on 06-Feb-2018 (Tue)

Equity securities represent ownership claims on a company’s net assets. As an asset class, equity plays a fundamental role in investment analysis and portfolio management because it represents a significant portion of many individual and institutional investment portfolios.

The study of equity securities is important for many reasons. First, the decision on how much of a client’s portfolio to allocate to equities affects the risk and return characteristics of the entire portfolio. Second, different types of equity securities have different ownership claims on a company’s net assets, which affect their risk and return characteristics in different ways. Finally, variations in the features of equity securities are reflected in their market prices, so it is important to understand the valuation implications of these features.

This reading provides an overview of equity securities and their different features and establishes the background required to analyze and value equity securities in a global context. It addresses the following questions:

• What distinguishes common shares from preference shares, and what purposes do these securities serve in financing a company’s operations?

• What are convertible preference shares, and why are they often used to raise equity for unseasoned or highly risky companies?

• What are private equity securities, and how do they differ from public equity securities?

• What are depository receipts and their various types, and what is the rationale for investing in them?

• What are the risk factors involved in investing in equity securities?

• How do equity securities create company value?

• What is the relationship between a company’s cost of equity, its return on equity, and investors’ required rate of return?

In studying decision making by consumers and businesses, microeconomics gives rise to the theory of the consumer and theory of the firm as two branches of study.

The theory of the consumer is the study of consumption—the demand for goods and services—by utility-maximizing individuals. The theory of the firm, the subject of this reading, is the study of the supply of goods and services by profit-maximizing firms. Conceptually, profit is the difference between revenue and costs. Revenue is a function of selling price and quantity sold, which are determined by the demand and supply behavior in the markets into which the firm sells/provides its goods or services. Costs are a function of the demand and supply interactions in resource markets, such as markets for labor and for physical inputs. The main focus of this reading is the cost side of the profit equation for companies competing in market economies under perfect competition. A subsequent reading will examine the different types of markets into which a firm may sell its output.

The study of the profit-maximizing firm in a single time period is the essential starting point for the analysis of the economics of corporate decision making. Furthermore, with the attention given to earnings by market participants, the insights gained by this study should be practically relevant. Among the questions this reading will address are the following:

• How should profit be defined from the perspective of suppliers of capital to the firm?

• What is meant by factors of production?

• How are total, average, and marginal costs distinguished, and how is each related to the firm’s profit?

• What roles do marginal quantities (selling prices and costs) play in optimization?

This reading is organized as follows:

Section 2 discusses the types of profit measures, including what they have in common, how they differ, and their uses and definitions.

Section 3 covers the revenue and cost inputs of the profit equation and the related topics of breakeven analysis, shutdown point of operation, market entry and exit, cost structures, and scale effects. In addition, the economic outcomes related to a firm’s optimal supply behavior over the short run and long run are presented in this section.

The goal of effective working capital management is to ensure that a company has adequate ready access to the funds necessary for day-to-day operating expenses, while at the same time making sure that the company’s assets are invested in the most productive way.

The scope of working capital management includes transactions, relations, analyses, and focus:

• Transactions include payments for trade, financing, and investment.

• Relations with financial institutions and trading partners must be maintained to ensure that the transactions work effectively.

• Analyses of working capital management activities are required so that appropriate strategies can be formulated and implemented.

• Focus requires that organizations of all sizes today must have a global viewpoint with strong emphasis on liquidity.

In this reading, we examine the different types of working capital and the management issues associated with each. We also look at methods of evaluating the effectiveness of working capital management.

The focus of this reading is on the short-term aspects of corporate finance activities collectively referred to as working capital management . The goal of effective working capital management is to ensure that a company has adequate ready access to the funds necessary for day-to-day operating expenses, while at the same time making sure that the company’s assets are invested in the most productive way. Achieving this goal requires a balancing of concerns. Insufficient access to cash could ultimately lead to severe restructuring of a company by selling off assets, reorganization via bankruptcy proceedings, or final liquidation of the company. On the other hand, excessive investment in cash and liquid assets may not be the best use of company resources.

