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Stock Fraud Lawyer Attorney SD = 21.2% SD = 21.2% What risk-return combination do you get if you put all your money into one stock or the other? But suppose you start mixing one with the other. 25%M+75%S Mega Manufacturing Startup Semiconductor 17.5% +40% +10% -12.5% +10% -20% 32.5% +10% +40% 2.5% -20% +10% EV = +10% EV = +10% EV = +10% Stock Fraud Lawyer Attorney $200 Read for p. 489 on bankruptcy costs and the Penn Central RR Agency problems and financial distress: · Gambling for resurrection · Refusal to contribute equity capital · Cash-out-and-run · Play for time (a version of gambling for resurrection) · Bait-and-switch (RJR LBO: took $300 million from the bondholders) Options I Basics: · Present value of a perpetuity: C/r Stock Fraud Lawyer Attorney Calls, Puts, and Shares: · A call option gives its owner the right to buy stock at a specified exercise or strike price on or before a specified exercise date. European options--only on the particular date; American options--on or before that date. · A put option gives its owner the right to sell stock at a specified exercise or strike price on or before a specified exercise date. European options--only on the particular date; American options--on or before that date. Intel Options Prices in July 1995; Stock Trading at $65 a Share Exercise Date Exercise Price Price of Put Price of Call 10/95 $65 $6.25 $4.625 1/96 $65 $8 $5.875 1/96 $70 $5.875 $8.5 Value of call at expiration = max(price of share - exercise price, 0) Stock Fraud Lawyer Attorney Now the answer is going to be: Choice Net Present Value (12% Discount Rate) Cash out $250,000 Build $257,143 Invest $250,000 You should choose option B--build. Why? Simplest answer: it is the best thing you can do with the money. · Go short the stock market $100,000; use your receipts to fund the extra construction money you need; and thus find yourself with the expected payoff (0, $288,000)--clearly better than the (0, $280,000) of "invest" Stock Fraud Lawyer Attorney · Consumer expectations. If consumers expect product prices to rise, the more of the product they will demand now. · Advertising. Effective advertising can promote and expand demand for the product of a company, or advertising can expand the marketplace for an entire industry. · Demographics. As the population demographics change over the years so do consumer tastes and the products that they consume. The demand curve for a product portrays the important relationship that exists between the quantity of a product that would be purchased and the prices that are charged for the product. Movement along the demand curve reflects a change in the quantity demanded. For example when prices decline, the quantity of the product demanded by consumers will increase. This is called the law of demand, and explains why demand curves normally slope downward and to the right. When the demand curve shifts, this is known as a change in demand. Change in demand is caused by some factor other than price. The price elasticity of demand refers to the responsiveness of the quantity of goods that are demanded in relation to changes in the price of the product. Stock Fraud Lawyer Attorney · Corporate management can manipulate the financial statements by making accounting choices which are available to them and still remain within the acceptable standards required by the generally accepted accounting principles (GAAP) in order to put the best face on information contained within the financial statements. · There is always a time delay between the end of an accounting reporting period and the actual publication of the firm's quarterly or annual financial statements. The delay can be several months. · Management choices regarding the reporting of financial activities will vary from company to company, making comparisons difficult for an investor. For example, 2 identical corporations in the same industry may choose different depreciation rates for their equipment, or they may choose different accounting techniques for reporting inventory. · Ratios do not necessarily disclose the quality of their components. For example, a high current ratio might mean that a company has high accounts receivable or inventories and not cash. · Financial statements are based on historic costs and therefore may be misleading during periods of inflation. Interpreting financial ratios · The long-term trend of the ratios can be as important as the absolute value of the ratio itself. · General economic conditions affect the ratios; therefore, the investor should study the ratios with respect to the stage of the business cycle. Stock Fraud Lawyer Attorney · The second term is the sum of the idiosyncratic risks u associated with the securities i--all divided by N-squared. Now a funny thing happens as N gets large: the second term vanishes: the sigmas stay (roughly) the same size, and you are adding up more (N) of them, but each one is divided by N-squared. So as N approaches infinity, the second term gets small--eventually small enough to ignore. An even funnier thing happens if we consider the variance of a portfolio made up of a large number of stocks (N large), for which the average beta happens to be one. · Then the first term is simply sigma-squared-m, and the second term is negligible: the variance of the portfolio is the variance of the "market" Conclusion: If an investor is doing his or her job--trying to get to a portfolio that has the minimum risk for a given expected return--then "idiosyncratic" risk can be diversified away: by putting all your eggs into many baskets, you essentially eliminate any idiosyncratic risk factors from your portfolio. Hence a security's "riskiness"--from the point of view of its impact on the overall riskiness of your portfolio as a whole--is summarized by its beta. Risk and Return Stock Fraud Lawyer Attorney · Underwriting not always fun. BP shares sold at 3.30 pounds per share; arrangements finalized on October 15, 1987; stock market crash; ultimately market price was 2.96 pounds per share--the underwriters lost more than a billion dollars. Private Placement Much lower transaction costs; have to find someone willing to take the issue; good for small and medium sized firms. Should you worry about dilution? Quangle's profitability: Book net worth $100,000 Number of shares 1000 Book value per share $100 Stock Fraud Lawyer Attorney The factors that affect supply changes, and which can shift the supply curve include: · A change in the price of the inputs of production such as raw materials, labor, or capital. · Changes in production technology such as the use of additional or more efficient machinery or production methods. · Changes in fiscal or monetary policy such as the imposition of taxes or other incentives or disincentives introduced by governments. · Natural disasters such as fires, floods, ice storms, or tornadoes which reduce the availability of goods on hand and may interrupt production schedules. Profit is the major determinant of a supply curve. Therefore, a major factor that affects the supply curve is production cost. The law of supply says that, in the short run, producers will manufacture more of the product at higher prices. Supply curves normally slope upward and to the right. This relationship exists because companies will only produce more of a given product if the price at which they can sell the product covers the cost of production and yields a profit. Interest rates and yield curves Stock Fraud Lawyer Attorney A bondholder should investigate the long-term trend of this ratio since it is a better indication of the firms continuing ability through good times and bad times to meet its interest obligations. As a rule of thumb, the more volatile a company's earnings, the higher the times interest earned ratio should be. Liquidity Current The current ratio measures the business's ability to meet its current obligations (due within the next 12 months) with its current assets. This ratio should be similar to the industry average. For many businesses, an acceptable level of coverage is on the order of 2:1. If the ratio is too low it can indicate possible solvency problems. Excessive investment in current assets, on the other hand, can indicate an ineffective use of the firm's short-term resources. A high current ratio can indicate uncollected accounts receivable, too much inventory, or it can indicate that management is stockpiling cash. Acid-Test (Quick) The acid test or quick ratio is used to determine the business's ability to pay its current liabilities using only the most highly liquid of its current assets. This ratio is a more stringent measure of a firm's liquidity since it ignores the value of