SU4- Financial Investment & Asset Valuation
Financial investment basics
Common investment classes
Market
Factors
Company
Valuation methods
Fixed-income securities
Risks
Derivatives
Assets
Markets
Types
Tangible
Real
Intangible
Financial
E.g. securities (stocks, bonds), derivative contracts (value dependent on agreed upon financial asset's value), cash
Physical nature
E.g. real estate (land), equipment, commodities, natural resources, infrastructures
High liquidity
No physical form
E.g. patents, copyright, trademarks, intellectual property
Valuation- depends on cash flow generation potential
Types
Debt- promise to repay borrowed funds e.g. bonds, certificates of deposit
Equity- ownership in an entity e.g. common, preferred stock
Transaction mode
Publicly (regulated) traded- listed/traded on exchanges, OTC or phone/internet, through security dealers
Privately (non-regulated) traded- often illiquid, transacted by licensed investment representation
Spot market- where financial instrument delivered when traded
Future delivery- thru contracts (e.g. forwards, futures, options)
Primary market- for newly issued securities
Secondary market- for subsequent security sales
Money market- for debt securities with short-term maturities
Capital market- for longer-term debt securities/equities without specific maturity date
Main categorisation
Securities- provide lenders protection against defaults e.g. fixed income (bonds, notes), equity, pooled investment vehicles (mutual/hedge funds)
Contract- right to goods/service payment e.g. futures, forwards, options, swaps, insurance
Commodities- basic goods/raw materials used as input to produce other goods e.g. agricultural products (grains), industrial/precious metals (gold), energy products (electricity, oil, natural gases)
Currencies
Positions
Long (buy)- current/future ownership; expects asset value increase
Short- agreement to sell/deliver asset; expects asset value decrease
Short-sell- sell borrowed stock
Equity
Common stock
Preferred stock
Warrants
Public equity- accessible to general public
Private equity- issued to institutional investors via private placement
Types
Leveraged buyout
Private investment in public equity (PIPE)
Residual claim on firm's assets
Dividends- paid only after debtholder, preferred stockholder
Voting rights
Board of directors
Management decisions
Common stock-like features- shares do not mature
Debt-like features- periodic dividends
Priority- before common stock holders
No voting rights
Can have put/call features
Vs. options
Similarity- right to buy firm's equity at fixed exercise price
Differences
Directly issued by company itself (instead of 3rd pt)
Traded OTC rather than in exchange
Issue new (not existing/recycled) stocks upon exercise
No dividends, voting rights
Characteristics
Less liquid
Weaker corporate governance- less reporting requirements
No public scrutiny- firm can focus on long-term development (potentially greater return)
Venture capital
Capital provided to start-ups in early life cycle, funding development
Fund commitment- typically 3-10 years before getting return
Investors- commonly family, relatives, private equity funds
Investors buy firm's equity using borrowed money
Firm's assets
Collateral for investor's loan
Undervalued- can be used to pay loan over time
Public firm (urgently needs capital)- sell stocks to private investors, often at a discount below market price
Share price- negotiated btw offering firm and investors (not market-determined)
Market vs book value
Market value- based on market perception of firm's (current/potential/future) performance
Book value- based on management's decisions (E = A - L)
Industry
Environment
Determines
Peers
Industry avg
Trend
Classification
By products/service offered
By government bodies' determined categorisation e.g. SGX listed companies follow Singapore Standard Industrial Classification (SSIC)
Demographic (population characteristics e.g. age, education, income)- affects preferences, buying behaviours
Govt
Tech- changes goods/services delivery way e.g. automation, internet connectivity, digital/social media, telecomm
Social- spending behaviour, way of living
Macroeconomic (economy aspects e.g. GDP, inflation/interest/unemployment rate)- affected by political stability, natural disasters, trade regulation changes, demand
Regulation e.g. taxes, trade control, subsidies, import/export regulations
Stability
Analysis- of internal strengths, weaknesses
Profile
Financial condition
Products/services
Demand, supply
Pricing
Competitive strategy
Discounted CF models- find investment PV based on future CF using discount rate
Relative valuation measures- value comparison
Dividend discount model (DDM)
Free cash flow to equity (FCFE)
Asset-based models- focuses on firm's net asset value (E = A - L)
Predicts stock price
Based on future dividend (per share) discounted back to PV
CF that can be distributed to common shareholders; excess cash after meeting all debt obligations, expenditures
Time series- historical avg as benchmark
Cross-sectional- industry avg as benchmark
Commonly compared indicators e.g. P/E ratio, operating margin
Limitation
Asset market value- hard to obtain
Problematic for firms with many intangible assets
Ignores prospective earnings
To supplement with other valuation methods
Useful when planning for liquidation
Characteristics