Effective working capital management encompasses several aspects of short-term finance: maintaining adequate levels of cash, converting short-term assets (i.e., accounts receivable and inventory) into cash, and controlling outgoing payments to vendors, employees, and others. To do this successfully, companies invest short-term funds in working capital portfolios of short-dated, highly liquid securities, or they maintain credit reserves in the form of bank lines of credit or access to financing by issuing commercial paper or other money market instruments.

Working capital management is a broad-based function. Effective execution requires managing and coordinating several tasks within the company, including managing short-term investments, granting credit to customers and collecting on this credit, managing inventory, and managing payables. Effective working capital management also requires reliable cash forecasts, as well as current and accurate information on transactions and bank balances.

There are conflicts among other stakeholders, such as those between: customers and shareholders customers and suppliers shareholders and government or regulators.

The agency theory is a supposition that explains the relationship between principals and agents in business. Agency theory is concerned with resolving problems that can exist in agency relationships due to unaligned goals or different aversion levels to risk. The most common agency relationship in finance occurs between shareholders (principal) and company executives (agents).

The audit function. It plays a critical role in ensuring the corporation's financial integrity and consideration of legal and compliance issues. The primary objective is to ensure that the financial information reported by the company to shareholders is complete, accurate, reliable, relevant, and timely.

Company reporting and transparency . It helps reduce of information asymmetry and agency costs.

Related-party transactions involve buying, selling, and other transactions with board members, managers, employees, family members, and so on. They can create an inherent conflict of interest. Policies should be established to disclose, mitigate, and manage such transactions.

• Remuneration policies. Does the company's remuneration strategy reward long-term or short-term growth? Are equity-based compensation plans linked to the long-term performance of the company?

1. Say on pay is the ability of shareholders in a company to actively vote on how much executives employed by the company should be compensated.

Contractual agreements with creditors ; indentures, covenants, collaterals and credit committees are tools used by creditors to protect their interests.

Contractual agreements with customers and suppliers .

Laws and regulations a company must follow to protect the rights of specific groups.

Two primary duties of a board of directors are duty of care and duty of loyalty.

Among other responsibilities, the board is to:

• establish long-term strategic objectives for the company with a goal of ensuring that the best interests of shareholders come first and that the company's obligations to others are met in a timely and complete manner.

• establish clear lines of responsibility and a strong system of accountability and performance measurement in all phases of a company's operations.

• hire the chief executive officer, determine the compensation package, and periodically evaluate the officer's performance.

• ensure that management has supplied the board with sufficient information for it to be fully informed and prepared to make the decision that are its responsibility, and to be able to adequately monitor and oversee the company's management.

Ethics is the study of moral principles used to make good choices.

• Ethical principles are beliefs regarding what is good, acceptable, or responsible behavior, and what is bad, unacceptable, or forbidden behavior. They provide guidance for our behavior.

• Ethical conduct is behavior that follows moral principles.

• Ethical actions are those actions that are perceived as beneficial and conform to

  the ethical expectations of society.

Ethics encompass a set of moral principles (code of ethics) and standards of conduct that provide guidance for our behavior. Violations can harm the community in a variety of ways.

The process can be considered to be a modification of the random walk in continuous time, or Wiener process, in which the properties of the process have been changed so that there is a tendency of the walk to move back towards a central location, with a greater attraction when the process is further away from the center.

The Ornstein–Uhlenbeck process can also be considered as the continuous-time analogue of the discrete-time AR(1) process.

In mathematics, the Ornstein–Uhlenbeck process (named after Leonard Ornstein and George Eugene Uhlenbeck), is a stochastic process that, roughly speaking, describes the velocity of a massive Brownian particle under the influence of friction.

The process is a stationary Gauss–Markov process, which means that it meets the three conditions of being a Gaussian process, a Markov process, and being temporally homogeneous.

