Introducing the Stock Market

The stock market is a primary source of financing for large and medium-sized corporations. It is famously volatile. Many factors could affect share prices: how well a company is doing, the valuation of its peers, trends in its industry, the state of the broader economy.

Purpose of the stock market:

1. Just as the bond market makes it easy to enter and exit load agreements, the stock market makes it easy to enter and exit company investments. A private investor can quickly and easily own parts of thousands of companies.
2. We saw that bonds typically provide low yields, similar to bank accounts. By buying shares in a company, you will ultimatesly earn the underlying commercial returns of the company.

IPOs are a way for entrepreneurs to monetize their investment and hard work. This incentivizes entrepreneurialism. Delisting is the opposite of doing an IPO. There is no revenue threshold aboce which a company must do an IPO.

Reasons of delisting:

1. The company may have been bought by a private equity fund.
2. Management may have been fed up with the regulatory burden of being a public company.
3. The compnay may have gone bust.
4. A whole industry may have died.

Summary:

• IPOs raise money and/or transfer ownership.
• Companies delist when they are bought, go bust, or balk at reporting requirements.
• Equity indices come in all shapes and sizes.
• Index performance is calculated from the performance of index members.

The Natrue of Equities

Factors to consider when comparing returns:

1. The role of dividends in qeuity returns
2. The nomial nature of stock and bond returns

Summary:

• Shareholders own a share of compnay earnings and assets
• Stocks are volatile because earnings are volatile
• Shareholder returns come from both shares going up and payments of dividends
• The range of shareholder outcomes is asymmetrical. Shares can go to zero or can multiply in value

Equity Research

• Industry classification
• Suppliers and buyers: supplier, competitor, customer
• Revenue projections: hos big is the pie and how big the compnay’s slice of that pie
• Cost base

Summary:

• Analysts must know the industries in which a company operates
• Industry estimates are foundational to a company financial model
• Industry drivers help formulate earnings estimates
• Investors assess compnay results by comparing them to estimates

Absolute Valuation

*Absolute valuation demands both short and long term financial forecasts *Relative valuation demands only short-term financial forecasts and not necessarily any historic financial data

Absolute valuation -> Discounted Cash Flow valuation

1. Estimate long-term furture cash flows from the firm -> understand historic performance
2. Estimate the rate at which to discount those cash flows to derive today’s value -> WACC, weighted average cost of capital
3. Based on 1 & 2, discount the estimated future cash flows by the WACC
4. Take the total firm value and derive the market capitalization -> Deduct the firm’s indebtedness and add the cash pile
5. Slice up the market capitalization by the number of shares outstanding to arrive at the estimated fair share price

Summary:

• Absolute valuation involves the discounting of future cash flows
• Future profits in the long term are worth less than future profits in the short term
• Good financial models balance simplicity with insight
• The concept of absolute valuation is theorectically perfect
• The outputs from absolute valuations are usually precisely wrong

Relative Valuation

Metrices: Dividend/yield, P/E Application: Self, peers, market

• Dividend payments may vary while bond payments usually do not
• Dividend yields are easier to calculate than bond yields: $divident per share/$price per share = dividend yield %

Earnings yield% = $earnings per share/$price per share

$price per share/$earnings per share = P/E ratio

Summary:

• Relative valuation is the quick and easy comparison of once valuation to another
• The risk of relative valuation is being led astray by unrealistic reference points
• Earnings and multiples are used to estimate fair share prices
• Fast growing companies warrant high multiples and vice versa
• The state of the economy is a key driver of relative valuations

Equity Summary:

1. Index movements are driven by movements in member stocks
2. The volatility of earnings leads to volatility of share prices
3. Uncovering industry drivers is key to estimating earnings
4. Absolute valutaion is in theory perfect but has practical limitations
5. Relative valuation is easier but sensitive to earnings growth