BMC

Equities - Introducing the Stock Market

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Estimate discount rate or WACC

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The Yield Curve and Why It Matters

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When you buy an equity, the most you can lose is 100% and your potential gain is unlimited.

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Summary of absolute valuation

-Absolute valuation aka DCF -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 theoretically perfect -The outputs from absolute valuations are usually precisely wrong

Summary of equity research

-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 company results by comparing them to estimates

Widget Co. has a market capitalization of $125M. It does a 5-for-1 stock split. It then does a 1-for-25 reverse stock split. Finally, it does 35-for-1 stock split. Nothing else changes. What's the new market cap?

$125M

Monitoring GDP

-GDP estimation by governments is time-consuming, periodic activity. -GDP arrives too late to be useful to investors. -Instead, investors glean GDP growth through more timely indicators. -The indicators that are released first attract the most attention.

Absolute valuation

1. Understand historic performance, estimate long term future CFs 2. Estimate discount rate or WACC 3. Take estimated future CFs, discount CFs back using WACC 4. Deduct the firm's indebtedness and add the firms cash pile to derive market cap 5. Divide estimated market cap by shares outstanding to find share price.

Equities = stocks = shares

All the same thing

Why do company manager-owners smile when they ring the stock exchange bell at their IPO?

An IPO reveals the value of the manager-owner's stake

Why are equities volatile?

Due to the residual nature of earnings

Economic surprise monitor

ECSU

Terminal functions currency risk

ECTR - interactive trade flow map FXCA - currency conversion calculator PEG - table of currencies linked to other currencies BI - provides analysis and data on a series of tailored industry dashboards FXTF - library of the world's currencies FXC - matrix of currency exchange rates WCRS MAC - Big mac index identifying potentially overvalued or undervalued currencies IFMO - world inflation monitor FXFC - displays foreign exchange rate forecasts FX24 - displays currency pair trading 24/7 FXFM - an FX rate forecast model which displays a bell curve of implied volatility FRD - displays FX forward rates for currency pairs

What is a reason one discounts future CFs as part of the absolute valuation process?

Investors prefer cash flows today to cash flows in the future

Charging bull

Made after second stock market crash. 1989, artist.

Which of the following is most likely to be the most challenging part of this first step of the absolute valuation process?

Making the assumptions upon which to project future performance

Equities - Relative valuation

Metrics: dividend yield, P/E Application: self, peers, market

What does it mean when a company's corporate spread tightens?

The company's bonds are outperforming the benchmark yield Thus making is closer to the government bond

You are an analyst for a home-building company tasked with creating a financial model of home-building trends. Which of the following factors should your model address?

The price of wood products and long term interest rates

Which of the following is the biggest pitfall of economic indicators? -They only serve as proxies for economic activity. -They are generated by sources with their own biases and agenda. -They are not sufficiently timely to make informed investment decisions. -They do not employ a statistically relevant sample size.

They are not sufficiently timely to make informed investment decisions.

Bonds vs equities

Worst case for bonds is not getting any of your money back. But you do get coupons. Worst case for equities is losing 100%, best case is unlimited

Inflation

a general increase in prices and fall in the purchasing value of money.

Credit default swap

an insurance policy on the default risk of a corporate bond or loan higher the spread, higher the risk

Stock split

the division of a single share of stock into more than one share, when the think price is too high

ECTR

trade flow between countries

Differences between dividend yields and bond yields

-Dividends payments may vary while bond payments usually do not -Dividend yields are easier to calculate than bond yields

Summary of Stock Market

-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

How to estimate future company earnings

-Industry Classification -Suppliers and buyers -Revenue Projections -Cost base

Relative valuation summary

-Relative valuation is the quick and easy comparison of one 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 valuation

Summary of the nature of equities

-Shareholders own a share of company 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.

Summary of movements in the yield curve

-The far left of the yield curve is the overnight interest rate set by the central bank -The far right of the yield curve is driven primarily by inflation expectations. -While the left hand end of the yield curve is locked, the right hand end floats freely. -A steep yield curve signals improving times -A flat yield curve signals worsening times -An inverted yield curve often precedes a recession.

stock buyback

A company's purchase of shares of its own stock on the open market. Shows confidence in company

The importance of cash flows in the absolute valuation process is most similar to which of the following?

A fishery exceeding fish quotas, because it values short term income more than long term fishing stock

A luxury cell phone maker has a high fixed-cost base and a lot of debt. Which stakeholder in the company would you rather be?