the firm's inventory. A ratio of 1:1 is considered desirable, but no single standard exists. Stock Fraud Lawyer Attorney A low turnover rate indicates that the firm should pay more attention to collecting its accounts receivable. Accounts Receivable can amount to interest free loans to customers. The firm should analyze its accounts receivable in terms of its stated credit policy. Debt Total Debt to Equity This debt ratio measures a firm's leverage, and is therefore an estimate of its financial risk. A high-level of debt can be a warning sign of possible problems in the future and indicates high financial risk. A high-level of debt implies high fixed interest costs, which reduces the firm's financial flexibility and its ability to pay dividends to the common shareholders. A low level of debt can indicate that management is not optimizing the firm's capital structure and is therefore not maximizing total shareholder wealth Total Debt to Assets This ratio measures the level of support that is provided to the firm by its creditors. The reciprocal of this ratio is called the asset coverage ratio. The asset coverage ratio shows the amount of assets backing the companies debt and is a safety measure from a bondholder's perspective. This ratio should be calculated using total tangible assets in order to determine a conservative estimate of the firms ability to re-pay a bondholder. Times Interest Earned The times interest earned, or the interest coverage ratio, measures the margin safety for a corporation's bondholders. This ratio measures the firm's ability to pay its annual fixed interest charges from its ongoing business operations. There are no set rules determining an acceptable number of times earnings should cover interest. Stock Fraud Lawyer Attorney Additionally, if a creditor believes that inflation will rise over the term of the loan, the nominal interest rate charged for the loan will be increased so that the debt will be repaid in real dollars. In a free market open economy which engages in international trading, the level of interest rates, in addition to the domestic supply and demand factors just discussed, is also impacted by: · Central bank operations. Central banks can influence short-term interest rates through money-market operations. · The foreign exchange rate. If interest rates are higher in the U.S. than in , investment funds will flow to the U.S. (money goes where money grows) which may force the Bank of to protect the currency by raising short-term interest rates. · Central bank credibility. If central bank policy is to keep inflation low and under control, interest rates can remain low. The yield curve is a graphic representation of the relationship that exists between short and long-term interest rates at different points in time over the business cycle. Changes in the level of interest rates can dramatically affect both the price and the demand for debt securities. Stock Fraud Lawyer Attorney But almost all stock trades are secondary market trades: Trades unrelated to raising new capital for Ford Motor Company. What is the present value of a stock? PV(Stock) = PV(Expected Future Dividends) But don't people expect capital gains? Yes, but. Expected rate of return=required rate of return=market capitalization rate r = (D + P(1))/P(0) You can flip this formula around: given expectations of P(1), the dividend, and r, you can deduce P(0). How do we know that that is the right P(0)? Because it the price were higher, people would have to be really dumb to buy the stock; if the price were lower, everyone would already be trying to buy it. But what determines next year's price? r = (D(1) + P(2))/P(1) Forward induction. Stock Fraud Lawyer Attorney But by definition we don't know whether new information will be good or bad. Suppose analysts aren't competitive, and there are predictable cycles: we make money off these cycles--for a while. · Weak efficiency: the past pattern of prices doesn't allow you to make money · Semi-strong. Published information doesn't allow you to make money · Strong. All the hard work in the world doesn't allow you to make [much] money. One of the senior people on my brother's risk-arb desk, an equity analyst; trailing the S&P 500 The crash of '87 as a challenge to the efficient markets hypothesis. What was the news? Response seems to be (a) the market is better at relative prices than at absolute benchmarks, and (b) with P=D/(r-g) only a small shift in g is necessary to produce big shifts in P. Experts believe that the '87 crash does not undermine the evidence for market efficiency with respect to relative prices No Theory Is Perfect: Anomalies: Small firm effect--small firm estimated betas are not high enough to account for their high returns Stock Fraud Lawyer Attorney By "efficient" we mean a bunch of things · that all relevant and ascertainable information is reflected in the market price already because it is widely and cheaply available to investors. · Stock prices are a random walk (with drift) · Weak efficiency: the past pattern of prices doesn't allow you to make money · Semi-strong. Published information doesn't allow you to make money · Strong. All the hard work in the world doesn't allow you to make [much] money. One of the senior people on my brother's risk-arb desk, an equity analyst; trailing the S&P 500 There are some conspicuously bad portfolio managers (those who trade a lot, and have high overhead expenses). There are very few consistently good ones. Let's expand this: Maurice Kendall: stock prices appeared to be a random walk (with drift). Price changes independent of the most recent price change. What this means for "technical analysis". Stock Fraud Lawyer Attorney Does this mean that securities markets are overrated? Almost surely not. Debt-to-market ratios vary between 11% and 36% across industrial economies. Corporate governance Dispersal of ownership; free-rider problem; managerial displacement via voting-with-the-feet and takeover threat; managerial displacement via directors' coup; agency problems created by separation of ownership and control offset by (i) rights issues provided to top managers (less than perfect); (ii) fear of lawsuits; (iii) threat of takeover. alternative systems--bank representatives on boards of directors; large voting blocks; universal banking; "keiretsu" General Motors --> 100% of shares widely held Daimler-Benz --> 32% "widely held"; 28% Deutsche Bank (U.S. banks forbidden to hold equity in non-financial corporations) (Deutsche Bank votes 42% "deposit rights");14% Kuwait; 25% Mercedes Auto Holdings. You can't mount a takeover of Daimler-Benz; then again, you don't have to wait for a takeover artist in order to realize value. Stock Fraud Lawyer Attorney Examples of coincident economic indicators include: GDP, industrial production, personal income, and retail sales. · Lagging indicators tend to change after the economy has turned and include: the unemployment rate, labor costs, inventory levels, and the rate of inflation. The Phases of the Business Cycle The business cycle consists of four segments, which can be identified by the following signs or signals: 1) Recovery and expansion. Inflation is stable, or rising only slightly. Typically, these stages last longer than the contraction phase. Businesses are investing in new capacity to meet increased consumer demand. Corporate profits are rising because profit margins are increasing. Business is confident about the future and is planning production increases. New business start-ups outnumber bankruptcies. Inventories are under control. Retail sales are healthy. Unemployment is steady or falling. Job creation is strong. Stock Fraud Lawyer Attorney If capital is rationed--if you cannot find anyone willing to get you more on any reasonable terms--it is a pretty good bet that you are not making any profits and should give your capital back to your investors. Stock Fraud Lawyer Attorney If the dividend is sufficiently large, you might want to capture it and exercise just before the ex-dividend date. Real options encountered in practice areusually pretty complicated. Warrants and Convertibles A warrant is an American call option issued by a company on its own stock. Complications of warrants: · Exercise before maturity to capture the dividends · Dilution. If the warrants are exercised, the stock price goes down because the number of shares goes up. · If there are warrants outstanding, then ownership of a stock entails the obligation to satisfy a call from the holders of the warrants. A convertible bond is a close relative of the bond + warrant package. In 1991 Wendy's International issued $100 million of 7% convertible bonds due in 2006 convertible at any time to 81.3 shares