CFA Level I - Reading 45

A company increases its value and creates wealth for its shareholders by earning more on its investment in assets than is required by those who provide the capital for the firm. A firm’s WACC may increase as larger amounts of capital are raised. Thus, its marginal cost of capital, the cost of raising additional capital, can increase as larger amounts are invested in new projects. This results in an upward-sloping marginal cost of capital curve. Given the expected returns (IRRs) on potential projects, we can order the expenditures on additional projects from highest to lowest IRR. This will allow us to construct a downward sloping investment opportunity schedule.
The intersection of the investment opportunity schedule with the marginal cost of capital curve identifies the amount of the optimal capital budget. The intuition here is that the firm should undertake all those projects with IRRs greater than the cost of funds, the same criterion developed in the capital budgeting topic review. This will maximize the value created. At the same time, no projects with IRRs less than the marginal cost of the additional capital required to fund them should be undertaken, as they will erode the value created by the firm.

An additional issue to consider when using a firm’s WACC (marginal cost of capital) to evaluate a specific project is that there is an implicit assumption that the capital structure of the firm will remain at the target capital structure over the life of the project.

The cost of common equity (k_ce) is the rate of return stockholders require on the equity capital the firm retains from earnings.

1. The CAPM approach:
   k_ce = RFR + Beta[E(R_MKT − RFR)]
   
2. The bond-yield plus risk-premium approach:
   k_ce = bond yield + risk premium
   
3. The discounted cash flow or dividend yield plus growth rate approach:
   k_ce = (D₁ / P₀) + g 

In the weighted average cost of capital calculation, the cost of preferred stock must be adjusted for the cost to issue new preferred stock.

To reflect the increased risk associated with investing in a developing country, a country risk premium is added to the market risk premium when using the CAPM.
The general risk of the developing country is reflected in its sovereign yield spread. This is the difference in yields between the developing country’s government bonds (denominated in a developed market currency) and Treasury bonds of a similar maturity. To estimate an equity risk premium for the country, adjust the sovereign yield spread by the ratio of volatility between the country’s equity market and its government bond market (for bonds denominated in the developed market’s currency). A more volatile equity market increases the country risk premium, other things equal.

CFA Level I - Reading 44

The capital budgeting process is the process of identifying and evaluating projects where the cash flows will be received over a period longer than a year and has four administrative steps:

1. Idea generation.
2. Analyzing project proposals.
3. Create the firm-wide capital budget.
4. Monitoring decisions and conducting a post-audit.

Capital budgeting projects may be divided into the following categories:

• Replacement projects to maintain the business.
• Replacement projects for cost reduction.
• Expansion projects.
• New product or market development.
• Mandatory projects.
• Other projects. 

1. Decisions are based on cash flows, not accounting income. The relevant cash flows to consider are incremental cash flows. Sunk costs should not be included in the analysis. Externalities should be included in the analysis.
2. Cash flows are based on opportunity costs. Opportunity costs should be included in project costs. These are cash flows generated by an asset the firm already owns, that would be forgone if the project under consideration is undertaken.
3. The timing of cash flows is important. Cash flows received earlier are worth more than cash flows to be received later.
4. Cash flows are analyzed on an after-tax basis. The impact of taxes must be considered when analyzing capital budgeting projects.
5. Financing costs are reflected in the project’s required rate of return. Only projects that are expected to return more than the cost of the capital needed to fund them will increase the value of the firm. 

• The average accounting rate of return (AAR) is defined as the ratio of a project’s average net income to its average book value.
• The profitability index (PI) is the present value of a project’s future cash flows divided by the initial cash outlay.

• Location: European countries tended to use the payback period method as much or more than the IRR and NPV methods.
• Size of the company: The larger the company, the more likely it was to use discounted cash flow techniques such as the NPV and IRR methods.
• Public vs. private: Private companies used the payback period more often than public companies. Public companies tended to prefer discounted cash flow methods.
• Management education: The higher the level of education, the more likely the company was to use discounted cash flow techniques.

