder-of-record date
1-2 business days
The declaration date Payment date
¾ Ex-dividend date is normally set for stocks one or two business days
before the record date.
6-6
DCF models
1-17
Discounted Cash Flow Models
¾ Equity valuation key principle: discounted future cash flow
Balance Sheet˖Asset=Debt + Equity
Debt Fixed income

Asset
Equity Future Cash Flow
Ways of borrowing money
Equity valuation
future cash flow discounted

Dividend Ke
Capital Gains
2-17

¾ Valuing Preferred Stock
z The preferred stock holders are promised to receive a stated dividend
for an infinite period.
z Preferred stock is perpetuity since it has no maturity.
z Valuation model of a preferred stock:
Dp Dp Dp Dp
Vp = + +}+ =
1+r 1+r
p p
2
1+r
p
N
rp
3-17

¾ Target˖
˖Gordon Growth dividend discount model (GGM) or Dividend
Discount Model(DDM)˖
D0 1+gc D1
p0 = =
re -gc re -gc
¾ ऍ੫গ߄㔀গ
Dividend discount model˄DDM˅ऍ੫গ߄

‫ޫޥܕٵ‬৐ўਗ਼ॠ
One year holding period
DDM
‫ޫޥܕٵ‬৐ўਗ਼ॠ
Two year holding period
DDM
‫ݸ‬ୡޫ‫ޥܕ‬৐ўਗ਼ॠ
Infinite holding period DDM
৐Ӯ㔗ؓ‫׌‬େࠆֹ ‫י‬୘ࠝ৐Ӯ۲ࢻࠆֹ
Constant dividend growth model Multistage dividend discount model
4-17
¾ Valuing common stock –Dividend discount model (DDM)
z One-year holding period
D1 Pj1 p0 D1 p1
Vj= +
1+r 1+r 0 1
z Two-year holding period
D1 D2 Pj2 p0 D1 D2 p2
Vj= + + t
1+r 1+r 2 1+r 2 0 1 2
5-17

z Multiple-Stage Dividend Growth Models
D1 D2 Dn Pn
V0 = + +}+ +
1+re 1+re 2
1+re 1+re
n n
Dn+1
Pn= p0 D1 D2 Dp
re -gc … t t
tÆ∞
0 1 2 … t
z The general DDM
D1 D2 Df n
Dt
f ¦
Vj= + +}+ =
1+r 1+r 2
1+r t=1 1+r
t
6-17

z Gordon growth model (Constant growth model)
9 Assumption for the infinite period DDM
Dividends grow at a constant rate.
The constant growth rate will continue for an infinite period.
The required rate of return r is greater than the infinite growth
rate g...if it is not, the model gives meaningless results.
D0 1+gc D0 1+gc D 1+gc

2 f
V0 = + + + 0
1+re 1+re
2
1+re
f
D0 1+gc D1
V0 = =
re -gc re -gc
7-17
¾ Valuing Common Stock –Dividend discount Model (DDM)
z Gordon growth model (Constant growth model)
9 Limitations
Very sensitive to estimates of r and g
Difficult with non-dividend stocks
Difficult with unpredictable growth patterns (use multi-stage
model)
9 Important Conclusion
The wider is the difference between r and g, the smaller the
value of the stocks.
Small changes in the difference between r and g will cause
large changes in the stocks’ value
8-17

¾ Other variable parameters:
z D0
z gc
z re
¾ Distribution of EPS
D0 1 RR u EPS
Dividend D0 1 g c
EPS p0 gc ROE u RR
re g c
Retention Rate
re RFR E Rmkt RFR
9-17

z The required rate of return (capital asset pricing model(CAPM))
r=RFR nominal+β(RM -RFRnominal )
z Another way to estimate required rate of return

r current bond yield + equity risk premium
z Growth rate in Dividends
9 Use the historical growth in dividends for the firm.
9 Use the median industry dividend growth rate.
9 Estimate the sustainable growth rate.
g=sustainable growth rate = b × ROE

b = retention ratio = 1 – dividend payout rate
10-17
z Two-stage DDM
9 the growth rate starts at a high level for a relatively short period of
time, then reverts to a long-run perpetual level.
Dividend Growth (g)
15%
3%
Stage 1 Stage 2
Time
Year 4
11-17

z Three-stage DDM
Dividend Growth (g)
25%
15%
3%
Stage 1 Stage 2 Stage 3
Time
Year 3 Year 8
12-17

