49. Margin balance falls below margin requirement, investor receives margin call, either he has to liquidate the position or bring the margin amount to minimum requirement. Trigger Price for margin call = Initial Price 1 – Initial Margin 1 – maintenance Margin Formula
50.
51. Functions include:Enable indexed portfolio creation Works as a Benchmark for investment managers Proxy for market portfolio to measure beta and systematic risk Facilitate comparisons across international markets Aiding market technicians for investment decisions
80. Benefits of Diversification If Securities from different countries and different asset classes are combined together, risk reduces to great extent because correlation between securities from two different countries is definitely much lower than 1
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82. Many times, arbitrage process, to bring the security to efficient prices through fundamental analysis , is not riskless. Traders do not know that when the gains would be realized. Example : Internet stock bubble
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84. Existence of risk as it is difficult to find two securities having same risk with mispricing
85. With limitation of funds, arbitragers can eliminate only significant mispricing
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88. Reasons of existence of Anomaly Trading Restrictions Restrictions on some trading strategy make it impossible to exploit any anomaly. Example: restriction on Short selling at the opening of IPO Irrational behavior Limits on arbitragers – Previously discussed (Limited capital, strategy risk, restriction by lenders of the funds etc)
104. Valid for mature firms which regularly pay hefty dividends
105. As per dividend discount model, Current price = Div1/(1+k) + Div1*(1+g)/(1+k)^2 + …… The equation reduces to – Current Price = Div(1)/[k– g]
106. Growth Rate of the Company Earnings would rise on funds invested back in the business. ROE would be generated on those retained funds. Growth rate is firms’ earnings plough back times its ROE g = Retention Ratio * ROE
125. Changes in political climate and government policies can affect industries significantly.
126. Example: Imposition of Import duties help domestic industries and players 4. Policies and Regulation
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128. After picking best industries, analyst has to find the best stock. For that, he needs to analyze the fundamentals of the company, its future prospects, its intrinsic value and current price of the stock.
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130. Good company with strong fundamentals, high growth prospects may not turn into good investment option as everything is already priced in its current price.
131. So, analyst should always look for good stock which will generate high returns rather than good company.
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136. Speculative companies are the companies, equipped with risky assets, having potential to earn enormous returns.
137. Earnings, revenues of these companies are dependent on some uncertain factors. Example : Oil exploration, diamond mining etc
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139. Growth stock enjoys high multiples such as PE ratio and trade at high prices compared to its peers
140. Value Stock refers to the company, having strong fundamentals, still enjoys low multiples such as PE ratio, PBV multiple etc.
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142. Earnings Multiplier Model and DDM As per Gordon’s Indefinite DDM, Current Price = Div(1)/[r– g] P0 = Div(1)/[r– g] Multiply both sides by forward earnings, P0/E1 = Div(1) * E1 /[r– g] PE Ratio = Div(1) * E1 /[r– g]
149. On the basis of the calculation of the earnings (Denominator ) P/E Ratio can be categorized as –Leading P/E Ratio: Next years expected earnings are taken. Trailing P/E Ratio: Earnings of the most recent 12 months are taken
150. Leading P/E Ratio= Market Price per Share Forecasted EPS for next 12 months Trailing P/E Ratio= Market Price per Share EPS over previous 12 months Advantages P/E Ratio is popular in the investment community. Empirical research shows that P/E differences are significantly related to long term stock returns.
151. Disadvantages Negative earnings can produce useless P/E Ratios. Volatility in the earnings and abnormal income can make interpretation of P/E Ratio difficult. Differences in the Accounting policy can hinder comparison.
152. Price to Book Value Ratio P/B Ratio indicate the cost of investment in relation to the book value of net assets available per share as per the balance sheet. P/B Ratio= Market price per share Book value per share Book Value= Common Share holders equity = Total Assets- Total Liabilities - Preference shares
153. Advantages The book value is generally positive and so can be used even when negative earnings render P/V Ratio useless. Book value is more stable that EPS P/BV Ratio can be used to value companies that are expected to go out of business Empirical evidences show that P/BV Ratio helps to explain differences in long term average returns
154. Disadvantages P/BV does not recognize non physical assets like human capital Difference in Accounting policies for valuation of assets can make comparison difficult Inflation and Technological change can cause the book and the market value of the assets to change radically.
155. Price to Sales Ratio The P/S Ratio indicates the Cost of the investment of investor in relation to the sales per share P/S Ratio= Market value per share Sales per share
156. Advantages As sales are always positive P/S Ratio can be used even in the case of distressed firms Sales are difficult to manipulate unlike earnings are book value P/S ratios are relatives less volatile
157. Disadvantages High growth in sales does not necessarily indicate growth in operation profits Difference in revenue recognition practices can distort the forecasts As only sales are considered, differences in the cost structure across companies are not considered.
158. Price to Cash Flow Ratio The Price to Cash Flow Ratio indicates the cost of investment per unit of cash flow generated. For the purpose of the P/CF Ratio any of the following may be considered as the cash flow- Cash Flow= Net income+ Depreciation+ Ammortisations Adjusted CFO= CFO +Net cash interest outflow net of tax Free Cash Flow available to Equity Share Holders EBITDA
159. P/CF Ratio= Market Price per Share Cash Flow per share Advantages Cash flows are difficult to manipulate Price to cash flow is more stable than price to earning Reliance on Cash Flow rather than earnings addresses the problem of the difference in the quality of the reported earnings
160. Disadvantages The definition of the term Cash Flow are not clear eg: EBITDA, FCFE Some items affecting actual cash flow from operation are ignored when EPS plus non cash transaction approach is used example: change in working capital FCFE can be volatile