The Relationship Between NPV and Stock Price: In theory, a positive NPV project should cause a proportionate increase in the company’s stock price. In reality, changes in the stock price will result more from changes in expectations about a project’s profitability.

CFA Level I - Reading 51

The assumptions of capital market theory are:

• Markowitz investors: All investors use the Markowitz mean-variance framework to select securities. This means they want to select portfolios that lie along the efficient frontier, based on their utility functions.
• Unlimited risk-free lending and borrowing: Investors can borrow or lend any amount of money at the risk-free rate.
• Homogeneous expectations: This means that when investors look at a stock, they all see the same risk/return distribution.
• One-period horizon: All investors have the same one-period time horizon.
• Divisible assets: All investments are infinitely divisible.
• Frictionless markets: There are no taxes or transaction costs.
• No inflation and constant interest: There is no inflation, and interest rates do not change.
• Equilibrium: The capital markets are in equilibrium. 

The market portfolio is the portfolio consisting of every risky asset; the weights on each asset are equal to the percentage of the market value of the asset to the market value of the entire market portfolio. For example, if the market value of a stock is $100 million and the market value of the market portfolio is $5 billion, that stock’s weight in the market portfolio is 2 percent ($100 million / $5 billion).

Since the market portfolio contains all risky assets, it must represent the ultimate in diversification. All the risk that can be diversified away must be gone.

Beta is a standardized measure of systematic risk. Beta measures the sensitivity of a security's returns to changes in the market return.

Relaxing the CAPM assumptions changes the model’s implications.

• Different borrowing and lending rates: The CAPM cannot be derived without equal borrowing and lending rates, unless investors can create a zero-beta portfolio. This puts a kink in the CML.
• Transaction costs: The existence of transactions costs means that the SML is a band (with fairly tight upper and lower bounds on prices) rather than a line.
• Heterogeneous expectations and planning periods: The impact of heterogeneous expectations and multiple planning periods on the CAPM is similar to the impact of transactions costs—the SML becomes a band rather than a line.
• Taxes: Individual investors facing different marginal tax rates will have different after-tax return expectations, so their SMLs and CMLs will be quite different. 

Combining the CML (risk-free rate and efficient frontier) with an investor’s indifference curve map separates out the decision to invest from what to invest in and is called the separation theorem. The investment selection process is thus simplified from stock picking to efficient portfolio construction through diversification.

CFA Level I - Reading 49: The asset allocation desicion

There are four general steps in the portfolio management process:

1. Write a policy statement that specifies the investor’s goals and constraints. Then itemize the risks the investor is willing to take to meet these goals.
2. Develop an investment strategy designed to satisfy the investor’s policy statement based on an analysis of the current financial and economic conditions.
3. Implement the plan by constructing the portfolio, allocating the investor’s assets across countries, asset classes, and securities based on the current and future forecast of economic conditions.
4. Monitor and update the investor’s needs and market conditions. Rebalance the investor’s portfolio as needed.

The policy statement:

• Identifies needs and constraints of the investor.
• Helps investors understand the risk and costs of investing.
• Acts as a guide for the portfolio manager.
• States the performance standards and the benchmark.
• Enforces investment discipline on the client as well as the portfolio manager.

Investment objectives must be stated in terms of both risk and return.
Return objectives may be stated in absolute terms (dollar amounts) or percentages. Return considerations also cover capital preservation, capital appreciation, current income needs, and total returns.
Specifying investment goals in terms of just return may expose an investor to inappropriate, high-risk investment strategies. Also, return-only objectives can lead to unacceptable behavior on the part of investment managers, such as excessive trading to generate excessive commissions (churning).
Risk tolerance is a function of the investor’s psychological makeup and the investor’s personal factors such as age, family situation, existing wealth, insurance coverage, current cash reserves, and income.

