financial services
WEN.XU
lecture_5_notes.pptxLecture 5
Stocks and Investment Funds
By
Dr Jacinta Nwachukwu
Principal Lecturer in Finance
School of Economics, Finance and Accounting
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Learning Outcomes
1. The key characteristics of shares
2. Understanding share price information
3. The use of dividend valuation model to estimate the intrinsic value of a stock
4. The use of the Capital Asset Pricing Model (CAPM) equation to calculate the required rate of return for a security
5.The concept of beta coefficient
6.The types of investment funds commonly used to pool a wide range of financial securities into a well-diversified portfolio
7. Appreciate the importance of investment funds to individual investors
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Lecture Outline
Types of stocks
Reading stock market information
World stock indices
Stock valuation model
The capital asset pricing model
The beta coefficient
Types of investment funds
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Types of stocks
Common stock
Preferred shares
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Preferred Stock
A preference stock is seen as a hybrid of bond and equity share capital.
Like bonds, preferred stock has a constant stream of dividends which must be paid before dividends are given to common shareholders.
Like bonds, they have the advantage of a higher priority claim to a firm’s assets in case of bankruptcy
However, unlike interest payments to debt security holders, the company management can omit preferred dividends without running the risk of bankruptcy, although most preferred share dividends are cumulative
This means that the firm will have to pay the accumulated sum of all omitted preferred dividends before dividends can be paid to common stock holders
For non-cumulative preferred shares, unpaid dividends are lost to shareholders who have no right to claim them in the future
Then too, unlike holders of equity stock, preferred shareholders do not normally benefit from increases in the profits and asset values of the corporation
Moreover, holders of preferred shares do not normally vote unless the company defaults on its contractual dividend payments
A significant proportion of preferred shares have a provision which allows the holder to convert them into a stated number of common stocks
Preferred dividends are sometimes exempted from income tax, meaning that their after-tax yield to institutional investors with high tax rates may be greater than on bonds.
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Common Stock
A share of common stock represents an ownership interest in a firm and allows the holder to receive dividends as well as capital gains if the quoted market price of the stock goes up
However, the liabilities of common stockholders in a limited company are confined to the amount of money they have put into the company
This means that only money invested in the company can be lost unless the shareholders have given personal guarantees for the debts of the business
The owners of common stock in a firm normally have the right to:
(i) Vote at a formal annual general meeting on a range of strategic and policy issues, including the election and sacking of board members and managers who are underperforming
(ii) Partake in the distribution of profits of the enterprise. However, the stockholder is a remnant claimant
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2. Reading stock market information
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Reading stock market information
| High | Low | Company | Price | Yld | P/E | |
| 19.0 | 11.5 | Ashley L | 17 | ….. | 7.4 | 12.9 |
| 431.4 | 321.9 | Marks and Spencer | 390.2 | + 6 | 4.1 | 20.0 |
| 307.1 | 255.0 | Morrison | 280.0 | + 3.9 | +3.0 | 12.9 |
| 2361 | 1816 | Next | 2083 | …. | 3.5 | 11.0 |
| 454.9 | 368.4 | Tesco | 428.3 | +85 | 3.2 | 15.8 |
Table 1 shows some of the information on shares frequently reported in financial newspapers. These are used by investors to analyse stocks before they buy or sell them.