A shareholder in a booming economy

What may be a problem of comparing the P/E of a stock to the P/E of the overall market?

A stock's P/E ratio can remain above or below market average for extended periods

GDP per capita is a measure of prosperity because it divides the total GDP of a country by its population. Which of the below forecasts for a country would result in the highest GDP per capita growth.

An increase of 2% in GDP and a population growth of 0%. (Want to find biggest difference in GPD to pop growth)

Which one of the following actors benefits when interest rates go up?

An investor who is about to buy bonds.

When yield curve inverts

Bad omen! 6/7 crises have had inverted curves.

Fixed income index

Bloomberg Barclays Aggregate. Bonds are much less volatile

What does the release of earnings announcements have in common with the release of economic indicators?

Both are scheduled in advance.

Investors who fear rising inflation may buy Treasury Inflation Protected Securities (TIPS). How do TIPS shield lenders from inflation?

By compensating investors for inflation

Which economic indicator is most directly linked to the average person's cost of living? PMI CPI Nonfarm payrolls GDP

CPI

What is the primary driver of the left hand end of the yield curve (Short term)

Central bank interest rates

What is the Fed's favorite inflation gauge?

Core PCE

Currencies

Currency Market Mechanics

FXC

Currency Rates Matrix

What do you think the Fed did with interest rates following 9/11

Cut interest rates

When an analyst is looking at a company for the first time, which of the following four activities does he do first?

Defines the industry or industries in which the company operates

A rise in which of the following inputs will increase an absolute valuation?

Earnings estimates

How is enterprise value calculated?

Enterprise value = market cap - cash + debt

Terminal functions movements in the yield curve

FOMS - shows Fed open market committee statements SRCH - an encyclopedia of bonds BUDG - provides data and analytics on the US fed budget YAS - yields and spreads on gov bonds DEBT - ownership stats of sovereign debt for select countries including the US GC3D - displays how a yield curve moves through time CAST - a visualization of issuer capital structure DDIS - visualization of issuer debt repayment schedules GY - a historic yield chart for a selected bond WB - monitors major sovereign bond yields and spreads WCDM - a country debt monitor analyzing the financial condition of countries for debt investors WIRP - shows the probability ascribed by the market to future interest rate decisions RATD - credit rating scales and definition from various debt rating agencies CSDR - displays real time credit ratings for sovereign borrowers CRPR - displays current and historical credit rankings by issuer from various rating agencies SOVR - a monitor of global sovereign credit default swap spreads GC - a visualization tool for real time and historic yield curves FXFC - displays foreign exchange rate forecasts IFMO - displays inflation tracking and data such as rates, targets, and forecasts GEW - shows key economic stats by country ECFC - displays economic forecasts ILBE - shows breakeven inflation rates derived from inflation protected securities FOMC - policy decisions, news, and analysis of the fed open market committee BYFC - displays gov bond yield estimates for various points in the future

Fixed income = fixed amount of money returned APR = yield

Fixed income DOES NOT EQUAL fixed APR Fixed income DOES NOT EQUAL fixed price

Which of the following important US economic indictors is only available on a quarterly basis? Nonfarm payrolls CPI PMI GDP

GDP

What is the prime reason that Jenny's discretionary income is more volatile than her salary?

Her mortgage payments and necessities are fixed.

Which of the following has the biggest impact on consumer goods during war times?

High inflation

Why do companies do IPOs?

IPOs incentivize entrepreneurs to innovate as IPOs provide a way for entrepreneurs to monetize their work.

Consider the GDP formula. A country is undergoing a boom in consumption of domestic and foreign luxury goods. In one year, the dollar growth in imports is greater than the dollar growth in domestic consumption. Assuming all else equal, what happened to GDP? -There is not enough info to tell -It went down -Stayed the same -It went up

It went down.

Legendary investor Warren Buffett said, "Gold gets dug out of the ground..... Then we melt it down, dig another hole, bury it again and pay people to stand around guarding it. It has no utility. Anyone watching from Mars would be scratching their head." Based on this quotation, what quality of gold is he referring to?

Its storage cost

Index weight %

Market cap of one stock / total market caps for all stocks in index

Unemployment

Measures the number of people who are able to work, but do not have a job during a period of time.

Reverse stock split

Occurs when a corporation calls in its stock and replaces each share with less than one new share; increases both market value per share and any par or stated value per share.

