chapter 11: valuation chapter 12: microstructure ecn 324 financial markets & institutions dr....

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Chapter 11: ValuationChapter 12: Microstructure

ECN 324Financial Markets &

Institutions

Dr. David P. Echevarria

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Benjamin GrahamThe essence of Graham's value investing is that any investment should be worth substantially more than an investor has to pay for it. He believed in thorough analysis, which we would call fundamental analysis. He sought out companies with strong Balance sheets, or those with little debt, above-average profit margins, and ample cash flow. (Securities Analysis, 1934, written with David Dodd)He coined the phrase "margin of safety" to explain his common-sense formula that seeks out undervalued companies whose stock prices are temporarily down, but whose fundamentals, for the long run, are sound. The margin of safety on any investment is the difference between its purchase price and its intrinsic value. The larger this difference is (purchase price below intrinsic), the more attractive the investment - both from a safety and return perspective - becomes. The investment community commonly refers to these circumstances as low value multiple stocks (P/E, P/B, P/S).



John Burr Williams

One of the first economists to view stock prices as determined by “intrinsic value”, is recognized as a founder and developer of fundamental analysis. He is best known for his 1938 text "The Theory of Investment Value", based on his Ph.D. thesis, which was amongst the first to articulate the theory of Discounted Cash Flow (DCF) based valuation, and in particular, dividend based valuation.



Nassim Taleb

“The Black Swan”The black swan theory or theory of black swan events is a metaphor that describes an event that comes as a surprise, has a major effect, and is often inappropriately rationalized after the fact with the benefit of hindsight.1.The disproportionate role of high-profile, hard-to-predict, and rare events that are beyond the realm of normal expectations in history, science, finance, and technology2.The non-computability of the probability of the consequential rare events using scientific methods (owing to the very nature of small probabilities)3.The psychological biases that make people individually and collectively blind to uncertainty and unaware of the massive role of the rare event in historical affairs



MPT and CAPM

MPT: Modern Portfolio TheoryTwo Sources of Risk: Variance & Covariance

CAPM: Capital Asset Pricing ModelTwo Sources of Risk: Market, Firm-Specific

Valuation ModelsGordon Growth: Dividend growth, RRORPrice/Earnings ratio: attractiveness of earnings



Questions to Answer

What is the difference between the MPT and CAPM in terms of risk measurement?What are the principal determinants of stock price movements?


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BROKERS

C.Brokerage AccountsCash account

Pay full cost of all securities purchased3 business day settlement

Margin accountFinance portion of purchases (interest charges)Same day settlementMargin Calls

Securities Investor Protection Corporation SIPC

Insures brokerage accounts up to $500,000Does not cover market losses


MARKET TRADING DYNAMICS

Market OrderBuy or sell at the best current priceSettlement in three business daysRound lot = 100 shares, Block = 10,000+

Limit OrderPuts a limit on priceTime period can vary: day, GTC

Stop OrderBecomes order if price reaches specified priceNo guarantee of execution at specified price


MARKET TRADING DYNAMICS

D.Long PositionExpectation - market heading higherPurchase stock via market order at the AskPurchase stock via limit order at specified price

E.Selling ShortExpectation - market heading lowerStock borrowed from broker Profits on drop in pricesNYSE uptick rule discontinued


REGULATION OF FINANCIAL MARKETS

Securities Act of 1933Registration of securitiesProspectus required - full and fair disclosure

Securities Act of 1934Securities and Exchange Commission (SEC)Insider trading prohibitedReporting requirements - form 10-K (EDGAR)

State regulationsBlue sky laws - vary by state


HOMEWORK QUESTIONS

1. How cash accounts differ from margin accounts?

2. What happens when you get a margin call from your broker?

3. How does a trader earn profits in a short sale? Long position?

4. What was the primary purpose of the 1933 Securities Act? 1934 Act?

5. What does the SEC’s EDGAR system do?

chapter 11: valuation chapter 12: microstructure ecn 324 financial markets & institutions dr....

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