Category: 101 Concepts for Level I

08-06-18 Concept 70: Execution, Validity and Clearing Instructions

Orders entered must specify what security to trade, size of the trade and whether to buy or sell. The order can also include additional instructions: Execution instruction: specifies how the order will be filled. Validity instruction: specifies when the order may be filled. Clearing instruction: specifies how the final settlement will be done. Execution instructions types are: Market orders: are immediately executed at the best price available; however, there can be substantial slippages in execution price if a stock is thinly traded. Limit orders: set a minimum execution price on sell orders and maximum execution price on buy orders. This… Read More

101 concepts level I

08-06-18 Concept 71: Different Weighting Methods used in Index Construction

Index weighting determines how much weight each constituent security will be assigned in the index, thereby impacting the index value. The different weighting schemes used in construction of an index are: Price weighted index: weight on each security is determined by dividing its price by the sum of all prices. Equal weighted index: assigns equal weight to each constituent security at inception. Market capitalization weighted index: weight of each security is determined by dividing its market capitalization with total market capitalization. Fundamental weighted index: instead of using a stock’s price as a measure, fundamental weighting uses measures such as book… Read More

101 concepts level I

08-06-18 Concept 72: Weak-Form, Semi-Strong-Form, and Strong-Form Market Efficiency

Forms of Market Efficiency Past Market Data Public Information Private Information Weak form Yes No No Semi-strong form Yes Yes No Strong form Yes Yes Yes

101 concepts level I

08-06-18 Concept 73: Types of Equity Securities

There are two types of equity securities: common shares and preference shares. Common shares represent an ownership interest in a company, including voting rights. They entitle investors to a share of the company’s operating performance, participation in decision making in the form of voting rights and claim on the company’s net assets in case of liquidation. Common shareholders enjoy voting rights. In statutory voting, each share gets one vote. In Cumulative voting, each shareholder gets to cast one vote per share times the number of positions to be filled and shareholders can direct their total voting rights to specific candidates…. Read More

101 concepts level I

08-06-18 Concept 74: Peer Groups

A peer group is a set of comparable companies engaged in similar business activities. They are influenced by the same set of factors. Steps in constructing a preliminary list of peer companies: Use commercial classification systems. They often provide a useful starting point for identifying companies operating in the same industry. Examine the subject company’s annual report. Companies frequently mention specific competitors in their annual reports. Examine competitors’ annual reports to identify other potential comparable companies. Examine industry trade publications to identify additional peer companies. Confirm that each comparable or peer company has similar sources of sales and earnings.

101 concepts level I

08-06-18 Concept 75: Industry Life-Cycle Model

The following diagram shows an industry life cycle model. Embryonic Slow growth. High prices. Requires significant investment. High risk. Growth Rapidly increasing demand. Profitability improves. Prices fall. Competition is low. Shakeout Growth starts slowing down. Competition is intense. Profitability declines. Mature Little or no growth. Industry consolidates. Barriers to entry are high. Decline Growth is negative. Excess capacity. High competition. Limitations of the life cycle model include: Some stages may be longer or shorter than expected due to technological changes, government regulations, societal changes or demographics. It is less practical for analyzing industries going through rapid changes.

101 concepts level I

08-06-18 Concept 76: Dividend Discount and Free-Cash-Flow-to-Equity Models

Dividend discount model: Value is estimated as the present value of expected future dividends plus the present value of a terminal value. A stock paid a $10 dividend last year. The next year’s dividend will be 8% higher and the stock will sell at $150 at year-end. Calculate the value of this stock if the required rate of return is 12%. Solution: D1 = D0 x (1 + dividend growth rate) = $10 x 1.08 = $10.8 Free cash flow to equity model: Value is estimated as the present value of expected future free cash flow… Read More

101 concepts level I

08-06-18 Concept 77: Gordon (Constant) Growth Model and Multistage Dividend Discount Models

Gordon growth model (Constant growth dividend discount model): assumes that dividends will grow indefinitely at a constant growth rate. The value of the stock is calculated as: Calculate the value of a stock that paid a $10 dividend last year, if dividends are expected to grow forever at 6% and the required rate of return on equity is 8%. Solution: D1 = D0 x (1 + dividend growth rate) = $10 x 1.06 = $10.6 g is the sustainable growth rate i.e. rate at which earnings and dividends can continue to grow indefinitely. It is calculated… Read More

101 concepts level I

08-06-18 Concept 78: Basic Features of a Fixed-Income Security

The basic features of a fixed income security include: Issuer: Bonds can be issued by: supranational organizations sovereign governments non-sovereign governments quasi-government entities corporate issuers Maturity: Also known as a bond’s tenor. If original maturity is one year or less; bond is called money market security. If original maturity is more than a year; bond is called capital market security. Par value: The principal amount that is repaid to bond holders at maturity; also known as face value, maturity value or redemption value. If market price > par value; bond is trading at a premium. If market price < par… Read More

101 concepts level I

08-06-18 Concept 79: Cash Flows of Fixed-Income Securities

Bullet structure: Pays coupon periodically and entire payment of principal occurs at maturity. Amortizing bond An amortizing bond is a bond that repays part of its principal at each payment date. For a fully amortized bond, the amortizing bond’s outstanding principal amount is reduced to zero by the maturity date. However, for a partially amortizing bond, a balloon payment is required at maturity to repay the remaining principal as a lump sum. Sinking fund agreements: Here the issuer is required to retire a portion of the bond issue at specified times during the bond’s life. Floating rate notes (FRN) A… Read More

101 concepts level I