of common stock. Face value of $1000; 1000/81.3 = $12. Stock Fraud Lawyer Attorney Low and falling interest rates encourage consumers to spend now and therefore to increase their current consumption of goods and services particularly relatively expensive goods such as automobiles and appliances. · Savings rates of individuals. Rising interest rates encourage consumers to save rather than to consume. · The discretionary spending habits of consumers. Rising interest rates increase the cost of borrowing thereby increasing debt servicing costs. Rising debt service cost means that there is less discretionary income to be used for current consumption. The level of interest rates in a closed economy that does not engage in trade with foreigners, is determined primarily by the supply and demand for credit (loanable funds). The supply of loanable funds is determined by savers who invest their money, which is then, in turn, loaned to consumers. The willingness to save is based upon the individual's willingness to trade current consumption for future consumption. The price demanded for this tradeoff is the interest rate. The demand for loanable funds is a function of the desire for current consumption, and the lower the cost or interest rate, the greater the demand for loanable funds. Creditors will consider a debtor's credit risk in establishing the interest rate to be charged. Specifically, the higher the risk of default the higher the interest rate charged. Stock Fraud Lawyer Attorney Most products have elastic demand. Demand is said to be elastic when a given change in price produces a greater percent change in the quantity of the product that is demanded. The elasticity of demand is determined by the availability of substitute products and the percentage of the consumers total budget that is spent on the product. Necessities, in general, tend to be more inelastic than luxury goods. Gasoline represents a good example of a product with elastic demand. On the other hand, some products will be in demand no matter what the price; for example, insulin, which is used by diabetics. If the price of insulin were to double, in all probability the quantity of insulin demanded would remain constant. This situation is known as inelastic demand. The supply of a product is defined as the quantity of the product which producers or manufacturers are willing to produce and sell. A change in supply is different from the change in the quantity supplied. A change in the quantity supplied occurs when the price of the product itself changes, and this change is depicted as a movement along the existing supply curve. A change in supply occurs because of factors other than price. A change in supply is reflected by a movement or shift, of the entire supply curve, up or down. Stock Fraud Lawyer Attorney Payouts of capital (for Treasury shares). Net book value--different from market value. Tobin's q. Stockholders; majority voting; cumulative voting; Equity in disguise: "limited" partners, REITs, "Royalty Trust" Debt--can't vote, but interest is paid out of before tax income; and have rights to throw company into bankruptcy. funded debt--greater than one year maturity. Walt Disney has issued 100-year bonds. NatWest has issued "perpetuities". unfunded debt--less than one year commercial paper--usually backed by a bank "line of credit"; other uses of lines of credit. Sinking fund--for gradual repurchase of bonds Call--right to buy debt back at principal value. Typically five years of "call protection" Stock Fraud Lawyer Attorney Personal bankruptcies rise. The nightly News and newspapers are pessimistic about the future. Stock market activities weaken and decline. The central bank is using lower interest rates and is encouraging credit granting in order to attempt to stimulate economic activity. The investment strategy at this point in the cycle is to sell short-term bonds and to buy mid and long-term bonds which will benefit from falling interest rates. 4) Trough. The end of the recession is apparent and gradually conditions that are more favorable start to surface. Stock and bond indices are below the long-term trends. The rate of the deterioration of the economy starts to slow. The leading economic indicators are improving and signs of stability start to return. Production output is low. Business sales are depressed. Business outlook is pessimistic. Stock Fraud Lawyer Attorney Personal incomes are rising. Consumer confidence is high. Demand for credit is high. Consumer spending and housing construction fuels increasing economic activity. Confidence is high and expectations become excessively optimistic. Investors are told that this time the world is different and that the trees will in fact "grow to the sky" Typically, in the late stages of the expansion phase the central bank will start to tighten credit in an attempt to cool the economy off by raising short-term interest rates. Stock and bond markets are booming. Investment strategy at this point in the business cycle is to stop buying common stocks because the expansion, at some point, must end. 2) Peak. Optimism and overconfidence override prudence and caution. Stock market and other economic indices are higher than the long-term trends. Inflation is rising quickly caused by wage increases, labor shortages and product shortages. The pace of economic activity is high and efficiency starts to wane. Stock Fraud Lawyer Attorney r of 5% per year. If Intel stock can only (a) fall by 20% to $52 or rise by 25% to $81.25, then Option value = 0 in bad case; $16.25 in good case. Spread=5/9 spread of stock price. Suppose you bought 5/9 of a share and borrowed the PV of 5/9 of a share in the bad case from the bank--borrow $28.18, the PV of $28.89. Then you have the same payoffs as the option. Value of 5/9 of a share today is $36.11, minus $28.18 = $7.93. Stock Fraud Lawyer Attorney Short-term interest rates are reduced in an attempt to restart the economy. The investment strategy at this point in the cycle is to sell long-term bonds. Profits from long-term bonds should be repositioned by purchasing common stocks of cyclical industries that have fallen out of favor. The Phases of the Business Cycle Foreign exchange rates. Global economic conditions affect companies selling products into foreign markets, as witnessed by the "Asian flu" and its damage to the economy in the late 1990s. Additionally, the globalization of business may introduce new competitors and trading partners. A countries economy is unquestionably highly dependent upon foreign trade. This dependence on trading means that the value of the currency is vitally important to the livelihood and living standards of millions of citizens. The foreign exchange marketplace is global in scope and foreign exchange rates are based on the supply and demand for a particular currency. In the international foreign exchange markets, currencies are traded around the clock and the accepted convention is that all foreign exchange rates are established or measured relative to the U.S. dollar, which is considered to be an international standard. In the international arena, a country may employ either a fixed or a floating exchange rate system. Stock Fraud Lawyer Attorney So yes--but only if you know what you are doing. Why NPV leads to better decisions than other criteria. Suppose a manager asks how to decide whether to invest in project X "First forecast the cash flows generated by project X; second, determine the appropriate opportunity cost (rate of discount, required rate of return, etc.) that reflects both the time value of money and the systematic risk involved in project X. Third, use this opportunity cost of capital to discount the future cash flows. Fourth, calculate NPV. Invest in X if NPV > 0." He asks why. If NPV>0, then investing in X is best for the stockholders How will positive NPV show up in stock price? Answer; investors aren't stupid. Stock Fraud Lawyer Attorney The advent of the automobile, for example, which created jobs for mechanics, displaced and eventually eliminated jobs for horse carriage makers. · Cyclical unemployment refers to the normal waxing and waning in the unemployment rate that occurs due to the normal fluctuations during a business cycle. Economics & Business cycles An understanding of the business cycle helps an investor to focus on the "big picture", and is essential in order to set both short and long-term investment strategies and policies. Business activity can be classified as having seasonal variations, cyclical fluctuations, and long-term secular trends. In addition, the economy and business activity can be affected by random and unexpected occurrences such as a war or "Asian flu". Over the long run, the