¾ Valuing common stock –free cash flow to equity
z Valuation obtained by using FCFE involves discounting expected future
FCFE by the required rate of return on equity. FCFE reflects the firm’s
capacity to pay dividends.
z FCFE is useful the firm that does not pay dividends or pays dividends
but the dividends paid differ significantly from the company’s capacity
to pay dividends;
FCFE= net income + depreciation-increase in working capital-fixed

capital investment (FCInv)-debt principal repayments
+ new debt issues
FCFE = Cash Flow from Operations - FCInv + Net Borrowing

f
FCFEt FCFE0 (1+g)
V0 =¦ V0 =
1+re
t
t 1 re -g
13-17
Example
¾ The constant growth model requires which of the following?
A. g < r.
B. g > r.
C. g ≠ r.
¾ What would an investor be willing to pay for a share of preferred stock that
pays an annual $7 dividend if the required return is 7.75%?
A. $77.50.
B. $87.50.
C. $90.32.
14-17
Example
¾ An analyst estimates that a stock will pay a $2 dividend next year and that
it will sell for $40 at year-end. If the required rate of return is 15%, what is
the value of the stock?
A. $33.54.
B. $36.52.
C. $43.95.
¾ What is the intrinsic value of a company’s stock if dividends are expected to

grow at 5%, the most recent dividend was $1, and investors’ required rate
of return for this stock is 10%?
A. $20.00.
B. $21.00.
C. $22.05.
15-17
Example
¾ Assume that a stock is expected to pay dividends at the end of Year 1
and Year 2 of $1.25 and $1.56, respectively. Dividends are expected to
grow at a 5% rate thereafter. Assuming that Re is 11%, the value of the
stock is closest to:
A. $22.30.
B. $23.42.
C. $24.55.
16-17
Example
ଵǤହ଺ ൈଵǤ଴ହ
z V2 ൌ ଴Ǥଵଵି଴Ǥ଴ହ
ൌ ʹ͹Ǥ͵
$1.25 $ଵǤହ଺ା$ଶ଻Ǥଷ
z V0 = ൅ = $24.55
1.11 ଵǤଵଵమ
17-17
Price multiples
1-6
Price Multiple Approach

¾ Price multiples used for valuation include:
z Price to Earnings (P/E): This measure is the ratio of the stock price to
earnings per share. P/E is arguably the price multiple most frequently
cited by the media and used by analysts and investors.
z Price to Sales (P/S): This measure is the ratio of stock price to sales per
share.
z Price to Book Value (P/BV): The ratio of the stock price to book value
per share.
z Price to Cash Flow (P/CF): This measure is the ratio of stock price to
some per share measure of cash flow.
2-6
¾ Two main ways to apply these price multiples
z Price multiples based on fundamentals:
9 The value justified by (based on) fundamentals or a set of cash flow
predictions (intrinsic value) therefore are independent of the
current market prices.
z Price multiples based on comparables:
9 Compare relative values between one firm to another using price
multiples with market price.
3-6

¾ Multiples based on fundamentals
z The Earnings Multiplier Model Derived from DDM
9 According to infinite period DDM
D1
P0 =
r-g
9 Justified P/E: Assume we divide both sides of the equation by E1
(expected 12-month earnings), the equation changes to:
Leading P/E: Expected earnings(dividends) used are of next
period.
P0 D1 E1 1-b
= =
E 1 r-g r-g
Trailing P/E: Based on actual earnings for the previous period.
P0 D0 E0 (1-b)(1+g)
= 1+g=
E0 r-g r-g
4-6

