1 capital markets to help to finance companies 1.annual working capital increases = $ 150 billion...

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Capital MarketsCapital Markets

To help to finance Companies1. Annual Working Capital increases = $ 150 Billion

2. Annual Capital Expenditures “CAPEX” = $ 900 Billion

= $ 1,050 Billion

Source of funds:1. Annual Earnings = ($ 800 Billion)

GAP $ 250 Billion

2. Need to Issued New Debt ($ 250 Billion)

Or Issue new Shares of Equity = $ 0

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Assets & InvestingAssets & Investing

The Assets Fixed Income Bonds Real Estate

Equity Shares Units

Derivatives Options Futures

The Process Asset Allocation

Equity/Fixed

• 60/40

• 80/20

• 120/20 ?

Security Selection Security Analysis

Risk Return Trade-off

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Projected 10 year cumulative real return stock return 8%; bond return 4.5%

inflation 3%

80% stock / 20% bond 52%

70% stock / 30% bond 47%

60% stock / 40% bond 42%

50% stock / 50% bond 38%

40% stock / 60% bond 33%

30% stock / 70% bond 29%

20% stock / 80% bond 24%

Stock are riskier than Bonds.Rule of Thumb for Individuals – 100 minus

your age for Bond allocation

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Prices and Coupon RatesPrices and Coupon Rates

Return

Risk

Risk and expected Return Risk and expected Return

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Financial InstrumentsFinancial Instruments

Money Market Certificates of Deposit U.S. Treasury Bills Money Market Funds

Bond Market U.S Treasury Notes and

Bonds U.K. Gilts and Consols Municipal Bonds Corporate Bonds

Equity Market Common Stock Preferred Stock

Derivative Market Options Futures

Other Swaps Pass-throughs

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Intermediation and InnovationIntermediation and Innovation

Banks Commercial Banks Investment Banks

Funds Mutual Hedge Pension Private Equity Foreign Exchange Commodity

Securitization GNMA CMOs, CDOs

Bundling (Un) STRIPS

Engineering Custom-tailored Risk/Return Synthetics – derivative

hedges – mimic something

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Fixed Securities & RatesFixed Securities & Rates

Fixed CDs – bank time-deposits Paper – unsecured, trade-able company debt Acceptances – bank promises Eurodollars - $ denominated foreign bonds Repos, Reverse Repos – of treasury debt Treasuries – bills, notes, bonds

Rates Prime Fed Funds LIBOR TED Spread : the 3-month Treasury less LIBOR

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Denominated in basis points (bps). Historically 10 to 50 bps – average 30 bps

A rising TED spread indicates shrinking liquidity –an indicator of perceived credit risk:

T-bills are considered risk-freeLIBOR reflects the credit risk of lending banks.

Widening TED spread is a sign that lenders believe default risk on interbank (counterparty) loans is increasing.]

2007 average 150 – 200 bpsSeptember 2008 > 300 bps10/10/2008 465 bps

TED Spread

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Pick the Federal Reserve Bank

Chairmen?

Click Glenn Hubbard for the

parody

a c

d e

b

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What’s the problem with the Fed balance sheet?

Not it’s size. But the quality of the assets.

The largest piece of the pie is pass-thru-securities (pass thrus from sub-prime mortgages) CDO’s.

No one knows the real value of this balance sheet.

Did the Fed break the law? (Federal Reserve Act of 1913) by taking less than Federal government backed securities?

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Inflation?Deflation?

The problem is losing dollar strength.

Most people get this wrong. The effects are similar: prices go up, but the cause is subtly different. The weakening dollar due to the extreme moves by the Fed undermine Americans buying power.

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The Appeal of Common StocksThe Appeal of Common Stocks

Residual Owners: stockholders of a firm are the owners, who are entitled to dividend income and a prorated share of the firm’s earnings only after all the firm’s other obligations have been met Stocks allow investors to tailor investments to meet

individual needs and preferences.

Stocks may provide a steady stream of current income through dividends.

Stocks may increase in value over time through capital gains.

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From Stock Prices to Stock ReturnsFrom Stock Prices to Stock Returns

Stock Returns: take into account both price changes and dividend income

Over past 50 years, stock returns have ranged from +48.28% in 1954 to -21.45% in 1974

Stock returns over past 50 years have averaged around 11%

From 1998 through mid-’03, DJIA averaged 1.7%

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DJIA annual Returns since 2003DJIA annual Returns since 2003

2003 8341.63 10453.92 2112.29 25.32%

2004 10453.92 10783.01 329.09 3.15%

2005 10783.01 10717.50 -65.51 -0.61%

2006 10717.50  12463.15 1745.65 16.29%

2007 12463.15  13264.82 801.67 6.43%

2008  13264.82  8776.39 -4488.43 -33.84%

2009 8776.39  10428.05 1651.66 18.82%

2010 10428.05  11577.51 1149.46 11.02%

2011 11577.51  12217.56 640.05 5.53%

2012  12217.56  13104.14 886.58 7.26%

Average 5.95% Standard Deviation 16.02%

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Advantages of Stock OwnershipAdvantages of Stock Ownership

Higher returns than bonds.