Task: You are required to explain to meaning of the items in the table to a novice investor
Table 1
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3. World Stock indices
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Table 1: World Stock Markets (Feb 12. 2013)
| Region/Country | Index Name | Close | 52-Week %Change |
| World | Dow Jones Global Index | 273.36 | 9.7 |
| Australia | All Ordinaries | 4981.50 | 15.3 |
| Brazil | Sao Paulo Bovespa | 58497.83 | -8.6 |
| Canada | S&P/TSX ComP | 12789.02 | 3.5 |
| China | DJ CBN China 600 | 22861.92 | 9.1 |
| France | CAC 40 | 3686.58 | 9.2 |
| Germany | DAX | 7660.19 | 13.9 |
| Hong Kong | Hang Seng | 23215.16 | 11.7 |
| Japan | Nikkei Stock Avg | 11369.12 | 25.6 |
| Singapore | Straits Times | 3270.30 | 10.5 |
| United Kingdom | FTSE 100 | 6338.38 | 7.4 |
| United States | S & P 500 | 1519.43 | 12.5 |
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The Major International Stock Markets
Average 2000-2005 Australia Brazil Canada China France Germany Greece Hong Kong SAR, China India Italy Japan Nigeria Russian Federation Singapore South Africa Spain United Kingdom United States 1.6705036352809479 0.79942897415308611 2.8764770921555396 1.8617834543635203 4.1914653519886738 3.3118178251753774 0.32632408697884968 1.7769440050097625 0.81654505638444719 2.0186540887562039 9.6345146847840901 2.9777341860897748E-2 0.65275357809791834 0.60628983125108638 0.92233649815686092 2.0619803700672614 7.5796141411659992 44.451221732981161 Average 2006-2011 2.3283771562292848 2.2055251966302238 3.5478116505943125 8.2067109537934062 4.0554816814444514 2.9227058856873196 0.24168226886612953 2.0917868372886419 2.3660157451165906 1.2297525496153154 7.8106714710989333 9.7538959166141762E-2 1.8743251507049221 0.60002089959527294 1.5385362688972468 2.5244981925394376 5.5399805064682175 33.008434637912146Share of world stock market
3. Stock valuation: Using the Dividend Capitalisation model
Common shares
Preference shares
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The Valuation of Common Stock
The pricing of common equities is more complex than the valuation of bonds
This is because the income stream from equities is normally unknown and there is no maturity date as in the case of bonds
Generally speaking, holders of common shares expect a return from their investment in two ways during the holding period:
1. A stream of dividends
2. An increase in the value of the shares (capital gains)
Both sources of income; dividend and selling prices of stocks; are unknown at the time of purchase
The characteristics of the dividend capitalisation model which is commonly used in the valuation of stock is summarised in the chart 1
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Chart 1: The Dividend Capitalisation Model
t = 0
t = 1
t = 2
t = 3
T = n
DIV0 = X0
DIV1 = X1
DIV2 = X2
DIV3 = X3
DIVn = Xn
Expected selling price = Pn
k = cost of common equity
T = n
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The Dividend Capitalisation Model
According to the principle of present value, an investor who plans to buy a stock today and sell it in one year, should expect to receive a selling price equal to:
If the investor plans to hold the stock for 2 years, the current market price of the stock is equal to:
Extending the formula for an investment horizon of years. The equation becomes
What if the investor wants to hold the stock indefinitely?
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The DCM for an Indefinite Time Period
The equation for an indefinite investment horizon is:
Where
Substituting the value of dividends, the stock valuation equation becomes
To simplify the calculation, it is assumed that as gets bigger, the present value of the cashflows in the distant futures approximates to zero. This turns the PV equation into:
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Applying the dcm
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Applying the Dividend Capitalisation Model
Two immediate issues with the DCM equation are:
1. The dividend stream is uncertain
There is no specified number of dividends, if in fact they are paid at all
2. The dividends for most companies are expected to grow over time.
Thus, analysts normally assume different dividend growth rate cases
(i) A zero-growth rate,
(ii) A constant-growth rate and
(iii) A multiple growth rate
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The zero-growth rate DCM
A dividend stream with a zero-growth rate means that fixed dollar (or any other unit of currency) dividend is paid every time a dividend payment is declared
That is: each periodic dividend is equal to the current dividend and that this is being paid every year from now to infinity
Thus, the zero growth dividend case reduces to a perpetuity
The DCM equation simplifies to:
To illustrate, we suppose that:
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The constant growth rate DCM
Contrary to the assumption in the zero growth rate DCM, most companies paying a dividend expect that dividend to grow over time.
In the constant growth rate model, the future dollar amount of dividends which are to be subsequently discounted are expected to grow at a constant growth rate over a long period of time.
The constant growth rate DCM is expressed as:
To illustrate, we suppose that:
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4. The capital asset pricing model (CAPM)
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4. The capital asset pricing model (CAPM)
The CAPM formally relates the expected rate of return for any security or portfolio of financial assets with the relevant risk measure as represented by the following equation
Where:
= The required rate of return on the security
= The beta coefficient for security
= The expected rate of return on the market portfolio
Overall the CAPM equation states that the return which investor require from financial securities is a function of two primary components
(i) The risk free rate
(ii) The risk premium which rises with the perceived risk as measured by the beta coefficient.
Hence, according to the CAPM equation, the greater the risk of a security, the greater the return investor’s would require
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Something to think about
Assume that the beta for Tesco PLC is 1.15. Also assume that the risk free rate is 5 percent and that the expected return on the market is 12 percent.