economy has continued to expand and grow. However, this long-term growth has been volatile at times and the economy has experienced periodic fluctuations, which are known as the business cycle. There are no firm rules for identifying recessions or for dating business cycles; however, Statistics defines a recession as two consecutive quarters of declining GDP growth. Although each business cycle is itself unique, most business cycles follow a more or less predictable pattern. Although no business cycle will exactly match the previous cycle, some similarities and general conclusions can be drawn with respect to business and economic cycles and investment strategies in general. These strategies and phases can be tracked by watching certain economic indicators. · Leading economic indicators tend to anticipate the health of the general economy and include: building permits issued, housing starts, manufacturer's new orders for durable goods, stock prices, average number of hours worked per week, and commodity prices. · Coincident economic indicators change at approximately the same time and in the same direction as the overall economy. Stock Fraud Lawyer Attorney The bellwether or benchmark that is used to establish the level of interest rates in a Specific Country's economy is the federal government's treasury bills (T-bills) and bond issues. Under everyday and commonplace conditions, usually long-term interest rates are higher than short-term interest rates. When interest rates are plotted on a graph against the term to maturity, the resulting depiction of the term structure for interest rates is known as a normal yield curve. When short-term rates are higher than long-term rates, the yield curve is said to be inverted. The yield curve will often be inverted at the peak of an economic cycle because the Bank of will attempt to slowdown the pace of economic activity by manipulating short-term interest rates upwards, through its intervention in the money-market and other open market operations. The term structure of interest rates is described by different theories, which attempt to elucidate the shape of the yield curve. · Segmented market theory. This theory states that different participants in the bond market tend to concentrate their activities into the particular maturity segments, which most closely match their needs. Although this theory can explain any shape of yield curve, it is based on the unrealistic assumption that the market participants will never move out of their preferred segment no matter what the interest rate. · Preferred habitat theory. This theory states that investors and borrowers prefer to invest in certain maturity segments along the yield curve. The theory states that investors will shift out of their preferred maturity segment (habitat) if they are rewarded for the risk of doing so, by higher interest rates. · Pure expectations theory. Stock Fraud Lawyer Attorney The calculation of the CPI assumes that the same type and quantity of goods are purchased each month or each year, and the price of this basket of goods is compared and measured relative to a predefined base period. Another important indicator of inflation, are the settlements of collective agreements for unionized employees wage demands. The economic consequences of inflation include: · The erosion of the standard of living of those collecting and living on fixed incomes. · Debtors benefit since loans are repaid with cheaper future dollars. · Higher interest rates, which often translate into recessions. · A transfer of wealth from the public to the government, if the government is a major debtor, and if the tax system is progressive and it is not indexed to inflation. Unemployment One on the goals of economic policy is to produce and maintain full employment. Full employment does not mean zero unemployment. There will always be a certain number of unemployed persons in the economy for various reasons. · Fictional unemployment refers to individuals who are unemployed because they are voluntarily between jobs. Certain demographic sectors of the labor market change jobs more often than others. Young people for example, tend to have higher unemployment rates as they search for "better jobs". · Structural unemployment refers to the individuals who are displaced because their skills are no longer in demand due to advances in technology or to societal changes. Stock Fraud Lawyer Attorney The growth in potential GDP is a function of: · The growth rate of the labor force. The growth rate of the labor force is determined by demographics (birth rate, death rate, and immigration), and labor force participation rates (the percentage of the population that chooses to work). · The growth rate in the number of hours worked per worker. The growth rate in the number of hours worked is determined by societal attitudes towards work and leisure. · The growth rate of productivity. Productivity growth rate is a function of the technology used, innovation, social attitude, competition, resource utilization, and the skill of the labor force. Supply and Demand The demand for a product is defined as the quantity of the product which consumers are willing to purchase. Factors that affect the demand relationship of a product include: · The price of the product. Generally, the higher the product is priced, the lower the quantity demanded by consumers. · Consumer income. The higher the consumer's income, the more goods the consumer will demand. · The price and availability of related goods. If attractive substitute products are available at a lower price, less of a product will be in demand. Stock Fraud Lawyer Attorney The P/E multiple is one of the most widely used financial indicators or tools employed by investors. Book Value per Common The book value per common share is an indication of the margin of safety for common shareholders. This ratio indicates the dollar amount that would be available to be distributed to a common shareholder in the case of dissolution of the company. A more conservative estimate of the margin of safety would calculate the tangible net worth/per common share. Academic research has shown that the ratio which calculates price/book value is a good predictor of future investment results, and that stocks selling at low price/book value tend to outperform stocks selling at high price/book value multiples. Earnings per Common Share Earnings per common share or EPS is one of the most common financial ratios employed by investors and is frequently reported in the financial press. High net earnings per common share can indicate that management has the ability to pay dividends to the common shareholders. Conversely, low or negative EPS generally indicates that no dividends should be expected. Market Capitalization The market capitalization or market cap calculation computes the current fair market value (FMV) of the corporations common shares outstanding. Studies have shown that small cap stocks tend to outperform large cap stocks. Stock Fraud Lawyer Attorney There is minimal new capital investment. Inventories have declined. Unemployment is high. Personal income is down which causes reduced consumption. Consumer confidence is low. Doom and gloom are rampant. "The sky is falling". However, the inflation rate is falling along with interest rates. Labor is plentiful. Pent-up demand starts to build in the economy. Typically, raw material prices have fallen. Slowly, business and consumer confidence starts to rise. At this point in the cycle, the central bank is attempting to stimulate economic growth by easing credit. Stock Fraud Lawyer Attorney This is an above-market profit of $0.3333 per year forever--and discounting that above market return at 15% gives us a figure of $2.22 for the "value of the growth opportunity" this year. Next year we will have another growth opportunity--10% bigger--and so on for the year after that. So if we calculate the value of all growth opportunities: PVGO(0)/r-g we get $44.44 Which checks A growth stock: one in which the net present value of its opportunities to make above-market rate-of-return investments accounts for a large chunk of its stock price. Notice that it is not true to say that a share's value is equal to the discounted stream of future earnings per shares. Because retained earnings are not free cash flowing to the shareholders, but are themselves a source of some of the future dividends. Should we pay attention to P/E ratios? They depend on PVGO, and on r for firms of those risk characteristics. Stock Fraud Lawyer Attorney This theory states that the yield curve adjusts to the participants expectations regarding what the market believes that interest rates will be in the future. If the market