Over past 50 years, stocks averaged 11% and high-grade corporate bonds averaged 6%.

Inflation hedge – stock returns typically exceed the rate of inflation.

Easy to buy and sell stocks.

Price and market information is easy to find in financial media.

Unit cost per share of stock is lower than for bonds.

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Disadvantages of Stock OwnershipDisadvantages of Stock Ownership

Stocks are subject to many different kinds of risk: Business risk Financial risk Market risk Event risk

Difficult to predict which stocks will go up in value due to wide swings in profits and general stock market performance

Low current income compared to other investment alternatives

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Current Income from Stocks versus BondsCurrent Income from Stocks versus Bonds

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Common Stock ValuesCommon Stock Values

Par Value: the stated, or face, value of a stock Mainly an accounting term and not very useful

to investors

Book Value: the amount of stockholders’ equity The difference between the company’s assets minus the

company’s liabilities and preferred stock

Market Value: the current price of the stock in the stock market

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Common Stock ValuesCommon Stock Values

Market Capitalization: the overall current value of the company in the stock market Total number of shares outstanding multiplied by the market

value per share

Investment Value: the amount that investors believe the stock should be trading for, or what they think it’s worth Probably the most important measure for a stockholder

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DividendsDividends

Dividend income is one of the two basic sources of return to investors.

Dividend income is more predictable than capital gains, so preferred by investors seeking lower risk.

Dividends are taxed at maximum 15% tax rate, same as capital gains.

Dividends tend to increase over time as companies’ earnings grow; increases average 3-5% per year.

Dividends represent the return of part of the profit of the company to the owners, the stockholders.

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Key Dates for DividendsKey Dates for Dividends

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Dividends and Earnings Per ShareDividends and Earnings Per Share

Earnings Per Share: the amount of annual earnings available to common stockholders, stated on a per-share basis Earnings are important to stock price Earnings help determine dividend payouts

EPS

Net profitafter taxes

Preferred dividends

Number of shares ofcommon stock outstanding

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Dividends and Dividend YieldDividends and Dividend Yield

Dividend Yield: a measure to relate dividends to share price on a percentage basis Indicates the rate of current income earned on the

investment dollar Convenient method to compare income return to other

investment alternatives

Dividend yield Annual dividends received per share

Current market price of the stock

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Dividends and Dividend Payout RatioDividends and Dividend Payout Ratio

Dividend Payout Ratio: the portion of earnings per share (EPS) that a firm pays out as dividends Companies are not required to pay dividends Some companies have high EPS, but reinvest all money

back into company

Dividend payout ratio Dividends per share

Earnings per share

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Types of StockTypes of Stock

Blue Chip Stocks: financially strong, high-quality stocks with long and stable records of earnings and dividends Companies are leaders in their industries Relatively lower risk due to financial stability

of company Popular with investing public looking for steady growth

potential, perhaps dividend income Provide shelter during unsettled markets Examples: Wal-Mart, Proctor & Gamble, Microsoft, United

Parcel Service, Pfizer and 3M Company

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Types of Stock (cont’d)Types of Stock (cont’d)

Income Stocks: stocks with long and sustained records of paying higher-than average dividends Good for investors looking for relatively safe and high level

of current income Dividends tend to increase over time (unlike interest

payments on bonds) Some companies pay high dividends because they offer

limited growth potential More subject to interest rate risk Examples: Verizon, Conagra Foods, Pitney Bowes, R.R.

Donnelley, Bank of America and AmSouth Bancorp

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Types of Stock (cont’d)Types of Stock (cont’d)

Income Stocks: stocks with long and sustained records of paying higher-than average dividends Dividends tend to increase over time (unlike interest

payments on bonds)

Some companies pay high dividends because they offer limited growth potential

Examples: Verizon, Conagra Foods, Pitney Bowes, Wrigley

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Types of Stock (cont’d)Types of Stock (cont’d)

Growth Stocks: stocks that experience high rates of growth in operations and earnings

High rate of growth in earnings > market

Higher price appreciation (due to increasing earnings)

Riskier investment because price will fall if earnings growth cannot be maintained

Typically pay little or no dividends

Examples: Lowe’s, Harley-Davidson, Starbucks, Apple

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Types of Stock (cont’d)Types of Stock (cont’d)

Cyclical Stocks: stocks whose earnings and overall market performance are closely linked to the general state of the economy Stock price tends to move with the business cycle

Tend to do well when economy is growing, poorly in slowing economy

Best for investors willing to move in and out of market as economy changes

Examples: Caterpillar, Maytag Corp.