Capital preservation is the objective of earning a return on an investment that is at least equal to the inflation rate. The concern here is the maintenance of purchasing power. To achieve this objective, the nominal rate of return must equal the inflation rate.
Capital appreciation is the objective of earning a nominal return that exceeds the rate of inflation over some period of time. Achieving this goal means that the purchasing power of the initial investment increases over time, usually through capital gains.
Current income is the objective of earning a return on an investment for the purpose of generating income. The current income objective is usually appropriate when an investor wants or needs to supplement other sources of income to meet living expenses or some other planned spending need.
Total return is the objective of having a portfolio grow in value to meet a future need through both capital gains and the reinvestment of current income. The total return objective is riskier than the income objective, but less risky than the capital appreciation objective.
  
Liquidity refers to the ability to quickly convert investments into cash at a price close to their fair market value. Liquidity from the investor’s view is the potential need for ready cash. This may necessitate selling off assets at unfavorable terms. 

Time horizon refers to the time between making an investment and needing the funds. Since losses are harder to overcome in a short time frame, investors with shorter time horizons usually prefer lower risk investments. 

Tax concerns play an important role in investment planning because after-tax returns are what investors should be concerned with. The tax code in the U.S., and most other countries, is complex. 

Legal and regulatory factors are more of a concern to institutional investors than individuals, but the investment strategies of both may be restricted due to these constraints. 

Unique needs and preferences are constraints that investors may have that address special needs or place special restrictions on investment strategies for personal or socially conscious reasons.



Several studies support the idea that approximately 90% of a portfolio’s returns can be explained by its target asset allocations. The clear implication here is that differences in returns among asset classes are much more important in determining overall portfolio returns than differences in return due to which specific securities are selected within each asset class. For actively managed funds, actual portfolio returns are slightly less than those that would have been achieved if the manager strictly maintained the target asset allocation. This illustrates the real difficulty of improving returns by varying from target allocations (market timing) as well as of selecting undervalued securities in very efficiently priced markets.
Average asset allocations across countries differ for reasons related to demographics, social factors, legal constraints, and taxation.


One of the first steps in developing a financial plan is to purchase adequate life insurance coverage.

Most experts recommend a cash reserve equal to about six months' living expenses.



Life Cycle:
1. Accumulation Phase: Individuals in the early-to-middle years of their working careers are in the accumulation phase. These individuals are attempting to accumulate assets to satisfy fairly immediate needs (e.g. down payment for a house) or long term goals (children's education, retirement). These individuals are willing to make relatively high-risk investments in the hopes of making above-average nominal returns over time.

We must emphasize the wisdom of investing early and regularly in one's life.

2. Consolidation phase: Individuals are typically past the midpoint of their careers, have paid off much or all of their outstanding debts, and perhaps have paid, or have the assets to pay, their children's college bills. Earnings exceed expenses. The typical investment horizon is still long (20-30 years), so moderately high risk investments are attractive. At the same time, because individuals in this phase are concerned about capital preservation, they do not want to take very large risks that may put their current nest egg in jeopardy.

3. Spending phase: it begins when individuals retire. Living expenses are covered by social security income and income from prior investments, including employer pension plans. They seek greater protection of their capital, at the same time, they must balance their desire to preserve the nominal value of their savings with the need to protect themselves against a decline in the real value of their savings due to inflation.

Their overall portfolio maybe less risky than in the consolidation phase, they still need some risky growth investments (e.g. common stocks) for inflation protection.

A bear market early in our retirement can greatly reduce our accumulated funds. Annuity could be used to transfer risk from the individual to the annuity firm.

4. Gifting phase: It is similar to, and may be concurrent with, the spending phase. Individuals believe they have sufficient income and assets to cover their current and future expenses while maintaining a reserve for uncertainties. excess assets can be used to provide financial assistance to relatives or friends, to establish charitable trusts, or to fund trusts as an estate planning tool to minimize estate taxes.