Stock Market Crash

October 29, 1929, Ervin Fisher said it was going to drop. After statement, the Dow ended up dropping 88%

Steep yield curve

Sign of an accelerated economy

What are the possible weaknesses of this peer approach to valuation?

The chosen peers might not be true competitors, the company might have multiple divisions, and the most appropriate competitors might not have P/E multiples

As a general rule, what percentage of debt to GDP will make a government's bond yields spike?

There is no general rule.

Why does the yield curve naturally slope upwards?

To compensate leaders for the greater risk of long-term loans compared to short-term loans

What was the primary goal of Abernomics?

To halt the vicious cycle of deflation

Repayment schedule worries - how aggressive the repayment is

Will the borrower have the principal when the payment is due at the end?

when interest rates increase, bond prices:

decrease if interest rates rise, investors will no longer prefer the lower fixed interest rate paid by a bond, resulting in a decline in its price. coupon going to increase to initial principal price decrease?

Were the two oil crises in the 1970s linked to deflation or inflation?

inflation

issue a bond

needing to borrow money

PEG

pegged currencies, Hong Kong dollar is pegged to dollar

XAU Currency Function GP

price of gold

Deflation

prices decline, consumers defer purchases to await lower prices, company revenues decline, companies let go to workers to cut costs (cycle continues)

What input do both absolute valuation and relative valuation typically require?

short term forecasts

Dividend Yield

steady income stream, cash payments dividend per share/price per share The dividend yield is a financial ratio that tells you the percentage of a company's share price that it pays out in dividends each year.

When investors doubt the creditworthiness of a borrower, how do they alter their calculation of the bond yield to take into account these doubts?

(Initial) Price goes down, yields go up They aren't going to give you that much money initially because they don't think they will give it back.

Central banks and interest rates

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The yield for the long term is dependent on the short term.

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Bond valuation

-A bond yield is just the interest rate on an equivalent bank account for the duration of the bond. -The three biggest factors driving bond yields are the creditworthiness of the borrower, inflation, and short term interest rates -The bond market instills discipline in governments as declining creditworthiness makes future borrowing more expensive. -Short term borrowing is cheaper but riskier for borrowers than long term borrowing as it relies on the ongoing appetite of lenders. -As repayments to bondholders are fixed, inflation will corrode the purchasing power of fixed bond repayments, sending yields up. -As US gov bond yields serve as benchmarks for all investments, yields on other bonds tend to move with them.

Forecasting GDP

-Annalists forecast key economic indicators. -Long term economic estimates are foundational to financial models -Changes in estimates illustrate economic optimism and pessimism. Significant changes in estimates may herald an economic turning point. -Investors compile many indicators, rather than one, to predict turning points.

Central Banks and Currencies

-Central banks controls the levels of the currency markets -The standard inflation target is 2% for industrialized nations. -Inflation can lead to a vicious cycle of pay increases leading to price increases. -Deflation can lead to a vicious cycle of purchase deferrals and layoffs.

Currency risk

-Currency movements can wreak havoc on corporations and investors -Historic volatility and currency rate forecasts shed light on currency risk. -Forward agreements lock in currency rates in the future, facilitating hedging and speculation. -The fact that gold is scarce and cannot simply be printed has meant that it has retained value.

Why choose bonds?

-Debt repayments lower taxes, corporate taxes. Being financed by debt has tax benefits. -Can borrow for longer periods w bonds than with banks

Essential economic indicators

-Economic growth -Inflation -Unemployment -Business confidence -Housing

Roots of the bond market

-Fixed income is another word for the bond market, where loan agreements are bought and sold. -The term fixed income stems from the fixed nature of bond repayments. -The growth of governments has been the main factor giving rise to the $101T world bond market -Investors view US gov bonds as the safest, most liquid financial asset in the world. There are millions of bonds outstanding and investors use yields to compare one bond to another.

The roots of the bond market

-Fixed income is the biggest market of the world. -About 100 trillion dollars -Sovereign debt market = government market is biggest -Who has lent us so much money? US have lots of debt. Japan and China owns the most. They own government bonds. -US government bonds are the safest asset on earth. Most liquid asset -In some ways, US gov bonds are like the piggy bank of the world. Everyone puts their money in US gov bonds.

Tools to assess currency risk

-Historic volatility of currency pair values -Analyst forecasts of currency pairs

Economic growth

-Measured by GDP - GDP = C + I + G + (X-M) - ECST function to see breakdown

Central bankers and interest rates

-Most central banks have a mandate to prevent runaway inflation and deflation -As inflation is corrosive to bonds, fixed income investors watch hawk-ishly for any signs of inflation -Central banks closely monitor inflation expectations and the output gap when making rate decisions. -Central banks contain inflation and deflation by directly changing interest rates or by altering interest rate expectations. -Over the past few decades, short term interest rates have been the tool of choice to steer economies.