Calculate the CAPM required rate of return for Tesco PLC
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Over-Under valuation of securities
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Under and Over-valued Security
Beta Coefficient
Z
Expected return
X
Y
Z
Undervalued
Overvalued
Currently priced
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Under valuation of securities
The CAPM required rate of return is equal to the equilibrium rate needed to compensate investors for the relevant risk (i.e., systematic) undertaken in holding security .
A security is said to be under-valued if the expected return is greater than the CAPM required rate of return
This is because the security offers more expected return than investors require, given its level of risk
According to the CAPM equation, investors require a minimum return equal to , but the security is expected to offer a higher
Investors will purchase security , driving up the price
Such will lead to a fall in expected return until its value equals the CAPM required rate and the security is once again in equilibrium
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Over-valued security
A security is said to be over-valued if the expected return is lower than the CAPM required rate of return
This is because the security does not offer enough expected return, given its level of systematic risk
According to the CAPM equation, investors require a minimum return equal to , but the security is expected to offer a lower
As investors recognise this discrepancy, they will sell the security , driving down its price
Such will lead to an increase in its expected return until its value equals the CAPM required rate and the security is once again in equilibrium
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The Concept of Beta (Systematic or Covariance Risk)
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The Beta Coefficient
The Beta coefficient is a measure of risk relating the covariance of a security to its covariance with the market portfolio.
The formula for the Beta of an asset is:
For Tesco PLC, we assume that:
Standard deviation of Tesco stock = 6.01% per annum
Standard deviation of Market portfolio =4.71% per annum
Correlation between Tesco and Market portfolio = 0.58
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Table 1: Estimated beta coefficients in 2005
| Shares | Estimated Beta |
| Barclays Bank | 1.01 |
| Sainsbury’s | 0.93 |
| Marks and Spencer | 0.48 |
| BT | 1.58 |
| General Motors | 1.25 |
| Microsoft Corporation | 0.44 |
| Amazon.com | 1.82 |
| Coca-Cola | 0.34 |
| Heinz | 0.11 |
| Dell Computers | 1.41 |
| Merrill Lynch | 1.51 |
| Procter and Gamble | 0.28 |
Note: A Beta of 1.58 for BT, for example, indicates that the expected return on the company will rise by 1.58 percent following a 1 percent rise in the market portfolio
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5. Investment funds
This refers to the buying and selling of the shares of an investment company, that in turn, uses the money received to buy portfolio of securities of traded companies.
There are typically four distinct types of investment company
1. Unit trusts
2. Investment Trusts (Close-end fund)
3. Open end-funds (i.e., OEICs)
4. The exchange traded funds (ETF)
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Unit Trusts/OEICs
These are firms normally banks, investment and insurance companies, which are set up to buy shares in other companies. Individual investors are then invited to buy units in the fund operated by OEIC fund managers.
The price paid is the Net Asset Value of the institution.
NAV is the total market value of all the assets owned by the investment company minus liabilities (divided by the number of shares issued by the investment company).
The term “Open ended” means that the number of shares in OEICs are not fixed. They can rise or fall depended on the sale or purchase or units by investors.
OEICs are bought and sold directly from the fund manager at an administrative value which is equal to the NAV of the fund.
The continuing inflows and outflows of money into OEICs generated by retail investors can cause OECIs mangers to be active buyers and sellers in shares listed on the stock exchange. As a result, OECIs managers have a significant effect of stock market prices. See the Weblink below for the examples of OECIs traded on the UK stock exchange
http://www.morningstar.co.uk/uk/
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Types of open end funds
Expected return of funds
Risk
Money market fund
Bond funds
Hybrid (bond and stock) funds
Large cap funds
Small cap funds
Specialised stock funds funds
International stock funds
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Investment Trusts/ Close Ended Funds
Investment trusts or close ended firms again are companies (banks, insurance or investment firms) whose main purpose is to investment in other firms.
Individual investors buy units in the close-ended firm.
The purchase of close ended funds take place through the stock market. Such transaction has no effect on the size of the fund and does not require the involvement of the active fund manager
The fact that active fund managers are not needed for closed ended funds means that close ended funds can include a variety of asset classes and different income classes.
They are said to sell at a discount when market price less than the NAV of investment trust's total assets. It is said to sell at a premium if the market price is higher than the NAV of the investment trust.
Closed ended funds have maturity dates. The funds can be bought and sold until the trust matures. On the maturity date of the fund, the component investments are sold and the capital returned to the investors.
Investment funds can borrow extensively to buy shares. Such increase in gearing means that the price of investment trusts is more volatile than OEICs, which are only able to borrow up to ten percent of the fund.