CFA Level I - Reading 50

Markowitz assumptions:

• Returns distribution. Investors look at each investment opportunity as a probability distribution of expected returns over a given horizon.
• Utility maximization. Investors behave such that they maximize their expected utility over a given investment horizon, and their indifference curves exhibit diminishing marginal utility of wealth.
• Risk is variability. Investors measure risk as the variance of expected returns.
• Risk/return. Investors make all investment decisions by considering only the risk and return of an investment opportunity. This means that their utility (indifference) curves are a function of the expected return and variance of the returns distribution they envision for each investment.
• Risk aversion. Given two investments with equal expected returns, investors prefer the one with the lowest risk. Likewise, given two investments with equal risk, investors prefer the one with the greatest expected return

Covariance is a measure of the degree to which 2 variables move together relative to their individual mean values over time.

The magnitude of the covariance depends on the variances of the individual return series, as well as on the relationship between the series.

The zero correlation does not mean the 2 assets are independent.
If the correlation coefficient were -1, a zero variance portfolio could be constructed.

Covariance can be standardized by dividing by the product of the standard deviations of the two securities being compared. This standardized measure of co-movement is called correlation.



Adding a new security to a portfolio has 2 effects on the portfolio's std. deviation: 1. the asset's own variance of returns. 2. the covariance between the returns of this new asset and the returns of every other asset.

An important factor to consider when adding an investment to a portfolio is not the new security's own variance but its average covariance with all the other investments in the portfolio.

A portfolio is efficient if it (1) maximizes return for a given risk level, or (2) minimizes risk for a given return target. The efficient frontier represents the set of portfolios that will give you the highest return at each level of risk (or, alternatively, the lowest risk for each level of return).

The efficient frontier line bends backwards due to less than perfect correlation between assets.

The optimal portfolio for each investor is the highest indifference curve that is tangent to the efficient frontier. The optimal portfolio is the portfolio that gives the investor the greatest possible utility.
 

CFA Level I - Reading 61

interest rates increase => bond price decreases
interest rates decrease=> bond price increases

coupon rate = yield => price = par
coupon rate > yield => price > par
coupon rate < yield => price < par

The longer the bond's maturity, the greater the bond's price sensitivity to changes in interest rates.

The lower the coupon rate, the greater the bond's price sensitivity to changes in interest rates.

The value of a bond with embedded options will change depending on how the value of the embedded options changes when interest rates change.

A decline in interest rates will result in an increase in the price of callable bond but not by as much as the price change of an otherwise comparable option-free bond.

Duration is a measure of the price sensitivity of a bond to a change in yield.
=(Price if yield decline - Price if yield rise) / (2 * Initial price * Change in yield in decimal)

Duration is approximately equal to the point in years where the investor receives half of the present value of the bond's cash flows.

Correct?:
The dollar change in price is approximately equal to the product of the duration and the current value of the bond divided by 100.

Incorrect:
If a bond has an effective duration of 7.5, it means that a 1% change in rates will result in a 7.5% change in price.
Because of convexity, it will be approximately a 7.5% change in price, not an actual 7.5% change in price.



Disadvantages of call division:
1. The cash flow pattern is not known with certainty.
2. The investor is exposed to reinvestment risk if the interest rates are lower.
3. The price appreciation potential will be reduced.

Call risk is composed of three components: the unpredictability of the cash flows, the compression of the bond’s price, and the high probability that when the bond is called the investor will be faced with less attractive investment opportunities.

Amortizing securities makes reinvestment risk greater.

Zero coupon bond may be attractive to certain investors because there is no reinvestment risk, but on the other hand, it exposes to greater interest rate risk.

Credit risk includes:
1. Default risk: the issuer will fail to satisfy the terms of the obligation.

2. Credit spread risk:
The yield on a bond is made up of 2 components: the yield on a similar risk-free bond and a premium above the yield on a default-free bond necessary to compensate for the risks associated with the bond. The risk premium is referred to as a yield spread.
The part of the risk premium or yield spread attributable to default risk is called the credit spread. If credit spread widen, the market price of the bond will decline.

The yield differential above the return on a benchmark security measures the credit spread risk. Credit spread risk is also known as the risk premium or spread.