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Types of Stock (cont’d)Types of Stock (cont’d)

Defensive Stocks: stocks that tend to hold their value, and even do well, when the economy starts to falter

Stock price remains stable or increases when general economy is slowing

Products are staples that people use in good times and bad times, such as electricity, beverages, foods and drugs

Best for aggressive investors looking for “parking place” during slow economy

Examples: Proctor & Gamble, WD-40, Walmart

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Market CapitalizationMarket Capitalization

Small-Cap Stocks: under $1 billion

Mid-Cap Stocks: $1 billion to $4 or $5 billion

Large-Cap Stocks: more than $4 or $5 billion

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Types of StockTypes of Stock

Small-Cap Stocks: small companies with market capitalizations less than $1 billion Provide opportunity for above-average returns

(or losses)

Short financial track record

Erratic earnings

Not widely-traded; liquidity is issue

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Types of Stock (cont’d)Types of Stock (cont’d)

Mid-Cap Stocks: medium-sized companies with market capitalizations between $1 billion and $4 or $5 billion Provide opportunity for greater capital appreciation

than Large-Cap stocks, but less price volatility than Small-Cap stocks

Long-term track records for profits and stock valuation

“Baby Blues” offer same characteristics of Blue Chip stocks except size

Examples: Wendy’s, Barnes & Noble, Petsmart, Cheesecake Factory

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Types of Stock (cont’d)Types of Stock (cont’d)

Large-Cap Stocks: large companies with market capitalizations over $4 or $5 billion Number of companies is smaller, but account for 80% to

90% of the total market value of all U.S. equities

Bigger is not necessarily better

Tend to lag behind small-cap and mid-cap stocks, but typically have less volatility

Examples: AT&T, General Motors, Microsoft

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Investing in Foreign StocksInvesting in Foreign Stocks

Globalization of financial markets is growing U.S. equity market is less than 50% of world

equity markets

Six countries make up 80% of world equity market

U.S. market remains largest and one of best performing equity markets

Much of performance of non-U.S. markets is due to changes in currency exchange rates

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Stock Investment StrategiesStock Investment Strategies

Buy-and-Hold Investors buy high-quality stocks and hold them for

extended time periods

Goal may be current income and/or capital gains

Investors often add to existing stocks over time

Very conservative approach; value-oriented

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Stock Investment Strategies (cont’d)Stock Investment Strategies (cont’d)

Current Income Investors buy stocks that have high dividend yields

Safety of principal and stability of income are primary goals

May be preferable to bonds because dividends levels tend to increase over time

Often used to provide to supplement other income, such as in retirement

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Stock Investment Strategies (cont’d)Stock Investment Strategies (cont’d)

Quality Long-Term Growth Investors buy high-quality growth stocks, mid-cap stocks

and tech stocks

Capital gains are primary goal

Higher level of risk due to emphasis on capital gains

Significant trading of stocks may occur over time

Diversification is used to spread risk

“Total Return Approach” is version that emphasizes both capital gains and high income

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Stock Investment Strategies (cont’d)Stock Investment Strategies (cont’d)

Aggressive Stock Management Investors buy high-quality growth stocks, blue chip stocks,

mid-cap stocks, tech stocks and cyclical stocks

Capital gains are primary goal

High level of risk due to emphasis on capital gains

Investors aggressively trade in and out of stocks, often holding for short periods

Timing the market is key element

Time consuming to manage

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Stock Investment Strategies (cont’d)Stock Investment Strategies (cont’d)

Speculation and Short-Term Trading Also called “day trading” Investors buy speculative stocks, small-cap stocks and tech

stocks Capital gains are primary goal Highest level of risk due to emphasis on capital gains in

short time period Investors aggressively trade in and out of stocks, often

holding for extremely short periods Looking for “big score” on unknown stock Time consuming & high trading costs

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What is Security Analysis?What is Security Analysis?

“The process of gathering and organizing information and then using it to determine the intrinsic value of a share of common stock.”

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What is Intrinsic Value?What is Intrinsic Value?

Intrinsic Value The underlying or inherent value of a stock, as determined

through fundamental analysis

A prudent investor will only buy a stock if its market price does not exceed what the investor thinks the stock is worth.

Intrinsic value depends upon several factors: Estimates of future cash flows Discount rate Amount of risk

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“Top Down” Approach to Traditional Security Analysis“Top Down” Approach to

Traditional Security Analysis

Step 1: Economic Analysis State of overall economy

Step 2: Industry Analysis Outlook for specific industry Level of competition in industry

Step 3: Fundamental Analysis Financial condition of specific company Historical behavior of specific company’s stock

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Efficient Market HypothesisEfficient Market Hypothesis

Efficient Market: the concept that the market is so efficient in processing new information that securities trade very close to or at their correct values at all times

Efficient market advocates believe: Securities are rarely substantially mispriced in

the marketplace No security analysis is capable of finding mispriced

securities more frequently than using random chance

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Who Needs Security Analysis in an Efficient Market?