An Ornstein–Uhlenbeck process, x_t, satisfies the following stochastic differential equation:

d x t = θ ( μ − x t ) d t + σ d W t {\displaystyle dx_{t}=\theta (\mu -x_{t})\,dt+\sigma \,dW_{t}}

where θ > 0 {\displaystyle \theta >0} , μ {\displaystyle \mu } , and σ > 0 {\displaystyle \sigma >0} are parameters and W t {\displaystyle W_{t}} denotes the Wiener process.

The Ornstein–Uhlenbeck process is one of several approaches used to model (with modifications) interest rates, currency exchange rates, and commodity prices stochastically. The parameter μ {\displaystyle \mu } represents the equilibrium or mean value supported by fundamentals; σ {\displaystyle \sigma } the degree of volatility around it caused by shocks, and θ {\displaystyle \theta } the rate by which these shocks dissipate and the variable reverts towards the mean. One application of the process is a trading strategy known as pairs trade.^[3][4][5]

A stochastic differential equation (SDE) is a differential equation in which one or more of the terms is a stochastic process, resulting in a solution which is also a stochastic process.

Typically, SDEs contain a variable which represents random white noise calculated as the derivative of Brownian motion or the Wiener process.

Ethical actions are those actions that are perceived as beneficial and conform to

the ethical expectations of society.

Ethics encompass a set of moral principles (code of ethics) and standards of conduct that provide guidance for our behavior. Violations can harm the community in a variety of ways.

A profession is:

• based on specialized knowledge and skills.

• based on service to others.

• practiced by members who share and agree to adhere to a common code of

  ethics.

A profession's code of ethics:

• communicates the shared principles and expected behaviors of its members.

• generates confidence not only among members of the organization but also

  among non-members (clients, prospective clients, and/or the general public).

A profession may adopt standards of conduct to enhance and clarify the code of ethics.

Laws often codify ethical actions that lead to better outcomes for society or specific groups of stakeholders. Legal and ethical conduct often coincide, but they are not always the same.

• Some legal behaviors are not considered ethical.

• Some ethical behaviors may not be legal in certain countries.

Laws and regulations are not always the best mechanism to reduce unethical behavior. They often lag behind current circumstances; legal standards are often created to address past ethical failings and do not provide guidance for an evolving and increasingly complex world. In addition, new laws designed to reduce or eliminate conduct that adversely affects the markets can create opportunities for different but similarly problematic conduct.

Investment professionals should act beyond legal standards, making good judgments and responsible choices even in the absence of clear laws or rules.

Both internal and external factors influence working capital needs

• Company size and growth rates

• Organizational structure

• Sophistication of working capital management

• Borrowing and investing positions/activities/capacities

• Banking services
• Interest rates
• New technologies and products
• Competitors
• Economy

Because analyzing vast amounts of data can be both time consuming and difficult, investors often use a single measure that consolidates this information and reflects the performance of an entire security market.

Security market indexes were first introduced as a simple measure to reflect the performance of the US stock market. Since then, security market indexes have evolved into important multi-purpose tools that help investors track the performance of various security markets, estimate risk, and evaluate the performance of investment managers. They also form the basis for new investment products.

in·dex, noun (pl. in·dex·es or in·di·ces) Latin indic-, index, from indicare to indicate: an indicator, sign, or measure of something.

ORIGIN OF MARKET INDEXES

Investors had access to regularly published data on individual security prices in London as early as 1698, but nearly 200 years passed before they had access to a simple indicator to reflect security market information.1 To give readers a sense of how the US stock market in general performed on a given day, publishers Charles H. Dow and Edward D. Jones introduced the Dow Jones Average, the world’s first security market index, in 1884.2 The index, which appeared in The Customers’ Afternoon Letter, consisted of the stocks of nine railroads and two industrial companies. It eventually became the Dow Jones Transportation Average.3Convinced that industrial companies, rather than railroads, would be “the great speculative market” of the future, Dow and Jones introduced a second index in May 1896—the Dow Jones Industrial Average (DJIA). It had an initial value of 40.94 and consisted of 12 stocks from major US industries.4^,5 Today, investors can choose from among thousands of indexes to measure and monitor different security markets and asset classes.