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Unit Trusts/OEICs vs Investment Trusts
Unit Trusts/OEICs
Mutual Funds run by a professional manager who can advertise and sell units directly to the general public
Open ended number of shares
Restrictions on borrowing
Administrative valuation
No discounts/premiums
Investment Trusts
Listed company on the stock exchange
Closed number of share
Unlimited borrowing
Market valuation
Discounts/premiums
Has a financial end date
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Exchange Traded Funds (ETFs)
Open-ended funds that trade on stock markets.
Usually index tracker funds that replicate stock indices such as FTSE 100 or FTSE all shares that are sold on the stock exchange, index funds (stocks, bonds, commodities).
Unlike conventional OEICs which have to be purchased directly from their managers at the prices which are established once a day at a stated time at the end of each trading day, ETFs have the advantage of being traded at prices that continuously reflect the current value of the relevant index.
Compared with investment trusts, ETFs have the advantage of not trading at a discount or premium
ETFs are large block of shares and can be broken into its components and each share sold off separately.
Because ETFs are sold in large quantities, they are out of reach of many small investors. This means that the market have poor liquidity as it could be difficult to find buyers and sellers
Also ETFs entail large stockbroker commissions. But because they are bought and sold in large quantities, they have low management fees
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End of Lecture
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Take home assignment
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Take home assignment
Your brother has £1000 and a five-year investment horizon and asks your advice about whether he should invest in Barclays PLC’s stock currently trading at 650pence per share
Suppose that on the date of your brother’s request, analysts at the Financial Times had expected Barclay’s management to continue to pay 40 pence per year in dividends for the foreseeable future and that Barclay’s shares would be selling for 1200 pence in five year’s time
Assume that after careful consideration you and your brother agreed that a nominal return of 15 percent per annum on investment in Barclays PLC shares will be acceptable.
Q1. Should you buy Barclays PLC shares at the quoted price?
Q2. Assume that you believed that the dividend of 40 pence would grow by a constant rate of 10 percent indefinitely and that the selling price would be 1500 pence. Should you still buy Barclays PLC shares at the quoted price?
Q3. You are considering whether to advice your brother to purchase an optimal portfolio rather than a single investment in Barclays PLC’s stock either through an investment trust or Unit trust/OEIC.
You are required to explain to him the main differences between ‘Investment Trusts’ and Unit Trusts/ OEICs’
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| Year | Dividend payment | Expected selling price | Discount rate | Present value of dividends | Present value of expected sale price |
| 0 | 40 | ||||
| 1 | |||||
| 2 | |||||
| 3 | |||||
| 4 | |||||
| 5 | 1200 | ||||
| Sum of present values | |||||
| Price of Tesco PLC shares |
APENDIX TABLE 1: CONSTANT DIVIDEND PAYMENT
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| Year | Dividend payment | Expected selling price | Discount rate | Present value of dividends | Present value of expected sale price |
| 0 | 40 | ||||
| 1 | |||||
| 2 | |||||
| 3 | |||||
| 4 | |||||
| 5 | 1200 | ||||
| Sum of present values | |||||
| Price of Tesco PLC shares |
APENDIX TABLE 2: GROWING DIVIDEND PAYMENTS
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Take home assignment
1. Distinguish between unit trusts and investment trusts
2. What are the relative merits of unit trusts, OEICs, investment trusts, investment bonds and endowment policies from the point of view of individual investors?
3. What might an investor consider when choosing between unit trusts, OEICs, investment trusts and investment bonds
4. If the efficient market hypothesis is valid, are investment analysis and active fund managements worthwhile? Your discussion should be based on evidence drawn from empirical research in this area.
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Why buy shares
https://www.youtube.com/watch?v=KFauoB8ppzc
https://www.youtube.com/watch?v=SXLkP4_gX1Y
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What are open and close ended funds
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What are ipos?
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Why dividends matter?
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What are etfs?
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Hedge funds explained
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The best place to invest in 2014
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How to invest like warren buffett investment strategies
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The construction of Share index explained
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What stock exchanges do?
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Further reading
Keith Redhead (2003), Introducing Investments: A Personal Finance Approach, chapters 3, 8, 12,18, 19,
Kent, D., Grinblatt., Titman, S., and Wermers, R (1997), “ Measuring Mutual Fund Performance with Characteristic-Based Benchmarks, The Journal of Finance, Vol.52, issue 3, Pg.1035-1058
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