3. Downgrade risk:
Triple A: prime grade
Double A: high quality grade
Single A: upper medium grade
Triple B: lower medium grade
Lower-rated: speculative grade

Investment grade bonds: AAA, AA, A, and BBB
Non-investment grade bonds ( speculative/high yield ): Below BBB


Liquidity Risk: the risk that the investor will have to sell a bond below its indicated value, where the indication is revealed by a recent transaction. The wider the bid-ask spread, the greater the liquidity risk.

Price of callable bond = price of option-free bond - price of embedded call option
Price of putable bond = price of option-free bond + price of embedded put option
If expected yield volatility increases, the price of the embedded call, or put, option will increase.

Price compression reduces the potential for price appreciation.
When a bond has a call provision, the potential for price appreciation is reduced, because the call caps the price of the bond near the call price, even if interest rates fall considerably. It is unlikely that investors would pay a price that exceeds the call price.


All else equal, reinvestment risk and price risk move in opposite directions. For example, when interest rates rise, bond prices decrease, but the loss is at least partially offset by decreased reinvestment risk (it is less likely that a bond will be called and bondholders can invest coupon payments at higher yields). When interest rates fall, price risk decreases because the bond value is rising and reinvestment risk increases because it is more likely that the issuer/borrower will call the security and the bondholder must reinvest coupon payments at lower yields.
 

Technical default usually refers to an issuer’s violation of bond covenants, such as debt ratios, rather than the failure to pay interest or principal.

Sovereign risk: the risk that as a result of actions of the foreign government, there may be either a default or an adverse price change even in the absence of a default.
1. Unwillingness of a foreign gov't to pay.
2. The inability to pay due to unfavorable economic conditions in the country.

CFA Level I - Reading 60

The affirmative covenants of indenture set forth activities that the borrower promises to do. The negative covenants set forth certain limitations and restrictions on the borrower's activities.

Step-Up Notes: The securities whose coupon rate increases over time.
Single step-up notes: There is only one change (or step-up).
Multiple step-up notes: There is more than one changes.

Deferred Coupon Bonds

Accrual bonds, unlike zero-coupon bonds, do not always sell at a discount to face value. The interest accrues forward and thus the bonds are likely to sell for more than face value.

Floating-Rate Securities: Coupon rate = Reference rate + Quoted margin
A floater could have a Cap, the maximum coupon rate that will be paid, or a Floor, the minimum coupon rate.

Inverse floaters: whose coupon rate move in the opposite direction from the change in the reference rate.
Coupon = K - L * (Reference Rate)

Full Price (or Dirty Price) = bond price + accrued interest
A bond in which the buyer must pay the seller accrued interest is said to be trading cum-coupon (with coupon).
If the buyer forgoes the next coupon payment, the bond is said to be trading ex-coupon (without coupon).

In the instance that the bond issuer defaulted the interest payments, and the bond is sold without accrued interest, it is called to be traded flat.

If the issuer is not required to make any principle repayment prior to the maturity date, such bonds are said to have a bullet maturity. Otherwise the bonds are said to be amortizing securities, for example, mortgage-back securities, or sinking funds.

Callable bonds:
If the bond issuer may not call the bond for a number of years, the issue is said to have a deferred call. The date at which the bond may first be called is referred to as the first call date.

When less than entire issue is called, the certificates to be called are either selected randomly or on a pro rata basis. Pro rata redemption means that all bondholders will have the same percentage of their holdings redeemed.

A make-whole premium provision (or a yield-maintenance premium provision) provides a formula for determining the premium that an issuer must pay to call an issue.

Call protection is much more robust than refunding protection.

Sinking fund provision: An indenture may require the issuer to retire a specified portion of the issue each year.

Convertible bond is an issue that grants the bondholder the right to convert the bond for a specified number of shares of common stock.

Put provision grants the bondholder the right to sell the issue back to the issuer at a specified price on designated dates.

A nondollar-denominated issue is one in which payments are not denominated in US dollar.

Regular redemption price refers to bonds being called according to the provisions specified in the bond indenture. When bonds are redeemed to comply with a sinking fund provision or because of a property sale mandated by government authority, the redemption prices (typically par value) are referred to as "special redemption prices." There is no such thing as a specific redemption price.