Equity securities represent ownership claims on a company’s net assets. As an asset class, equity plays a fundamental role in investment analysis and portfolio management because it represents a significant portion of many individual and institutional investment portfolios.

The study of equity securities is important for many reasons:

1. The decision on how much of a client’s portfolio to allocate to equities affects the risk and return characteristics of the entire portfolio.
2. Different types of equity securities have different ownership claims on a company’s net assets, which affect their risk and return characteristics in different ways.
3. Variations in the features of equity securities are reflected in their market prices, so it is important to understand the valuation implications of these features.

This reading provides an overview of equity securities and their different features and establishes the background required to analyze and value equity securities in a global context. It addresses the following questions:

• What distinguishes common shares from preference shares, and what purposes do these securities serve in financing a company’s operations?

• What are convertible preference shares, and why are they often used to raise equity for unseasoned or highly risky companies?

• What are private equity securities, and how do they differ from public equity securities?

• What are depository receipts and their various types, and what is the rationale for investing in them?

• What are the risk factors involved in investing in equity securities?

• How do equity securities create company value?

• What is the relationship between a company’s cost of equity, its return on equity, and investors’ required rate of return?

In a general sense, economics is the study of production, distribution, and consumption and can be divided into two broad areas of study: macroeconomics and microeconomics. Macroeconomics deals with aggregate economic quantities, such as national output and national income. Macroeconomics has its roots in microeconomics , which deals with markets and decision making of individual economic units, including consumers and businesses. Microeconomics is a logical starting point for the study of economics.

This reading focuses on a fundamental subject in microeconomics: demand and supply analysis. Demand and supply analysis is the study of how buyers and sellers interact to determine transaction prices and quantities. As we will see, prices simultaneously reflect both the value to the buyer of the next (or marginal) unit and the cost to the seller of that unit. In private enterprise market economies, which are the chief concern of investment analysts, demand and supply analysis encompasses the most basic set of microeconomic tools.

Traditionally, microeconomics classifies private economic units into two groups: consumers (or households) and firms. These two groups give rise, respectively, to the theory of the consumer and theory of the firm as two branches of study. The theory of the consumer deals with consumption (the demand for goods and services) by utility-maximizing individuals (i.e., individuals who make decisions that maximize the satisfaction received from present and future consumption). The theory of the firm deals with the supply of goods and services by profit-maximizing firms. The theory of the consumer and the theory of the firm are important because they help us understand the foundations of demand and supply. Subsequent readings will focus on the theory of the consumer and the theory of the firm.

Investment analysts, particularly equity and credit analysts, must regularly analyze products and services, their costs, prices, possible substitutes, and complements, to reach conclusions about a company’s profitability and business risk (risk relating to operating profits). Furthermore, unless the analyst has a sound understanding of the demand and supply model of markets, he or she cannot hope to forecast how external events—such as a shift in consumer tastes or changes in taxes and subsidies or other intervention in markets—will influence a firm’s revenue, earnings, and cash flows.

Having grasped the tools and concepts presented in this reading, the reader should also be able to understand many important economic relations and facts and be able to answer questions, such as:

• Why do consumers usually buy more when the price falls? Is it irrational to violate this “law of demand”?

• What are appropriate measures of how sensitive the quantity demanded or supplied is to changes in price, income, and prices of other goods? What affects those sensitivities?

• If a firm lowers its price, will its total revenue also fall? Are there conditions under which revenue might rise as price falls and what are those? Why?

• What is an appropriate measure of the total value consumers or producers receive from the opportunity to buy and sell goods and services in a free market? How might government intervention reduce that value, and what is an appropriate measure of that loss?

• What tools are available that help us frame the trade-offs that consumers and investors face as they must give up one opportunity to pursue another?

• Is it reasonable to expect markets to converge to an equilibrium price? What are the conditions that would make that equilibrium stable or unstable in response to external shocks?

• How do different types of auctions affect price discovery?

This reading is organized as follows.