Currency Market Mechanics

-Over $5T of currencies are traded every day. -1971 marked the dawn of the modern currency market -Several countries peg their currencies to other currencies to combat inflation and for stability -Locked exchange rates are not actually set in stone but are government aspirations -Floating currencies move against one another in a matrix -The US dollar is the world's reserve currency and is the most heavily traded currency.

The primary of GDP

-Real GDP growth is the main gauge of economic health. -Economic growth is cyclical, with a series of booms and busts. -Investors interpret the economy through economic indicators. -Leading indicators attract the most investor interest.

Currency Valuation Drivers

-The value of a currency is relative and not absolute -Trade-weighted baskets express currency overall strength and weakness. -In the long run, the law of one price drives currency values. -In the short run, these are three of the main drivers of currency valuation: surprise changes in interest rates, inflation, and trade

Summary of the yield curve and why it matters

-The yield curve represents the cost of borrowing for various loan lengths. -Yield curves are naturally upwardly sloping due to elevated risk of long term lending -Corporate bonds are priced using a spread off the government yield curve so the yield curve indirectly regulates company funding. -Consumer borrowing for big ticket items is priced off the yield curve. -Yields of developed economies are correlated, which means that the overall movement in yields has a global impact.

Which of these headlines is most likely to move a currency pair?

-US stocks sink on Fed's surprise increase of interest rates

What is the most common target inflation rate for an advanced economy?

2%

The purchase of which of the following products is most affected by interest rates?

Apartment

How do bonds work

Basically an IOU. Pay interest payments called coupons over a periodic x amount of time and then at the very end pay the principal back.

Why is the release of GDP statistics less interesting to investors than the release of other economic indicators? -Because the formula for GDP includes not only private investment but also other irrelevant factors -Because GDP is not official government data -Because governments consistently alter their GDP measurement methods -Because GDP are released well after other economic indictors

Because GDP statistics are released well after other economic indicators

Why does the US have a strong reputation for creditworthiness?

Because it has the right to tax the wealthiest population on earth

Why is fixed income called Fixed income? -Because bonds cannot rise in price over the life of the bond -Because current and future owners of a bond get the same effective annual interest rate -Because the price of the bond is fixed, given the safe haven nature of bonds -Because the repayment amounts and timings are fixed for ordinary bonds.

Because the repayment amounts and timings are fixed for ordinary bonds.

Fixed income

Bonds are considered _________ investments because a specified amount of interest is paid on a regular basis.

What is true of both the UK and US

Both countries are highly creditworthy.

Which of the following options is the best way for investors to manage currency risk? By vacationing each year in a country with a weak currency By locking in forward rates for known foreign payments By investing purely in very large stocks in their home market By investing in pegged currencies

By locking in forward rates for known foreign payments

In the U.S. why is there a strong relationship between unemployment and GDP? -As the economy booms, private investment, government spending, and net exports will cause GDP to rise, leading to unemployment. -Consumer spending accounts for two-thirds of the US economy. When the number of unemployed consumers rises, there is less consumer spending. -As the U.S. is a net exporter, exports go down when workers are unemployed. This is because there are fewer workers manufacturing products for the global markets. -In the US, government spending accounts for 17% of GDP. When unemployment rises, governments spend more on unemployment benefits. Therefore, GDP rises.

Consumer spending accounts for two-thirds of the U.S. economy. When the number of unemployed consumers rises, there is less consumer spending.

Why did the corporate spread significantly widen during the 2008 market crash?

Corporate bond issues go bankrupt more frequently than governments, as they do not have a tax base to fall back on in hard times.

What are the three main transmission mechanisms by which the yield curve effects the economy?

Corporate impact, global impact, consumer impact

Bond valuation drivers

Credit risk -debt/GDP -deficit/GDP -repayment schedule through credit ratings and credit default swaps Macroeconomics -short term interest rates and inflation

A drop in which of the following measures would typically send a government bond price down?

Creditworthiness

What is the primary reason for US gov bonds to ripple through the bond market?

Government bonds form a large portion of investor holdings, and corporate bonds are often priced relative to gov bonds.