Refunding from a new debt issue at a higher interest rate is not prohibited, however their purchase cannot be funded by the simultaneous issuance of lower coupon bonds.

CFA Level I - Reading 59

Trailing P/E (sometimes referred to as Current P/E) is a stock's current market price divided by the most recent four quarters' EPS. In such calculations, EPS is sometimes referred to as trailing 12 months (TTM) EPS. Trailing P/E is the one published in financial newspapers' stock listings.

Leading P/E (also called the forward P/E, or prospective P/E) is a stock's current price divided by next year's expected earnings.

For companies with rising earnings, the leading P/E will be smaller than the trailing P/E.

When calculating trailing P/E, an analyst must consider the following:
1. transitory, nonrecurring components of earnings that are company specific;
2. transitory components of earnings due to cyclicality (business or industry cyclicality);
3. differences in accounting methods;
4. potential dilution of EPS.

Nonrecurring items (such as gains and losses form the sale of assets, asset writedowns, provisions for future losses, and change in accounting estimates)  often appear in the income from continuing operations portion of the Income Statement. An analyst should pay particular attention to the Income Statement, its footnotes, and management discussion and analysis.

Two of several methods to calculate Business-cycle-adjusted EPS:
1. historical average EPS: the average EPS over the most recent full cycle. However, this method doesn't account for changes in the company's size.
2. average return on equity: the average return on equity (ROE) from the most recent full cycle, multiplied by current book value per share. This method reflects more accurately the effect on EPS of growth or shrinkage in the company's size.

Basic earnings per share reflects total earnings divided by the weighted-average number of shares actually outstanding during the period.
Diluted earnings per share is the division by the number of shares that would be outstanding if holders of securities such as executive stock options, equity warrants, and convertible bonds exercised their options.

Among the positive P/Es, the stock with the lowest P/E has the lowest purchase cost per currency unit of earnings. In order to include negative P/Es in the ranking, we could use earnings yield ratio (E/P).

Price to Book Value
Rationales for using P/BV:
1. Book value is a cumulative balance sheet amount, book value is generally positive even when EPS is negative.
2. Book value per share is more stable than EPS, P/BV maybe more meaningful than P/E when EPS is abnormally high or low, or is highly variable.
3. Book value per share has been viewed as more appropriate for valuing companies composed chiefly of liquid assets, such as finance, investment, insurance, and banking institutions.
4. Book value has also been used in valuation of companies that are not expected to continue as a going concern.
5. Differences in P/BVs may be related to differences in long-term average returns.

Possible drawbacks of P/BVs:
1. Other assets besides those recognized in accounting may be critical operating factors, such as human capital.
2. P/B can be misleading as a valuation indicator when significant differences exist among companies examined in terms of the level of assets used. Such differences may reflect differences in business models.
3. Accounting effects on book value may compromise book value as a measure of shareholders' investment in the company.
4. In the accounting of most countries, including the US, book value largely reflects the historical purchase costs of assets, as well as accumulated accounting depreciation expense. Inflation as well as technological change eventually drive a wedge between the book value and the market value of assets. As a result, book value per share often poorly reflects the value of shareholders' investments.

Calculation:
common shareholders' equity = shareholders' equity - total value of equity claims that are senior to common stock
book value per share =  common shareholders' equity / # of common shares outstanding

Example:

Given the following information, compute price/book value.

• Book value of assets = $550,000
• Total sales = $200,000
• Net income = $20,000
• Dividend payout ratio = 30%
• Operating cash flow = $40,000
• Price per share = $100
• Shares outstanding = 1000
• Book value of liabilities = $500,000

Book value of equity = $550,000 - $500,000 = $50,000 Market value of equity = ($100)(1000) = $100,000
Price/Book = $100,000/$50,000 = 2.0X

Calculating tangible book value per share involves subtracting  intangible assets from common shareholders' equity. It is not so appropriate to separate patents, but might be appropriate to subtract goodwill.