expects interest rates to rise, the yield curve should be positively sloped and if the market expects that interest rates will fall, the yield curve will be inverted. · Liquidity theory. The liquidity theory is based upon an investors aversion to risk. This theory states that short-term rates should be lower than long-term rates because the long-term bond rates must include a premium for their lack of liquidity. The liquidity theory claims that the yield curve should therefore, always be positively sloped. · Biased expectation theory. This theory combines both the pure expectations and liquidity theories. This theory can explain any shape of yield curve and because of the liquidity preference there is a natural bias towards a positive slope. Inflation Most people define inflation as the persistent rise in the cost of living over time. The most common measure of inflation is the consumer price index (CPI). The CPI measures the cost each month to buy a basket of consumer goods. This basket of goods supposedly represents the same goods that typically would be purchased by an average family. Stock Fraud Lawyer Attorney Under a fixed exchange rate system the currency is pegged against other currencies, usually by imposing currency controls which preclude the citizens from holding foreign currencies; or the central bank will take measures to ensure that the currency stays within a fixed range by purchasing or selling currency in the foreign exchange market. Currently, an example of the fixed exchange rate system is the Hong Kong dollar. A floating exchange rate means that the central bank will only intervene in the foreign exchange marketplace when it considers the movement of the currency to be excessive. Central banks can either buy or sell in the foreign exchange market, or they can manipulate short-term interest rates. The dollar has been freely floating since the 1950s. When the currency is under downward pressure, a central bank will intervene in the foreign exchange market by purchasing their own currency in an attempt to increase the demand for the currency and thereby attempting to support the value and strengthening of the currency. When the currency is weak relative to the U.S. dollar, products produced in your country are relatively inexpensive to an American or EU consumer. In other words, a weak currency benefits the respective exporters. At the same time, a weak currency means that products produced in the U.S. or EU are expensive when purchased by the weaker currency, which translates to mean that a weak currency puts importers at a comparative disadvantage relative to their U. Stock Fraud Lawyer Attorney We assume that the risk-free rate is more likely to vary than is the risk premium. Standard statistical measures of risk: Variance = Expected value of [r(market realized) - r(market expected)]^2 Standard deviation = sqrt(variance) HH +40% HT +10% TH +10% TT -20% Variance=.25*(.3)^2+.25*(.3)^2 = .045 Standard deviation=sqrt(.045)=.212=21.2% Stock Fraud Lawyer Attorney We have just valued our option. The number of shares to replicate the spread from an option is the hedge ratio or option delta. (If the option sells for more than $7.93, you have a money machine by selling options and covering. Value of put option--option delta = -4/9; payoff = +$13 in low state; = 0 in high state; sell 4/9 of a share and lend out $35.23 (collect $36.11 in six months). $35.23 - 4/9 x $65 = $6.34. V[call] + PV[exercise price] = V[put]+[share price] $7.93 +$65/1.025 = $6. Stock Fraud Lawyer Attorney Worth $70 million in the good state next year; worth zero in the bad state; call option today worth $22.9 million which is more than the $20 million payoff from immediate exercise. Is the binomial method for valuing options merely another application of decision tree analysis? Yes--with the proviso that option pricing theory is a very compact and powerful way of summarizing certain kinds of decision trees. Flexible Production: the opportunity to change your scale of operations. Option Value at a glance: · American calls--no dividends. Don't exercise it before maturity; treat it as a European call. · European puts--no dividends. Value of put = Value of call - value of underlying + PV(EP) · American puts--no dividends. It can sometimes pay to exercise an American put before maturity in order to reinvest the exercise price. For example, suppose that immediately after you buy an American put the price of the underlying falls to zero. In this case it is certainly better to exercise the put immediately; valuing it is not easy: Black-Scholes does not apply. · European calls on dividend-paying stocks; reduce the price of the stock in Black-Scholes by the PV of the dividends paid before the option matures, because some of today's stock value is made up of those dividends. · American calls on dividend paying stocks. Stock Fraud Lawyer Attorney Yet once you have bought the option you are "invested" in the underlying asset. Thus buying an option is a little bit like being offered an interest free loan of the amount of the strike price. The higher is the rate of interest and the longer is the time to maturity, the higher is the option value. 3. If the price of an asset falls short of the exercise price on the exercise date, you lose 100 percent of your investment--but no more. On the other hand, the more the price rises above the strike price, the more profit you will make. Therefore the option holder does not lose from increased volatility if things go wrong, but does gain if things go right. The value of the option increases with the varaince per period of the stock return multiplied by the number of periods to maturity. Why DCF Doesn't Work for Options: Because the riskiness of an option changes every time the stock price moves. Valuing Options: Price options by constructing a synthetic option. Suppose we have our $65 Intel stock, and buy a call option with a strike price of $65 and an expiration date six months from now. Let the risk-free interest rate r be 5% per year. Suppose, further, that Intel stock can only (a) fall by 20% to $52 or rise by 25% to $81. Stock Fraud Lawyer Attorney You need to set a rate X that earns you a fair return--a 0 NPV investment at the margin. What is this rental price? Use your annuity formula: $10.61 for machine A; $11.45 for machine B; Machine A looks cheaper, but: · What if you could rent machine B for a lot less in period 3 (because of rapid technological change, say, and rapidly falling costs)? · What if B had looked cheaper, but looking ahead you would have seen that inflation would have made the C(3) cost a lot more than $11.45? · Need to do equivalent-annual-cost comparisons in real dollars, and need to know in addition about expected future changes in machine rental costs. Deciding when to replace an existing machine (at 6% interest). C(0) C(1) C(2) C(3) Old Machine $4,000 $4,000 0 0 New Machine (Now) -$15,000 $8,000 $8,000 $8,000 New Machine (wait a year) -$15000 $8,000 $8,000, and same in year 4 Stock Fraud Lawyer Attorney Each shareholder wants three things: 3. 4. To be as rich as possible: that is, maximize current wealth 5. To transform that current wealth into whatever time pattern of consumption is desired 6. To choose the risk characteristics of that consumption plan 7. But stockholders don't need your help--don't need the company's help, don't need the financial manager's help--to reach the best time pattern of consumption. They can do that on their own (provided they have access to capital markets). They don't need your help to reach the best risk pattern. 