Term
Short (1-2 years) e.g. commercial paper
Intermediate (2-5 years) e.g. treasury notes
Long (5-10 years) e.g. bonds
Eventual principal repayment upon maturity
Period of steady income- periodic interest payment
Credit-rated (by agencies like S&P, Moody's)- range from AAA (most creditworthy) to D (default)
Some govt-guaranteed e.g. treasuries
Exchange rate risk- for foreign currency denominated
Interest rate risk- interest rate flux affects such market value of such securities
E.g. bonds
Characteristics
(Inherent) credit risk- default of interest/principal
If interest rate (hard to predict) drops, bond price increases
Additional reinvestment risk (finding alternative investment with same/higher interest rate)- for callable bonds where issuer has right to repurchase/retire bond
Price determination factors
Bond issuer
Par/face/redemption value (principal amt repaid upon maturity)
Maturity (date principal repayable)- fixed
Coupon payment
Call provision
Currency
Less credible- typically higher expected return rate as compensation
Issuing entities
Corporations
Govt
Sovereign national govt
Non-sovereign e.g. state govt
Quasi-govt
Supranational- global organisations e.g. World Bank
Financial
Non-financial
Affects credit/default risk
Bond price- always quoted as a % of the par value
When BP > par value- trading at premium
When BP < par value- trading at discount
When BP = par value- trading at par
Term to maturity/tenor- time remaining until maturity; remaining life
No maturity date- perpetual bonds (has steady interest stream forever but no principal repayment)
Coupon rate- expressed as a % of par value
Zero-coupon bonds
No interest payment prior to maturity date
All interest paid on maturity
Always sold at discount (lower than par value)
Fixed, periodic interest payment
If exercised
Issuer (repurchase/retire bond)
Flexibility to pay off debt earlier
Protection against interest rate risk
Higher interest rate offered as compensation
Investor loses interest income (reinvestment risk)
Exchange rate- fixed at purchase time
Dual-currency bond- coupon + principal in different currencies from each other
YTM- determines interest/discount rate premium
Analysis
Valuation
Zero-coupon- PV of par value (upon maturity)
PV of future CF/coupon payment + par value (upon maturity)
Discount rate concepts
EAR vs APR
Current yield
Bond equivalent yield- 2x semi-annual discount rate
YTM
YTC (yield to call) value
Duration
EAR (k)- actual return accounting for compounding
APR (r)- quoted rate not accounting compounding
Annualised coupon rate- reflects bond profitability relative to others
Annual coupon rate/current bond market value
Anticipated return (required rate of return)- discount rate that will make PV = current value, accounting for coupon payment reinvestment at a constant interest rate
YTM (accounts for compounded interest) vs. current yield (based on dividends)
Calculated thru trial-and-error
Lower YTM- higher price
For callable bonds
Valuation- assume bond gets called at call price
Time to regain bond price by total CF/initial investment; time needed for investor to be repaid
Measures interest rate risk (bond price sensitivity to interest rate changes)
Macaulay duration- weighted avg term to maturity
Weights- PV of each CF divided by bond price
Modified duration- measures interest rate sensitivity for small interest rate changes; effect of 1% changes in interest rate on bond price
Zero-coupon bond- duration = remaining life (thus, higher interest rate risk)
Types
Options
Positions
Call- buy
Put- sell
Sell option (option writer)- obligated to
Buy option- right to
Forwards
Futures
Swaps
Allows buyer right (not obligation) to buy/sell underlying asset at a given/strike price within specific period
Option premium- option price
Seller (option writer)- obligated to perform upon exercise
Customised futures
Traded OTC
Parties agree on asset specific price on future specific date
Function- hedge against underlying asset price changes
No payment until the specified future date
Types
Deliverable- delivers the actual underlying asset
Cash settled/non-deliverable (NDFs)- difference btw forward + market price of underlying asset paid in cash to other party
Standardised
Traded on exchange- more regulated
Counterparty- clearinghouse (removes counterparty risk) in exchange for a margin (initial and maintenance)
Series of forwards
No payment upon contract, only on the specified/settlement date
Not traded on secondary market
Unregulated- default risks
Participants- institutions
Valuation
Moneyness (if exercise)
Positive payoff- options is "in the money"
Negative payoff- "out of the money"
Current asset price = exercise price- "at the money"
Payoffs (at expiration)
Need to determine firstly if call / put option
Type indicator
Put- -1
Excel function: Max(0, type indicator x (stock price - strike price))
Call- +1
Factors affecting price
Underlying asset
Price
Volatility
Risk-free interest rate
TIme to expiration
Cost, benefits of holding asset
Exercise price
Pricing models
Black-Scholes
Binomial option
Black-Scholes-Merton (BSM)
Usage- European options with dividends
Usage- European options without dividends
Usage- American options
Iterative approach- 2 possible outcomes (price up/down) at each
Binomial tree
Starts with stock price
Shows different possible security price over time