P/S:
Rationales for using P/S:
1. Sales are generally less subject to distortion or manipulation.
2. Sales are positive even when EPS is negative.
3. Sales are generally more stable than EPS. P/S may be more meaningful than P/E when EPS is abnormally high/low.
4. P/S has been viewed as appropriate for valuing the stock of mature, cyclical, and zero-income companies.
5. Differences in P/S may be related to differences in long-term average returns.

Drawbacks:
1. A business may show high growth in sales even when it is not operating profitably.
2. P/S doesn't reflect a company's expenses, differences in P/S may be explained by differences in cost structure.
3. Revenue recognition practices offer the potential to distort P/S.

Bill-and-Hold involves selling products but not delivering those products until a later date.

P/CF:
Rationales for using P/CF:
1. Cash Flow is less subject to manipulation than earnings.
2. Cash flow is generally more stable than earnings.
3. Using P/CF rather than P/E address the issue of differences in accounting conservatism between companies (differences in the quality of earnings).
4. Differences in P/CF may be related to differences in long-term average returns.

Drawbacks:
1. When the EPS plus noncash charges approximation to cash flow from operations is used, items affecting actual cash flow from operations, such as noncash revenue and net changes in working capital, are ignored.
2. Theory views free cash flow to equity rather than cash flow as the appropriate variable for valuation. FCFE does have the possible drawback of being more volatile.

CFA Level I - Reading 57 & 58

An analyst should take into account how broad structural changes will affect specific industries over time. Four types of structural changes are:

• Demographics: Demographic factors include age distribution and population changes, as well as changes in income distribution, ethnic composition of the population, and trends in the geographical distribution of the population. As a large segment of the population reaches their twenties, residential construction, furniture, and related industries will see increased demand. An aging of the overall population can mean significant growth for the healthcare industry and developers of retirement communities.
• Lifestyles: An example of the effect of changing lifestyles on industry growth prospects is the increase in meals consumed outside the home and catalog sales, as the percentage of families with two employed spouses has increased. Consumption patterns are also affected by current perceptions of what is "in style" and trends in consumer tastes in recreation, entertainment, and other areas of discretionary expenditure.
• Technology: Changes in technology have had very important consequences for many industries over time. Change in the technology of transportation and communications have certainly had important effects on these industries, both in terms of products and services consumed but also in their production and pricing. Technological advances in computers and microprocessors in general have lead to sweeping changes in how inventory is managed and how products are distributed in many industries, particularly in the retailing industry.
• Politics and regulation: Changes in the political climate and changes in specific government regulations can also have significant effects on particular industries. The imposition of tariffs on steel will lead to increased domestic production and profitability; the rise of terrorist activity has helped some industries and imposed costs on others such as the airline and shipping industries; and requirements of a minimum wage and the widespread expectation of employment benefits packages have affected hiring practices and production methods, especially in labor intensive industries. Regulation of the introduction and sale of everything from new drugs to genetically engineered crops has important implications for many industries as well. 

A firm’s earnings per share (EPS) can be estimated using the following equation:

Expected EPS = [(sales)(EBITDA %) – depreciation – interest](1 – tax rate)

A firm’s expected earnings multiplier (P/E) can be calculated using either of two methods:

1. Macroanalysis approach estimates the company’s P/E ratio by comparing it to industry and market P/E ratios.
2. Microanalysis approach calculates a point estimate of the firm’s expected P/E ratio.

Estimate the firm’s projected dividend payout ratio, D₁/E₁. This is done with comparative analysis of the firm’s payout history, stated goals, and industry.

Estimate the firm’s required rate of return on equity: k = RFR + [E(R_MKT – RFR)]Beta

Estimate the firm’s expected growth rate: g = (retention rate)(ROE)

Compute the firm’s future earnings multiplier: (P/E)₁ = (D₁/E₁) / (k – g)

One way to evaluate the purchase of a stock is to compare the intrinsic value (based on the present value of expected dividends or cash flows) to the current market price. An alternative is to assume that the market price will move to the intrinsic value over some period and then compare the expected total return over the period to the investor’s required rate of return.