¾ Multiples based on comparables
z The methodology involves using a price multiple to evaluate whether an
asset is fairly valued, undervalued, or overvalued in relation to a
benchmark value of the multiple.
z Identify companies that are most similar according to a number of
dimensions. These dimensions include (but are not limited to) overall
size, product lines, and growth rate.
z The economic rationale underlying the method of comparables is the
law of one price: Identical assets should sell for the same price.
5-6
¾ Multiples based on comparables
z Price multiples are widely used because:
9 Can be calculated easily.
9 Can be used both cross-sectional (versus the market or another
comparable) and in time series.
z Disadvantages of using price multiples
9 The conclusion drawn under the comparable and fundamental
method may be reverse.
9 Price multiples may lose validity when firms use different
accounting methods.
9 Price multiples for cyclical firms may be highly influenced by
current economic conditions.
6-6
Enterprise value
multiples
1-3

¾ Enterprise value (cost to acquire the firm)
z Enterprise value (EV) is total company value, not equity.
z EV = market value of common stock + market value of preferred equity
+ market value of debt– cash and short-term investments
¾ Advantage
z Useful for comparing firms with different degrees of financial leverage
z EBITDA is useful for valuing capital-intensive business EB
z EBITDA is usually positive even when EPS is not.
z EBITDA is useful for comparing firms with different effective tax rate.
¾ Disadvantages
z Market value of debt is often not available.
9 Market value of similar debt can be used
9 Book value of debt can be used
2-3
Example
¾ Enterprise value is defined as the market value of equity plus:
A. the face value of debt minus cash and short-term investments.
B. the market value of debt minus cash and short-term investments.
C. cash and short-term investments minus the market value of debt.
¾ A firm has an expected dividend payout ratio of 60% and an expected

future growth rate of 7%. What should the firm’s justified forward
price-to-earnings (P/E) ratio be if the required rate of return on stocks
of this type is 15%?
A. 5.0Ø.
B. 7.5Ø.
C. 10.0Ø.
3-3
Asset-based models
1-7
Asset-Based Valuation
¾ An asset-based valuation of a company uses estimates of the market or
fair value of the company’s assets and liabilities. Because market values
of the firm assets are usually difficult to obtain, the analyst typically starts
with the balance sheet to determine the values of assets and liabilities.
¾ The asset-based valuation approach is not applicable when:
z Intangible assets or “off the books” assets take up a large proportion.
z Under a hyper-inflationary condition.
z Companies with assets don’t readily determinable market (fair) value—
—such as those with significant property, plant, and equipment.
¾ The asset-based valuation approach is most applicable when:
z Financial companies, natural resource companies, and formerly going-
concerns that are being liquidated.
¾ Asset-based models are frequently used for valuation of private companies.
2-7
Comparison of The Three Valuation Methods
¾ Discounted Cash Flow Models
Advantages Disadvantages
• Will grounded in finance theory. • Their inputs must be estimated.
• Widely accepted in the analyst • Value estimates are sensitive to
community. inputs.
3-7
Comparison of The Three Valuation Methods

¾ Comparable Valuation Using Price Multiples
• Evidence that some price • Lagging price multiples reflect the past.
multiples are useful for • May not be comparable across firms if the
predicting stock returns. firms have different size, products, and
• Price multiples are widely used growth.
by analysts. • Price multiples for cyclical firms may be
• Price multiples are readily greatly affected by economic conditions.
available. • A stock may appear overvalued by the
• They can be used in time series comparable method but undervalued by a
and cross-sectional comparisons. fundamental method, or vice versa.
• EV/EBITDA multiples are useful • Different accounting methods can result in
when comparing firm values price multiples that are not comparable.
independent of capital structure • A negative denominator in a price multiple
or when earnings are negative results in a meaningless ratio. The P/E ratio
and the P/E ratio cannot be used. is especially susceptible to this problem.
4-7
Comparison of the three valuation methods

