💲Intro to Investments Unit 5 – Equity Securities: Basics and Valuation

What Are Equity Securities?

• Equity securities represent ownership interest in a company, giving the holder a claim on the company's assets and earnings
• Most common type of equity security is common stock, which entitles the owner to vote at shareholders' meetings and receive dividends
• Equity securities contrast with debt securities (bonds), where the holder is a creditor of the company rather than an owner
• Holders of equity securities have the potential for capital appreciation if the company performs well and the stock price increases
• Equity securities carry higher risk compared to debt securities due to their lower priority claim on assets in the event of bankruptcy
• Companies issue equity securities to raise capital for growth, expansion, or other corporate purposes
• Equity securities can be bought and sold on stock exchanges, providing liquidity for investors

Types of Equity Securities

• Common stock is the most prevalent type of equity security, representing an ownership stake in a company
• Preferred stock is another type of equity security that typically offers fixed dividends and priority over common stockholders in the event of liquidation
  • Preferred stockholders generally do not have voting rights like common stockholders
• Warrants are equity securities that give the holder the right to purchase a company's stock at a specific price within a certain timeframe
• Convertible securities (convertible bonds or preferred shares) can be converted into a predetermined number of common shares at the holder's discretion
• Rights issues involve offering existing shareholders the opportunity to purchase additional shares at a discounted price
• Employee stock options are a form of equity compensation that allows employees to buy company stock at a predetermined price
• Restricted stock units (RSUs) are another type of equity compensation where employees receive company stock upon meeting certain vesting conditions

Stock Markets and Exchanges

• Stock markets facilitate the buying and selling of equity securities, enabling companies to raise capital and investors to trade shares
• Stock exchanges are organized marketplaces where stocks are traded, such as the New York Stock Exchange (NYSE) and Nasdaq
• Over-the-counter (OTC) markets are decentralized networks where stocks not listed on major exchanges are traded
• Stock markets provide price discovery through the interaction of buyers and sellers, determining the market value of a company's shares
• Exchanges have listing requirements that companies must meet to have their stocks traded, such as minimum market capitalization and financial reporting standards
• Market participants include individual investors, institutional investors (mutual funds, pension funds), and market makers who provide liquidity
• Stock markets are regulated by government agencies (Securities and Exchange Commission in the US) to ensure fair and transparent trading practices
• Advances in technology have led to the growth of electronic trading systems and algorithmic trading

Fundamental Analysis Basics

• Fundamental analysis involves evaluating a company's financial health, management, competitive advantage, and growth prospects to determine its intrinsic value
• Analysts review a company's financial statements (income statement, balance sheet, cash flow statement) to assess its profitability, liquidity, and solvency
• Earnings per share (EPS) is a key metric used in fundamental analysis, calculated by dividing a company's net income by the number of outstanding shares
• Price-to-earnings (P/E) ratio compares a company's stock price to its EPS, indicating how much investors are willing to pay for each dollar of earnings
  • A high P/E ratio may suggest that investors expect strong future growth, while a low P/E ratio may indicate undervaluation or slower growth expectations
• Dividend yield, calculated by dividing the annual dividend per share by the stock price, is another important consideration for income-oriented investors
• Analysts also assess a company's competitive position within its industry, considering factors such as market share, barriers to entry, and product differentiation
• Management quality is evaluated based on the track record of key executives, their strategic vision, and their ability to allocate capital effectively
• Fundamental analysis incorporates both quantitative (financial ratios) and qualitative (management quality, industry trends) factors to arrive at an investment decision

Valuation Methods for Stocks

• Discounted cash flow (DCF) analysis estimates a stock's intrinsic value by discounting future cash flows to their present value using a required rate of return
  • The required rate of return reflects the investor's opportunity cost and the perceived risk of the investment
• Dividend discount model (DDM) is a valuation method that calculates the present value of a stock's expected future dividends
  • The Gordon Growth Model, a variant of the DDM, assumes a constant dividend growth rate in perpetuity
• Relative valuation methods compare a stock's valuation multiples (P/E, price-to-sales, price-to-book) to those of its peers or industry averages
  • These methods assume that similar companies should trade at similar valuation levels, helping identify potential over- or undervaluation
• Asset-based valuation methods estimate a company's value based on the fair market value of its assets minus its liabilities
  • This approach is more relevant for companies with significant tangible assets, such as real estate or natural resource firms
• Earnings power value (EPV) is a valuation method that estimates a company's sustainable earnings and applies a multiple based on its risk profile and growth prospects
• Valuation methods are not mutually exclusive and are often used in combination to arrive at a comprehensive assessment of a stock's intrinsic value
• Valuation is as much an art as a science, requiring judgment and assumptions about future growth, risk, and market conditions