Section 2 explains how economists classify markets.

Section 3 covers the basic principles and concepts of demand and supply analysis of markets.

Section 4 introduces measures of sensitivity of demand to changes in prices and income.

The theory of the firm , the subject of this reading, is the study of the supply of goods and services by profit-maximizing firms. Conceptually, profit is the difference between revenue and costs. Revenue is a function of selling price and quantity sold, which are determined by the demand and supply behavior in the markets into which the firm sells/provides its goods or services. Costs are a function of the demand and supply interactions in resource markets, such as markets for labor and for physical inputs. The main focus of this reading is the cost side of the profit equation for companies competing in market economies under perfect competition. A subsequent reading will examine the different types of markets into which a firm may sell its output.

The study of the profit-maximizing firm in a single time period is the essential starting point for the analysis of the economics of corporate decision making. Furthermore, with the attention given to earnings by market participants, the insights gained by this study should be practically relevant. Among the questions this reading will address are the following:

• How should profit be defined from the perspective of suppliers of capital to the firm?

• What is meant by factors of production?

• How are total, average, and marginal costs distinguished, and how is each related to the firm’s profit?

• What roles do marginal quantities (selling prices and costs) play in optimization?

For random variables such as Cauhy, the long-tails of the distribution prevent the sum/integral from converging.

The focus of this reading is on the short-term aspects of corporate finance activities collectively referred to as working capital management . The goal of effective working capital management is to ensure that a company has adequate ready access to the funds necessary for day-to-day operating expenses, while at the same time making sure that the company’s assets are invested in the most productive way. Achieving this goal requires a balancing of concerns. Insufficient access to cash could ultimately lead to severe restructuring of a company by selling off assets, reorganization via bankruptcy proceedings, or final liquidation of the company. On the other hand, excessive investment in cash and liquid assets may not be the best use of company resources.

Effective working capital management encompasses several aspects of short-term finance:

1. Maintaining adequate levels of cash.
2. Converting short-term assets (i.e., accounts receivable and inventory) into cash.
3. Controlling outgoing payments to vendors, employees, and others.

To effectively manage their Workin Capital, companies invest short-term funds in working capital portfolios of short-dated, highly liquid securities, or they maintain credit reserves in the form of bank lines of credit or access to financing by issuing commercial paper or other money market instruments.

Working capital management is a broad-based function. Effective execution requires managing and coordinating several tasks within the company, including managing short-term investments, granting credit to customers and collecting on this credit, managing inventory, and managing payables. Effective working capital management also requires reliable cash forecasts, as well as current and accurate information on transactions and bank balances.

Creditors, most commonly bondholders and banks, are a company’s lenders and the
providers of debt financing. Creditors do not hold voting power (unlike common
shareholders) and typically have limited influence over a company’s operations.

3.1.3 Managers and Employees

Senior executives and other high level managers are normally compensated through salary, bonuses, equity based remuneration (or compensation). As a result, managers may be motivated to maximize the value of their total remuneration while also protecting their employment positions.

A company’s board of directors is elected by shareholders to:

1. Protect shareholders’ interests.
2. Provide strategic direction.
3. Monitor company and management performance.

3.1.5 Customers
Customers expect a company’s products or services to satisfy their needs and
provide appropriate benefits given the price paid, as well as to meet applicable
standards of safety.

Compared with other stakeholder groups, customers tend to be less concerned with,
and affected by, a company’s financial performance.

3.1.6 Suppliers
A company’s suppliers have a primary interest in being paid as contracted or agreed
on, and in a timely manner, for products or services delivered to the company.

Suppliers, like creditors, are concerned with a company’s ability to generate
sufficient cash flows to meet its financial obligations.

3.1.7 Governments/Regulators

Governments and regulators seek to protect the interests of the general public and
ensure the well being of their nations’ economies.

As the collector of tax revenues, a government can also be considered one of the
company’s major stakeholders

There are conflicts among other stakeholders, such as those between:

• customers and shareholders
• customers and suppliers
• shareholders and government or regulators.