¾ Price multiple valuations based on fundamentals
• They are based on theoretically sound • Price multiples based on
valuation models. fundamentals will be vary sensitive
• They correspond to widely accepted to the inputs(especially the k-g
value metrics. denominator).
¾ Asset-based models
• They can provide floor values • Market values are difficult to obtain.
• Reliable when the firm has primarily • Market values are different than
tangible short-term assets, assets with book values.
ready market values, or when the firm • Inaccurate when a firm has a high
is being liquidated. proportion of intangible assets.
• They are increasingly useful for valuing • Assets can be difficult to value
public firms that report fair values. during periods of hyperinflation.
5-7
Example
¾ Which of the following is least likely a rationale for using price
multiples?
A. Price multiples are easily calculated.
B. The fundamental P/E ratio is insensitive to its inputs.
C. The use of forward values in the divisor provides an incorporation
of the future.
¾ Which type of valuation model is viewed as having the disadvantage of

producing results that may not be comparable across firms?
A. Asset-based models.
B. Price multiple models.
C. Discounted cash flow models.
6-7
Example
¾ Which of the following firms would most appropriately be valued using
an asset based model?
A. An energy exploration firm in financial distress that owns drilling
rights for offshore areas.
B. A paper firm located in a country that is experiencing high inflation.
C. A software firm that invests heavily in research and development
and frequently introduces new products.
7-7
It’s not the end but just beginning.
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CFA一级基础段权益投资 Jcy 金程（打印版）

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Equity

Topic Weightings in CFA Level I

¾ SS12 Equity Investment (2)

Market Organization and Structure

1. Markets, Assets, and Intermediaries

Framework • Main Functions of the Financial System

Main Functions of the Financial Market

Main Functions of the Financial Market

Main Functions of the Financial Market

Well Functioned Financial Market

Intermediaries of Financial Market

Intermediaries of Financial Market

Intermediaries of Financial Market

Intermediaries of Financial Market

Intermediaries of Financial Market

Bonds With longer maturities (with maturity longer than 10 years)

y Own residual rights to the assets of the company;

Underwritten offering Best Efforts

Quote-Driven Market Order-Driven Market

¾ An investor who buys a government bond from a dealer’s inventory is

¾ Daniel Ferramosco is concerned that a long-term bond he holds might

¾ Which of the following would least likely be an objective of market

ʏ Lend securities ʑ Deposit cash and margin

Pay interest minus

Instructions of Transaction Processes

Instructions of Transaction Processes

Instructions of Transaction Processes

Instructions of Transaction Processes

Instructions of Transaction Processes

Security Market Indexes

1. Weighting Schemes for Stock Indexes

Framework • Price-Weighted Index

Definitions about Market Indexes

How an Index is Constructed

Weighting Schemes for Stock Indexes:

Methods of Index Construction

sum of stock prices

z Two major price-weighted indexes are the Dow Jones Industrial

change in average index value=

change in average index value=n x1x 2 Ăxn -1

9 The geometric-averaged index value is always less than the

Methods of Index Construction

current total market value of index stocks

Methods of Index Construction

¾ The 1-year return on a price-weighted index of these three stocks is

Rebalancing and Reconstitution

Other Investment Indexes

Other Investment Indexes

Other Investment Indexes

¾ The publisher of an index that includes 50 corporate bonds removes

¾ An index of 200 mid-cap growth stocks is best described as:

¾ Which of the following indexes of alternative investments is most likely to

1. Three Forms of Market Efficiency

Framework • The Weak-form EMH

Efficient Capital Market

Efficient Capital Market

Availability of • The more information is available to investors, the

Impediments to • Impediments to arbitrage, such as lack of

Transaction and • Higher costs of information, analysis, and trading,

Three Forms of Market Efficiency

Market info Public info All info available

Price Market info Public info

Volume Non-market info Private info

Trailing P/E: Based on actual earnings for the previous period.