Key Financial Ratios

• Financial ratios help investors and analysts evaluate a company's financial performance, liquidity, solvency, and valuation
• Profitability ratios measure a company's ability to generate profits relative to its sales, assets, or equity
  • Examples include gross margin, operating margin, net profit margin, return on assets (ROA), and return on equity (ROE)
• Liquidity ratios assess a company's ability to meet its short-term obligations using its current assets
  • Current ratio (current assets / current liabilities) and quick ratio (liquid assets / current liabilities) are common liquidity ratios
• Solvency ratios evaluate a company's ability to meet its long-term debt obligations
  • Debt-to-equity ratio (total debt / total equity) and interest coverage ratio (EBIT / interest expense) are key solvency ratios
• Valuation ratios compare a company's stock price to its earnings, sales, or book value to assess its relative valuation
  • Price-to-earnings (P/E), price-to-sales (P/S), and price-to-book (P/B) ratios are widely used valuation metrics
• Efficiency ratios measure how effectively a company uses its assets and manages its liabilities
  • Examples include asset turnover ratio (sales / total assets) and inventory turnover ratio (cost of goods sold / average inventory)
• Dividend-related ratios, such as dividend yield (annual dividend per share / stock price) and dividend payout ratio (dividends / net income), are important for income-oriented investors
• Ratios should be analyzed in the context of a company's industry and peers, as well as its historical performance, to identify trends and potential red flags

Market Efficiency and Stock Pricing

• Market efficiency refers to the degree to which stock prices reflect all available information about a company and its prospects
• Efficient Market Hypothesis (EMH) suggests that stock prices quickly adjust to new information, making it difficult for investors to consistently outperform the market
  • EMH has three forms: weak (prices reflect historical data), semi-strong (prices reflect all public information), and strong (prices reflect all public and private information)
• Behavioral finance challenges the EMH, arguing that investor psychology and biases can lead to mispricing and inefficiencies in the market
  • Examples of behavioral biases include overconfidence, herding, and loss aversion
• Anomalies, such as the small-cap effect (small companies outperforming large ones) and the value effect (undervalued stocks outperforming growth stocks), suggest that markets may not always be perfectly efficient
• Fundamental analysis and technical analysis are two approaches investors use to identify mispriced securities and make investment decisions
• Market sentiment, which reflects the overall attitude of investors towards the market or a specific stock, can influence short-term price movements
• Stock prices are also affected by macroeconomic factors, such as interest rates, inflation, and economic growth
• The degree of market efficiency can vary across different markets and asset classes, with some being more efficient than others

Risks and Returns in Equity Investing

• Equity investing involves various risks that investors must consider when making investment decisions
• Market risk, also known as systematic risk, refers to the potential for losses due to overall market fluctuations
  • Diversification across different sectors and asset classes can help mitigate market risk
• Company-specific risk, or unsystematic risk, is the risk associated with investing in a particular company
  • This risk can be reduced through diversification across multiple companies and sectors
• Liquidity risk is the risk of not being able to buy or sell a stock quickly at a fair price, which can be a concern for small-cap or thinly-traded stocks
• Political and regulatory risks can impact stock prices, especially for companies in heavily regulated industries or those with significant exposure to certain countries
• Inflation risk is the risk that rising prices will erode the purchasing power of investment returns over time
• Currency risk is a consideration for investors holding foreign stocks, as exchange rate fluctuations can impact returns when converted back to the investor's home currency
• The risk-return tradeoff is a fundamental concept in investing, suggesting that higher potential returns come with higher levels of risk
• Investors can manage risk through diversification, asset allocation, and risk management techniques such as stop-loss orders and hedging strategies