8. How then can you help? 9. By increasing the market value of each shareholder's stake--by seizing all investment opportunities that have a positive net present value. Other corporate goals? "Maximize profits"--which year's profits? How about trading off present for future profits? Which accountant? Stock Fraud Lawyer Attorney , the time required to convert raw materials into finished goods, to sell the finished goods, and to collect the accounts receivable. The amount of working capital required by a firm varies by industry, season, and stage of the business cycle. Value Dividend Payout The payout ratio indicates the % of net earnings that the corporation pays out in the form of dividends to the equity owners. Growth company's usually have low or zero payout ratios. The Board of Directors of a corporation tends to prefer to maintain a steady payout ratio rather than allowing the payout ratio to fluctuate with corporations earnings. The Board of Directors of a blue-chip company does not increase dividends without considering the informational content of the dividend. Generally, when a blue-chip company increases its dividend, this signals that the Board believes that the future prospects for the business are expected to be good. The retention ratio (RR) is the % of earnings that are retained in order to finance the future operations of the business. The RR is calculated as (1-payout ratio) P/E Multiple The P/E multiple or P/E ratio is calculated only for common shares. This ratio calculates the trailing P/E ratio, since it is based on the previous 12 months earnings. The P/E multiple should be used to evaluate companies which are in the same industry, in order for the results of a comparison to be meaningful. The P/E multiple varies widely from industry to industry. In simplistic terms, the P/E multiple indicates the price that investors are willing to pay today for each dollar of a corporation's earnings. Accountants and auditors ... Some public accountants specialize in forensic accounting—investigating and interpreting white collar crimes such as securities fraud and embezzlement ... legaljob.org/stats.bls.gov/oco/ocos001.htm - 64k - Supplemental Result - Stock Fraud Lawyer Attorney "State of the World" UniversalUtility MegaManufacturing ExcitingExports StartupSemiconductor HH +20% +40% +40% +20% HT +0% +10% +50% -20% TH +10% +10% -30% -20% TT -10% -20% -20% +20% Suppose WE am choosing portfolios from Mega Manufacturing and Startup Semiconductor: We get the highest return from Mega Manufacturing, but we can get a lower standard deviation--at not much cost in return--by starting to diversify. Suppose WE diversify among the four different stocks: Stock Fraud Lawyer Attorney Choose the portfolio S that just touches the line that goes through the riskfree-rate point and lies entirely to one side of the feasible portfolio set. Then borrow (and lend) until you get to the risk-return characteristics you want; simply combine the "best" efficient risky portfolio with the risk-free rate. Capital asset pricing model. : Plot beta on the horizontal axis; expected return on the vertical axis; start with the riskfree rate. Add the diversified market. Draw the security market line. Everything must yield the expected return that places it on the market line for its beta. Relationship between beta-return diagram and risk-return diagram: risk return diagram adds in idiosyncratic risk. Stock Fraud Lawyer Attorney Beta Calculating portfolio risk; suppose we invest x1 in security 1 and x2 in security 2. What is the return on the entire portfolio? That part is easy: it is just the weighted average of the individual returns. What is the risk of the entire portfolio. We set it out on a 2 x 2 grid: the risk--the variance-- is the sum of these four boxes security 1 security 2 security 1 x12s12 x1x2s12 security 2 x1x2s12 x22s22 E(x(1)r(1)+x(2)r(2))^2 = E(x(1)r(1))^2 + E(x(1)r(1)x(2)r(2))+E(x(1)r(1)x(2)r(2))+E(x(2)r(2))^2 Stock Fraud Lawyer Attorney Diversification and risk: "State of the World" UniversalUtility MegaManufacturing SimpleService ExcitingExports StartupSemiconductor HH +20% +40% +20% +40% +20% HT +0% +10% +5% +50% -20% TH +10% +10% +5% -30% -20% TT -10% -20% -10% -20% +20% $100 in Mega Manufacturing: Expected Return=10% ($10); Std Dev=21.2% $50 in Mega, $50 in Universal Utility: Expected Return=7.5% ($7.5); Std Dev=16.0% $25 in Mega, $25 in Simple, $25 in Exciting, $25 in Startup: Returns are (30%, 11.25%, -8.75%, 12.5%) Expected Return=6.25% ($6.25), Std Dev=14.6% Stock Fraud Lawyer Attorney IM&C Professors go through a long example, IM&C, with investment, depreciation, working capital impacts, salvage values, taxes and tax shields, and so forth. Let me skip over it here; but let me urge you to spend a lot of time on it--because it is a good thing to read to try to assess what you have missed at the end of this, the first unit of the course. Project Interactions Optimal timing of investment. Year 1 2 3 4 5 6 7 thereafter "Harvest" Now: $1000 $900 $810 $729 $656 x.9 x.9 x.9 Build a road: -$100 $1300 $1170 $1053 $948 x.9 x.9 x.9 Build and wait: -$100 0 $1500 $1350 $1115 x.9 x. Stock Fraud Lawyer Attorney Patterns of corporate financing. Heavy reliance on internal financing. Debt-to-market ratios vary between 11% and 36% across industrial economies. Corporate governance Dispersal of ownership; free-rider problem; managerial displacement via voting-with-the-feet and takeover threat; managerial displacement via directors' coup; agency problems created by separation of ownership and control offset by (i) rights issues provided to top managers (less than perfect); (ii) fear of lawsuits; (iii) threat of takeover. How Corporations Raise Money Basics: · Present value of a perpetuity: C/r Stock Fraud Lawyer Attorney Summary: Finance is mostly a "marketing" problem; company tries to split cash flows into different streams that will appeal to different investors with different tastes, wealth levels, and tax rates. · Equity (either by direct issue or by retained earnings) · Debt · Preferred stock (hah!) · Options and derivatives Another look: internal funds as most important; mix of outside financing chagnes from year to year; net equity issues in the 1980s stronglynegtaive: people leveraged up. Inbox Software EquityAccount: Stock Fraud Lawyer Attorney Summary: Larger is cheaper--bunch security issues, for transaction costs are considerable There are no issue costs for retained earnings Private placements are well suited for the small, risky, unusual, and complex Watch out for underpricing--the lion's share of costs come from underpricing New issues may depress price (and so should be coreographed to be information-free) shelf registration for large firms that don't need to be warranteed by IBs Rights Issues: Stock Fraud Lawyer Attorney The Six Lessons of Market Efficiency Lesson 1: Markets have no memory (don't wait for recent price changes to be reversed; they probably will not be) Lesson 2: Trust market prices (more than your own hunches) Lesson 3: Look at market prices in detail to predict the future (term structure; market's unfavorable assessment of Viacom's takeover of Paramount; for the market price implicitly weights a lot of people's serious assessments) Lesson 4: Do not believe in financial illusions (dividends and stock splits; stock prices run up before a split) Lesson 5: Value is lost when the company does something that a shareholder can do on his own for smaller transaction costs Lesson 6: Demands for stocks should be highly, highly elastic. Note that the efficient markets hypothesis does not mean that the financing of a corporation will "take care of itself"; it provides a starting point, not an ending point, for analyis. Overview of Corporate Financing Stock Fraud Lawyer Attorney The timing option: Suppose a project is not "now or never". Suppose you can invest right away or wait. If the project is truly a winner, waiting means loss or deferral of positive early cash flows. If the project is a loser, waiting could prevent a bad mistake. The opportunity to invest in a positive NPV project is equivalent to an in-the-money call option. Optimal investment means exercising that call at the best time. A call option on a stock that pays dividends. Current value = $200 million; If demand is high in the future, project value rises to $250 million; if demand is low, project value falls to $160 million. If you delay the investment, you miss out on the first year's cash flow ($16 or $25 million). If you delay, you avoid a mistake in which you invest $180 million in a plant that turns out to be worth only $160 million. Call option. Stock Fraud Lawyer Attorney Portfolio Average real return(inflation-adjusted) Average risk premium(vis-a-vis Treasury bills) Treasury bills 0.6%/year 0 Treasury bonds 2.1%/year 1.4%/year Corporate bonds 2.7%/year 2.0%/year Stocks (S&P 500) 8.9%/year 8.3%/year Small stocks 13.9%/year 13.2%/year Arithmetic average returns--not compound annual rates of return. Difference? Compound annual have you reinvesting last year's gains (or losses) in the market. Hence a bad year--you not only lose money; you also lose your capital and can take less advantage of future good years. But over 69 years, 1926-1995: Average inflation factor 9. Stock Fraud Lawyer Attorney Basic economic concepts - Economics for the Financial Management Professional An understanding of the national and international economic environment is very important in preparing to make and implement financial decisions. The following basic economic concepts will help the investor to comprehend the economic environment before committing to a retirement or investment plan. Gross domestic product and gross national product. Gross domestic product (GDP) is a measure of the goods and services produced by labor and property that is a specific country. For the purposes of the