CFA Level I - Reading 56

There are 2 valuation approaches. The difference between these 2 approaches is the perceived importance of the economy and a firm's industry on the valuation:

1. The top-down, three-step approach. The advocates of this approach believe that both the economy/market and the industry effect have a significant impact on the total returns for individual stocks.

1) Analysis of alternative economies and security markets.
2) Analysis of alternative industries.
3) Analysis of individual companies and stocks.

2. The bottom-up, stock valuation, stockpicking approach. Those who employ this approach contend that it is possible to find stock that are undervalued relative to their market price, and these stocks will provide superior returns regardless of the market and industry outlook.

Discount Dividend Model
Present Value of Operating Free Cash Flow
Present Value of Free Cash Flow to Equty

Relative Valuation Techniques:

Earning Multiplier Model (P/E ratio): Current Market Price / Expected Earnings
P=D1/(k-g)  => P/E1 = (D1/E1) / (k-g)
The spread of k and g is the main determinant of the size of the P/E
 

CFA Level I - Reading 55

A mispricing is any predictable deviation from a normal or expected return.

CFA Level I - Reading 54 Con't

Behavioral Finance

One major bias is the propensity of investors to hold on to "losers" too long and sell "winners" too soon.

Confirmation bias: growth companies' confidence in forecasts, which causes analysts to overestimate growth rates for growth companies ans overemphasize good news and ignore negative news.

When there is a shift in sentiment, noise traders (nonprofessional with no special information) move together, which increase the prices and the volatility of securities during trading hours.

Escalation bias: investors put more money into a failure that they feel responsible for rather into a success. This also refers to "averaging down" on an investment that has declined in value since the initial purchase rather than consider selling the stock if it was a mistake.

Fusion investing is the integration of 2 elements of investment valuation - fundamental value and investor sentiment. The market price of securities is its fundamental value plus a term that indicates the demand from noise traders who reflect investor sentiment.

Portfolio management with superior analysts: the superior analysts should be encouraged to concentrate their efforts in mid-cap and small-cap. The superior analysts should pay particular attention to the BV/MV, to the size of stocks being analyzed, and to the monetary policy environment.

If you lack access to superior analysts, you should:
1. Determine and qualify your risk preferences.
2. Construct the appropriate risk portfolio by dividing the total portfolio between risk-free assets and a risky assets.
3. Diversify completely on a global basis to eliminate all unsystematic risk.
4. Maintain the specified risk level by rebalancing when necessary.
5. Minimize total transaction costs.

CFA Level I - Reading 54

Weak-form EMH: current stock prices fully reflect all security market information. 

Semistrong-form EMH: security prices adjust rapidly to the release of all public information. The semistrong-form encompass the weak-form, and also includes all nonmarket information, such as earnings and dividend announcements, P/E, D/P, P/BV, stock splits, economy and political news, ect.

Strong-form EMH: stock prices fully reflect all information from the public and private sources. 

When the two most significant variables - the dividend yield (D/P) and the bond default spread - are high, it implies that investors are expecting or requiring a high return on stocks and bonds. This occurs during poor economic environments.

Low P/E ratio stocks (low-growth firms) experienced superior risk-adjusted returns, whereas high P/E (high-growth firms) had significantly inferior risk-adjusted results.

Hypothesis of the inverse relation between the Price-Earnings/Growth Rate (PEG) ratio and the return: low PEG (<1) will have above-average returns, while high PEG (>3 or 4) will have below-average returns.

Small firms outperformed the large firms after considering risk and transaction costs, assuming annual rebalancing. Small firm effect is a long-term phenomenon.

A positive relationship between BV/MV ratio and the average return. More importantly, both Size and BV/MV ratio are significant when included together and they dominate other ratios. (It might only works during expansive monetary policy.)

Most studies found no short-term or long-term positive impact on security returns because of a stock split, although the results are not unanimous.