Stakeholder management involves identifying, prioritizing, and understanding the interests of stakeholder groups and on that basis managing the company's relationships with stakeholders.

The framework of corporate governance and stakeholder management reflects a legal, contractual, organizational, and governmental infrastructure.

Meno is a Socratic dialogue written by Plato. It appears to attempt to determine the definition of virtue

Meno is reduced to confusion or aporia. In response to Meno's paradox (or the learner's paradox), however, Socrates introduces positive ideas: the immortality of the soul, the theory of knowledge as recollection (anamnesis), which Socrates demonstrates by posing a mathematical puzzle to one of Meno's slaves, the method of hypothesis, and, in the final lines, the distinction between knowledge and true belief.

Two primary duties of a board of directors are duty of care and duty of loyalty.

Among other responsibilities, the board is to:

• establish long-term strategic objectives for the company with a goal of ensuring that the best interests of shareholders come first and that the company's obligations to others are met in a timely and complete manner.

Among other responsibilities, the board is to:

• establish clear lines of responsibility and a strong system of accountability and performance measurement in all phases of a company's operations.

Among other responsibilities, the board is to:

• hire the chief executive officer, determine the compensation package, and periodically evaluate the officer's performance.

Among other responsibilities, the board is to:

• ensure that management has supplied the board with sufficient information for it to be fully informed and prepared to make the decision that are its responsibility, and to be able to adequately monitor and oversee the company's management.

From a corporation's perspective, risks of poor governance include:

• weak control systems or inefficient monitoring tools;

• ineffective decision making;

• legal, regulatory, and reputational risks;

• default and bankruptcy risks.

Benefits of effective governance and stakeholder management include:

• better operational efficiency and control brought by effective monitoring tools and control mechanisms;

• better operating and financial performance;

• lower default risk and cost of debt.

Economic Ownership and Voting Control
What is the company's ownership and voting structure among shareholders?
Why do some shareholders own a small portion of a company's stock but get most of the voting power?
Does the practice really insulate managers from Wall Street's short-term mindset?

Dual-class structures create an inferior class of shareholders, and may allow management to make bad decisions with few consequences.

Board of Directors Representation
Analysts should assess whether the experience and skill sets of board members match the needs of the company.
Are they truly independent?
Are there inherent conflicts of interest?

Remuneration and Company Performance
What are the main drivers of the management team's remuneration and incentive structure?
Does the remuneration plan reward long-term or short-term growth?
Is it based on the performance of the company relative to its competitors or other peers?

Equity-based remuneration plans can offer the greatest incentives.
Are they linked to the long-term performance of the company?
What is the impact on the income statement?

Investors in the Company
What is the composition of investors in a company?
Are there any significant investors in the company?
Any sizable affiliated stockholders that can block the votes of the majority?
Any activist shareholders that could bring rapid changes for the company?

Strength of Shareholders' Rights
How robust are the shareholder rights at the company?
How robust compared to those of peers?

Managing Long-Term Risks
How effectively is the company managing long-term risks, such as securing access to necessary resources, managing human capital, exhibiting integrity and leadership, and strengthening the long-term sustainability of the enterprise?

ESG integration can be implemented across all asset classes.

ESG Factors in Investment Analysis
Environmental factors include natural resource management, pollution prevention, water conservation, energy efficiency and reduced emissions, the existence of carbon assets, and adherence to environmental safety and regulatory standards.

Social factors generally pertain to human rights and welfare concerns in the workplace, product development, and, in some cases, community impact.

ESG Implementation Methods Asset managers and asset owners can incorporate ESG issues into the investment process in a variety of ways.

• Negative screening is a type of investment strategy that excludes certain companies or sectors from investment consideration because of their underlying business activities or other environmental or social concerns.

• Positive screening and best-in-class strategies focus on investments with favorable ESG aspects.

• Thematic investing focuses on a single factor, such as energy efficiency or climate change.

• Impact investing strategies are targeted investments, typically made in private markets, aimed at solving social or environmental problems.