Who Needs Security Analysis in an Efficient Market?

Fundamental analysis is still important because:

All of the people doing fundamental analysis is the reason the market is efficient

Financial markets may not be perfectly efficient

Pricing errors are inevitable

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Industry AnalysisIndustry Analysis

Evaluate the competitive position of a particular industry in relation to other industries Looking for new opportunities &

growth potential

Identify companies within the industry that look promising Looking for strong market positions, pricing leadership,

economies of scale, etc.

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Issues that Affect an IndustryIssues that Affect an Industry

What is the nature of the industry?

Is the industry regulated?

What role does labor play in the industry?

How important are technological developments?

Which economic forces have the most impact on the industry (e.g., interest rates, foreign trade)?

What are the important financial and operating considerations (e.g., access to capital)?

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Growth Cycle Stages and Investments

Growth Cycle Stages and Investments

Growth Cycle reflects the vitality of an industry or a company over time.

Initial development: industry is new and risks are very high

Rapid expansion: product acceptance is growing and investors become very interested

Mature growth: expansion comes from growth in the economy and returns are more predictable

Stability or decline: demand for product is diminishing and investors avoid this stage

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Fundamental AnalysisFundamental Analysis

Evaluate the financial condition and operating results of a specific company Competitive position Composition and growth in sales Profit margins and dynamics of earnings Asset mix (i.e. cash balance, inventory, accounts receivable,

fixed assets) Financing mix ( i.e. debt, stock)

The value of a stock is influenced by the financial performance of the company that issued the stock.

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Where Do We Start?Where Do We Start?

Interpreting Financial Statements

Using Financial Ratios

Fundamental analysis is often the most demanding and most time-consuming phase of stock selection.

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Major Groups of Financial RatiosMajor Groups of Financial Ratios

Liquidity Ratios: the company’s ability to meet day-to-day operating expenses and satisfy short-term obligations as they become due

Activity Ratios: how well the company is managing its assets

Leverage Ratios: amount of debt used by the company Profitability Ratios: measures how successful the company is at

creating profits Common Stock Ratios: converts key financial information into

per-share basis to simplify financial analysis

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Common Stock RatiosCommon Stock Ratios

Price/Equity Ratio: shows how the stock market is pricing the company’s common stock One of most widely used ratios in common stock selection Often used in stock valuation models

Higher ratio: more expensive Lower ratio: less expensive

P/E Market price of common stock

EPS

EPS Net profit after taxes Preferred dividends

Number of common shares outstanding

55Copyright © 2005 Pearson Addison-Wesley. All rights reserved.

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Common Stock Ratios (cont'd)Common Stock Ratios (cont'd)

What is the P/E ratio for a company with profits of $139.7 million, 61,815,000 outstanding shares of common stock and a current market price of $41.50 per share?

EPS $139,700,000

61,815,000 shares or $2.26

Price/Earnings ratio $41.50

$2.26 or 18.4

56Copyright © 2005 Pearson Addison-Wesley. All rights reserved.

7-56

Common Stock Ratios (cont'd)Common Stock Ratios (cont'd)

Price/Earnings Growth Ratio (PEG): compares company’s P/E ratio to the rate of growth in earnings

Ratio > 1: stock may be fully valued PEG = 1: stock price in line with

earnings growth Ratio < 1: stock may be undervalued

PEG ratio=Stock’s P/E ratio

3- to 5-year growth rate in earnings

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Common Stock Ratios (cont'd)Common Stock Ratios (cont'd)

Payout Ratio: how much of its earnings a company pays out to stockholders in the form of dividends Traditional payout ratios have been 40% to 60% Recent trends have been lower payout ratios, with more tax

efficient stock buyback programs used frequently High payout ratios may be difficult to maintain and the

stock market does not like cuts in dividends

Payout ratio Dividends per share

Earnings per share

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Common Stock Ratios (cont'd)Common Stock Ratios (cont'd)

Book Value per Share: difference between assets and liabilities (equity) per share

A company should be worth more than its book value.

Book value per share Common stockholders’ equity

Number of common shares outstanding

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Common Stock Ratios (cont'd)Common Stock Ratios (cont'd)

Price-to-Book Ratio: compares stock price to book value to see how aggressively the stock is being priced

Higher ratio: stock is fully-priced or overpriced Lower ratio: stock may be fairly priced

or underpriced

Price-to-book-value Market price of common stock

Book value per share