GDP calculation, it does not matter whether residents own the resources; it matters only that the labor and other resources are located in a specific country. GDP is the most common measure or international standard of national economic performance that is used by governments and economists worldwide. Gross national product (GNP) is a measure of the goods and services that are produced by labor and property that is supplied by residents. It does not matter whether or not the laborers or the property is actually located in , so long as the resources are owned by Residents. Since there is more foreign investment in many countries than there is investment abroad, GDP is much larger than in some countries than GNP. By way of contrast, for the U.S., GDP and GNP are nearly identical. The economy's ability to produce is measured by its potential GDP. Stock Fraud Lawyer Attorney Resources Asset Turnover This ratio measures the effectiveness of the firm's use of assets to generate sales revenue. This ratio can vary over time for a given firm. Firms in the start-up stage tend to have low asset turnover ratios, while mature companies tend to have a more stable asset turnover. Generally, a high asset turnover ratio indicates that the assets are being effectively employed; however, a high asset turnover does not explicitly take into account that the firm might be using old assets, which have been fully depreciated. A firm using newly purchased assets will show a lower turnover ratio because of the higher depreciation costs even though the new machinery is highly efficient. Firms will try to keep their long-term asset turnover ratios close to the industry norm. Inventory Turnover The inventory turnover ratio indicates the number of times that an inventory is sold and replaced over a given time period. This ratio can be used to assess the quality of an inventory. Inventory turnover ratios vary widely by industry and obvious deviations from the industry standard may indicate problems. Too much inventory can indicate improper purchasing, inadequate marketing, or an undesirable product. On the other hand, too little inventory can cause problems with product availability and can therefore hurt sales. Receivable Turnover Stock Fraud Lawyer Attorney = +$100,000 - $56,988 = +$43,012 //when the appropriate discount rate is 10%, an offer to loan you money for 10 years at 3% is truly an amazing deal. (Use the "rule of 72" to see that it is an amazing deal right off) · Financing decisions are easier to reverse than investment decisions · It's much harder to make or lose lots of money by making bad financing decisions. · In investment decisions, you are not facing a perfect, competitive market · In financial makets, you are facing a nearly perfect, competitive market · If selling a security has a positive NPV to you, it probably has a negative NPV to the purchaser. You probably will not find many such purchasers. If capital markets are efficient, then purchase or sale of any security at the prevailing maket price is never a positive (or negative) NPV transaction. Stock Fraud Lawyer Attorney · .as dividends: (1-Tc)(1-Tp) · .as capital gains (retained earnings): (1-Tc)(1-Te) · .as interest (1-Tp) · What if the marginal holder is a pension fund, or a foundation? In America today, it is probably the case that debt has a noticeable tax advantage. Financial distress: Value of Firm $500 $1000 $1500 Unleveraged Value of Equity $500 $1000 $1500 Moderately Leveraged Value of Debt $400 $400 $400 Stock Fraud Lawyer Attorney · If the option sells for more than $7.93, you have a money machine by selling options and then covering by (a) buying 5/9 times as many shares as you sold options, and (b) funding your purchase by borrowing $28.18 at the risk-free rate for each option you sold. The $28.18+$7.93 will pay for the 5/9 share of stock--and you are perfectly hedged. Anything more than $7.93 for the option that you sold is pure gravy. Did that go by too fast? Let's value the put option Value of put option payoff · = +$13 in low state; · = 0 in high state; · difference = -4/9 times the spread in the stock price between the bad and good states. Therefore: · sell 4/9 of a share; · lend out $35.23 (to collect $36.11--the price of 4/9 of a share in six months in the good state). $35. Stock Fraud Lawyer Attorney Business revenues are down, profits are falling. Production costs are rising faster than prices, which causes profit margins to shrink. Business is no longer making large capital investment. Business output typically exceeds sales. Inventories start to build up due to falling sales. Accounts receivable start to rise, which causes a shortage of working capital and this forces businesses to seek bank financing. Business confidence erodes. Consumer confidence declines, housing sales fall, and big-ticket consumer spending drops as consumers worry about the future. Central bank intervention to control inflation, by raising short-term interest rates often causes inverted yield curves at this point in the cycle. Monetary policy bias is towards tightening credit, aimed at causing the economy to slow. Rising interest rates cause bond prices to fall. Stock prices have weakened and stock market activity drops off. New stock and bond issues are poorly accepted by investors and become rare. Stock Fraud Lawyer Attorney But the real world ain't binomial; Black-Scholes plays a pretty big part in it. Warrants and Convertibles Basics: · Present value of a perpetuity: C/r · Present value of a growing (or shrinking) perpetuity: C/(r-g) · Present value of C dollars t years from now: C/[(1+r)t] · Present value of a C-dollar t-year annuity: C[(1/r)-(1/[r(1+r)t]) · "Rule of 72": (1+r)t = 2 (approximately) whenever rt=.72 · beta = [E((r1-r*1)(rm-r*m)]/[(rm-r*m)2] · r*i = r*f + betai(r*m-rf) Stock Fraud Lawyer Attorney Companies should discount cash flows depending on their systematic riskiness--not on whether their expected return exceeds the company cost-of-capital. Measuring betas: · Look at past "stuff"--at the past fluctuations in the company's stock price relative to the market. o Alphas--drift in price over the recent past (ought to be ironed down to competitive levels by the market) o R-squared: the proportion of the total risk of the company that is systematic market risk. o Residual standard deviation: how much idiosyncratic risk is associated with the security. o Standard errors of alpha and beta; these things are estimates, after all; estimates are only estimates: AT&T's beta varies from 0.54 to 0.26 to 0.67 to 0.96 over successive five year periods; does its "true" beta vary that much? Probably not (but maybe). H-P's estimated beta varies from 1.27 to 1.39 to 1.36 to 1. Stock Fraud Lawyer Attorney Discounted-Cash-Flow formula A much easier formula to work with than "price equals the present value of expected future dividends" is: · "market capitalization rate equals dividend yield plus expected rate of dividend growth" Duke Power Example 5.2% dividend yield; 4.1% rate of dividend growth projected; seems to imply a 9.3% required rate-of-return on equity for Duke Power. Danger: your estimate of the required rate-of-return is only as good as your estimate of dividend growth. Do not use the simple constant-growth formula to test whether the market is correct in its assessment of stock value. If your estimate is different, it is more likely that you are wrong than that the marekt is wrong. Earnings Suppose a business is earning $10 a share (expected to continue forever), the market capitalization rate is 8%, and the firm pays out some of its earnings as dividends and invests the rest in projects that yield the market capitalization rate--and suppose we know that the company is going to be able to continue this policy forever. What is its price? You might say that you need to know the dividend in order to calculate its price. Actually, you don't. Stock Fraud Lawyer Attorney Dividend increases are good news--signal managerial optimism. Dividend Controversy · Right wing: increasing payouts raise value · Middle of the road: who cares about dividend policy? · Left wing: increasing payouts lowers value Franco Modigliani and Merton Miller; //Homemade leverage proof: Assets Liabilities + NW Cash $1,000 0 Debt Fixed Assets $9,000 $10,000 + NPV Equity Stock Fraud Lawyer Attorney Dividends are irrelevant once one buys the proposition that the value of a firm is the value of its current assets plus future investment opportunities. Capital Structure Basics: · Present value of a perpetuity: C/r · Present value of a growing (or shrinking) perpetuity: C/(r-g) · Present value of C dollars t years from now: C/[(1+r)t] · Present value of a C-dollar t-year annuity: C[(1/r)-(1/[r(1+r)t]) · "Rule of 72": (1+r)t = 2 (approximately) whenever rt=.72 · beta = [E((r1-r*1)(rm-r*m)]/[(rm-r*m)2] · r*i = r*f + betai(r*m-rf) Stock Fraud Lawyer Attorney Fledgling Electronics: Market capitalization rate r of 15% per year $5 first-year dividend Thereafter dividend grows by 10% per year Market price of $100 a share Now suppose Fledgling has earnings per share of $8.33, so that it is plowing back into its business 40% of its earnings. The growth rate of earnings (and of dividends, and of the stock price) is equal to the return on equity investments times the plowback ratio--which for a growth rate of 10% and a plowback ratio of 40%, must imply that Fledgling has open to it investment opportunities that pay 25% rates of return. What if Fledgling didn't invest? $8.33/.15 = $55.56 as its stock market value. The other $44.44 must come from the "present value of growth opportunities". What are its growth opportunities? Well, this year it is the opportunity to invest $3.33 in earnings in investments that pay 25% rates of return (rather than the market's 15% rate of return). Stock Fraud Lawyer Attorney Fledgling Electronics: Market capitalization rate r of 15% per year $5 first-year dividend Thereafter dividend grows by 10% per year Market price of $100 a share Now suppose Fledgling has earnings per share of $8.33, so that it is plowing back into its business 40% of its earnings. The growth rate of earnings (and of dividends, and of the stock price) is equal to the return on equity investments times the plowback ratio--which for a growth rate of 10% and a plowback ratio of 40%, must imply that Fledgling has open to it investment opportunities that pay 25% rates of return. What if Fledgling didn't invest? $8.33/.15 = $55.56 as its stock market value. The other $44.44 must come from the "present value of growth opportunities". What are its growth opportunities? Well, this year it is the opportunity to invest $3.33 in earnings in investments that pay 25% rates of return (rather than the market's 15% rate of return). This is an above-market profit of $0.3333 per year forever--and discounting that above market return at 15% gives us a figure of $2. Stock Fraud Lawyer Attorney Floating versus fixed rates. London Interbank Offered Rate; eurobonds; eurodollars. Leased equipment--looks a lot like debt; Preferred stock--a security that lacks the voting rights of common stock, and that lacks the bankruptcy protection rights of debt; rarely issued save by public utilities which want to have a high nominal capital base. Convertibles; a warrant--nothing but an option to buy a certain number of common shares from the Treasury at a set price on or before a set date. Convertible bond--a package of a corporate bond and a warrant Derivatives Traded options; Chicago Board of Trade Options Exchange Futures--an order you place in advance to buy or sell at a fixed price at some future date. Hillary Rodham Clinton. Forward--a tailor-made future contractnot traded on an exchange. Stock Fraud Lawyer Attorney Is something truly weird ever going on? Think about gold The last term is the only thing floating out there; either we must expect the value of gold to be very, very high; or the required rate of return on gold is very, very, low; or there are no rational investors holding gold, and rational investors have shorted gold as much as they dare to. Discounted-Cash-Flow formula A much easier formula to work with than "price equals the present value of expected future dividends" is: · "market capitalization rate equals dividend yield plus expected rate of dividend growth" Duke Power Example 5.2% dividend yield; 4.1% rate of dividend growth projected; seems to imply a 9.3% required rate-of-return on equity for Duke Power. Danger: your estimate of the required rate-of-return is only as good as your estimate of dividend growth. Do not use the simple constant-growth formula to test whether the market is correct in its assessment of stock value. If your estimate is different, it is more likely that you are wrong than that the market is wrong. Earnings Suppose a business is earning $10 a share (expected to continue forever), the market capitalization rate is 8%, and the firm pays out some of its earnings as dividends and invests the rest in projects that yield the market capitalization rate--and suppose we know that the company is going to be able to continue this policy forever. Stock Fraud Lawyer Attorney Limits to sensitivity analysis: what does "optimistic" mean? What if variables are interrelated? Scenarios. Different consistent combinations. Capital Budgeting and Performance Basics: · Present value of a perpetuity: C/r · Present value of a growing (or shrinking) perpetuity: C/(r-g) · Present value of C dollars t years from now: C/[(1+r)t] · Present value of a C-dollar t-year annuity: C[(1/r)-(1/[r(1+r)t]) · "Rule of 72": (1+r)t = 2 (approximately) whenever rt=.72 · beta = [E((r1-r*1)(rm-r*m)]/[(rm-r*m)2] Stock Fraud Lawyer Attorney Marvin sells 500,000 primary shares (for the company) and 400,000 secondary shares (from VCs and from founders) Assets Liabilities + Net Worth $72 0.9 m shares IPO Cashfrom new equity $37.5 $48 0.6 2nd Stage Equity Fixed assets $5 $80 1.0 1st Stage Equity "Intangible" $221.5 $64 0.8 Founders' Equity $264 $264 "Contentment at selling an article for one-third of its subsequent value is a rarity" General Cash Offers by existing companies; SEC registration; "shelf" registration; market reaction to new stock issues-- 1/3 of value soaked up in stock price decline Stock Fraud Lawyer Attorney Note that the efficient markets hypothesis does not mean that the financing of a corporation will "take care of itself"; it provides a starting point, not an ending point, for analyis. Six Lessons of Market Efficiency Basics: · Present value of a perpetuity: C/r · Present value of a growing (or shrinking) perpetuity: C/(r-g) · Present value of C dollars t years from now: C/[(1+r)t] · Present value of a C-dollar t-year annuity: C[(1/r)-(1/[r(1+r)t]) · "Rule of 72": (1+r)t = 2 (approximately) whenever rt=.72 · beta = [E((r1-r*1)(rm-r*m)]/[(rm-r*m)2] · r*i = r*f + betai(r*m-rf) Stock Fraud Lawyer Attorney Proofs of the CAPM: Start with the market portfolio M, yielding return r*(m) and variance V(m). Add a small amount e of security S to the portfolio by selling e of the market: return = (1-e)r*(m) + er*(s) variance = Variance[(1-e)M+eS]=Expected Value[(1-e)^2M^2+2e(1-e)MS+e^2S^2] =V(m)[(1-e)^2+2e(1-e)beta(S)+e^2beta(S)^2] =V(m)[(1-e)+ebeta(S)]^2 Suppose this new risk, variance point is not on the security market line. If it is above the security market line, then it is a new super-efficient portfolio--and everyone should stampede into it. If it is below the security market line, then it is an _inefficient_ portfolio--and no one should want to hold even a small amount e of stock S. Stock Fraud Lawyer Attorney Ratios Used to Analyze Financial Statements Profitability Return on Equity This ratio is used to determine the adequacy of the return on common shareholder's investment. Generally, the higher the ROE the better. Return on Assets This ratio measures the effectiveness to which management is employing the firm's resources. The ROA measures the return that the company earned on its assets; it does not measure the return earned by an investor. Low ROA might indicate poor management ability. Low ROA may also indicate that further analysis of the firm's assets might reveal inefficient assets which can be disposed of and converted to cash. Operations Gross Profit Margin Stock Fraud Lawyer Attorney Share repurchases as an alternative to dividends. · IRS has tried to define "proportional" repurchases of shares as cash dividends for tax purposes (successfully); wants to define "regular" repurchases. Lintner on dividends; firm managers are: · Changes much more important than levels · Transitory earnings don't lead to dividend changes · Terrified of reversing a recent change in dividends Partial adjustment model. Dividend increases are good news--signal managerial optimism. Dividend Controversy · Right wing: increasing payouts raise value Stock Fraud Lawyer Attorney Small firms have done better since the mid-1960s than the CAPM would predict; firms with a high market-to-book ratio have done better than the CAPM would predict. CAPM pretty sensitively dependent to everyone diversifying. Other Theories: Consumption CAPM; risk premium oddly large APT--a bunch of different kinds of undiversifiable macroeconomic risk; oil price risk, inflation risk, recession risk, and so forth. APT doesn't tell you what the macroeconomic risk factors are. One such list: · Slope of yield curve · Level of short-run interest rate · Exchange rate · Real GDP |