In 2015, an accounting gimmick gave Ireland a 26% growth rate in GDP. what does this event reflect about the nature of GDP? -Because the GDP is official, its numbers are not subject to interpretation. -Governments are required to change GDP calculations every five years. -Inputs to GD{ are all qualitative, not quantitative -If the measurement of economic activity evolves, GDP can change.

If the measurement of economic activity evolves, GDP can change

The primary of GDP

Main measure of economic activity 8% compounded annual growth since about 1960

Terminal functions - forecasting GDP

NH - shows a real time scroll of news headlines ECST S - provides economic data with context and customizable graphs ECOW - provides comprehensive data on economic indicators by country. GP - price chart used to identify trends and market patterns WECO - shows economic calendars, events, and releases by country. ECOS - provides full details behind economist estimates for calendar releases. ECFC - displays economic forecasts for identifying trends in global economies. ECSU - estimates changes in the economy and financial markets.

If the yield on a fixed-coupon bond goes up, does the borrower have to pay more interest?

No, the price goes down. The payments are fixed.

Inflation

Nominal GDP growth - inflation = real GDP growth

What typically happens to nonfarm payrolls, the PMI indicator, and housing starts at the onset of a recession in the United States?

Nonfarm payrolls go DOWN, the PMI indicator goes DOWN, the housing starts goes UP.

Which of the following lines is the best leading economic indicator? -Nonfarm payrolls -PMI -Real GDP growth -U.S. auto sales

PMI

Where does one find inflation?

Quarterly GDP report: the whole economy is the data input, the inflation source is the GDP price deflator. Monthly CPI: Bureau of labor of statistics posts it, the data input is a average basket of goods and services, and the inflation source is the labor departments inflation report.

Corporate bonds have higher rates than the government, they amount a corporation will pay then the gov, the gap between curves

Referred to as the spread

WECO function

Shows you all economic releases of the world through the year.

Three of the main currency drivers

Surprise changes in interest rates, inflation, and trade

Which of the following are short term drivers of currency valuation

Surprise changes in interest rates, inflation, and trade

Core PCE

The Personal Consumption Expenditures deflator that has had the impact of food and energy costs removed.

An investor is comparing two bonds of similar structure from the same issuer. Which bond should the investor buy?

The bond with the highest yield if the two bonds have the same maturity date.

How do Credit Default Swaps work

The buyer can shift some or all that risk onto an insurance company or other CDS seller in exchange for a fee. By doing this, the buyer receives credit protection while the seller guarantees the creditworthiness of the debt security.

What generally happens when a central bank unexpectedly increases interest rates? -The currency weakens -The currency weakens, then strengthens. -The currency strengthens -The currency strengthens, then weakens.

The currency weakens

Which of the following qualities of economic indicators do investors prize the most? -Sample size -Government source -Timeliness of release -Rigor

Timeliness of release

What is the main reason that investment banks create estimates of economic indictors? -To hold governments accountable for management of their economies. -To increase real GDP growth by exporting their intellectual property to foreign investors. -To know when specific economic data points are a positive or negative surprise. -To determine in which countries the bank should operate

To know when specific economic data points are a positive or negative surprise.

Why would Jack Welch suggest putting all company plants on barges?

To respond quickly to changes in the currency markets

Treasury Inflation-Protected Securities (TIPS)

Treasury issues in which the principal amount is tied to the Consumer Price Index to protect the buyer against the effects of inflation Compensates lender is inflation occurs

What quality of US gov bonds causes investors to by them when market volatility rises?

US gov bonds are considered low risk.

Inflation cycle

Workers expect prices to increase, workers demand pay increases, company wages go up, companies raise their prices (cycle continues)

IFMO

World inflation monitor

What does the Big Mac index show?

a) How currencies may be overvalued or undervalued b) How the Economist magazine estimates inflation c)How the law of one price is true of consumer products d)How interest rates and inflation affect value How currencies may be overvalued or undervalued

10 year treasury

benchmark for entire world

Triangular Arbitrage

currency transactions in the spot market to capitalize on discrepancies in the cross exchange rates between two currencies, making money by exchanging one currency for another for another

FDTR index

federal funds target rate

FXFM index

fx rate forecast model in

Hot money

stocks of funds that are moved around the world from country to country in search of the best return

Term premium

the additional interest investors require in order to be willing to buy a long-term bond rather than a comparable sequence of short-term bonds

yield

the annual rate of return on a bond if the bond were held to maturity the longer the maturity, the higher the yield because the chances of the borrower going bust is higher, overall more risks so their return is naturally higher.