[ALL YOU NEED TO KNOW IN INVESTMENT ANALYSIS TO PASS YOUR EXAMS]

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WHAT IS THE DIFFERENCE BETWEEN STOCKS AND SHARES?

ANSWER:

The stock of a company is sold in units called shares. A share is a unit of ownership, or equity, in a company or a corporation. Shares are one of the most traded financial instruments.

If you buy a share of a company, you are buying a piece of the company. When you own more than one share in a company or several companies, these are called stocks, because "stock" generally refers to a portfolio of shares.

On the stock markets, shares are also referred to as equities — if you see the term "equities trading", it is exactly the same as share trading.

The person who buys shares in a company is called a shareholder and has a claim on part of the corporation's assets and earnings.

BELOW ARE THE ASSUMPTIONS OF HARRY MARKOWITZ PORTFOLIO ANALYSIS THAT YOU NEED TO KNOW – THEY ARE VERY IMPORTANT;

1. An investor has a given sum of money to invest in present time.

2. Investors focus on the expected rate of return and on the variance of the security.

3. Investors prefer more returns and less risk

4. Investor wish to hold efficient portfolios; those yielding maximum expected return for a given level of risk or minim risk for a given level of expected return

5. Investors should diversify not just buying a security but several

6. The Investors seek to maximize the expected utility of total wealth

7. All investors have the same expected single period investment horizon.

8. Investors are risk averse

9. Perfect market are assumed.

INTRODUCTION

Economist view investment as an addition to fixed capital stock or the value of an economic output at any given point in time that takes the form of new investment, new structure, new production, change in inventory in whatever form. It should be noted that in economics, there are two types of investment namely;

a. Social Investment

b. Economic Investment

Social investment is undertaken to improve the wellbeing or the welfare of the citizens as such, no profit or return is expected from such venture.

Economic Investment is undertaken primarily for profit marking. For the purpose of this lecture, economic investment will be the bone of contention.

Financial analyst view of investment: Financial analyst define investment as the act of committing resources into an undertaken with the hope of reaping returns in the future. In this context, financial scholars see investment as the commitment of funds into an undertaken with an expectation of positive return commensurate with the level of risk assumed.

DISTINGUISHING BETWEEN INVESTMENT, GAMBLING AND SPECULATION

PARAMETERS	INVESTMENT	SPECULATION	GAMBLING
Time horizon	The length of time between the date investment is made and the future date when it is relinquished or sold is usually more than 1 year. The time horizon for investment is a long period of time – sometime commitment of funds.	The holding period for any form of speculation is usually less than 1year. It could be 2 weeks or 1 month or 5 months but less than a year.	The holding period of gambling can be measured in seconds.

Planning horizon	An investor has relatively longer planning horizon of at least one year. Before investing a feasibility study is conducted to determine whether or not the investment will generate adequate cash-flow and profit, withstand the risk it will encounter and remain viable in the long-term.	A speculator has a short planning horizon – usually few days or few months. In the actual sense, most speculators have no time for feasibility study or do not conduct F.S. All they do is identify and buy sellable asset in expectation of profit from market fluctuate or with the hope of selling them when t he price appreciate.	Gambling has absolutely no planning horizon. The Gambler does not do the kind of search; investigation, analysis, scrutiny or evaluation that is supposed to precede any rational investment activities.
Risk disposition	An investor is normally not willing to assume more than moderate risk, meaning that an investor is not willing to assume risk more than the expected return	A speculator is ordinarily willing to assume high risk.	Highly risky. A gambler takes on risk that is greater commensurate with the expected returns. He assumes higher risk.
Return expectation	An investor usually seeks a modest rate of return which is commensurate with the limited risk assumed by him.	A speculator looks for a high rate of return in exchange for the high risk borne by him.	A gambler expects higher returns.
Basis for decision	An investor attaches greater significance to fundamental factors and attempts a careful evaluation of the prospects of the firm.	A speculator relies more on hear say (rumour) and market psychology to forecast what the future market will be like. If he expects price increase, he commits his funds.	The basis for his decision is the outcome i.e. the return.

CHARACTERISTICS OF GOOD INVESTMENT

A good investment has the following characteristics:

a. REASONABLE INCOME: For any investment to be considered good enough, such an investment must be capable of yielding reasonable retune relative to the size of the fund invested. In other words, proportional to the cost of investment.

b. MARKETABILITY: A good investment must be highly marketable in the sense that it can be readily bought and sold.

c. LIQUIDITY: Any good investment must be highly liquid. This refers to the degree of ease in which such an investment can be converted into cash without any significant loss or value.

d. STABILITY OF INCOME: A good investment should be capable of yielding or generating income on continuous basis. It needs not to be constant in terms of amount, but it should be regular.

THE INVESTMENT PROCESS OR PORTFOLIO MANAGEMENT PROCESS

The investment process describes how an investor should go about making decisions with regards to what marketable securities to invest in, how extensive the investment should be, and when the investment should be made.

There are five steps in the investment process:

i. Setting Investment Policy

ii. Performs Security Analysis

iii. Constructs a Portfolio

iv. Revise the Portfolio

v. Evaluate the performance of the portfolio

Setting Investment Policy:

This is the investment planning stage where the investor defines his mission statement as well as his risk tolerance level. He also determines his investment objectives at this stage as well as his asset mix.

Perform Security Analysis:

Performing security analysis involves examining several individual security market prices in an attempt to predict future price movement.

Portfolio Construction:

Portfolio construction involves indentifying those specific assets in which to invest as well as determine the proportions of the investor’s wealth to put into each one.

Portfolio Revision:

Portfolio revision concerns the periodic repetition of the three previous steps. Revising a security is necessary because over time, the prices of the security changes, meaning that some securities that initially where not attractive may become attractive and others that were attractive at one time may no longer be so. Thus, the investor may want to add the former to his or her portfolio, while simultaneously deleting the latter.

Portfolio Performance Evaluation:

It involves determining periodically how the portfolio performed, in terms of not only the return earned but also risk experienced by the investor.

SCHOOLS OF THOUGHT ABOUT STOCK MARKET PRICES;

There are 3 schools of thought about the stock market prices:

1. Fundamentalist school of thought

2. Technical Analyst school of thought

3. Random walk school of thought

FUNDAMENTALIST SCHOOL OF THOUGHT

The fundamental analysts analyzes factor such as economic influences, industry factors, and pertinent company information such as product demand, earnings, dividends, and management in order to calculate an intrinsic value for the firm’s securities. He reaches an investment decision by comparing this value with the current market price of the security.

TECHNICAL ANALYSIS SCHOOL OF THOUGHT

Technical analysis, in essence involves the study of historical price and volume data either for one stock and deducing the future trend from this analysis. i.e. the technicians endeavor to predict future price levels of a stock by examining the past data from the market itself.

RANDOM WALK SCHOOL OF THOUGHT

The random walk hypothesis of stock market prices is concerned with the question of whether one can predict future prices from past prices. The fundamental idea behind the random walk hypothesis are that successive prices charge in individual securities are in-depth over time and that its actual price fluctuates randomly about its intrinsic or theoretical value.

SOME PAST QUESTIONS

a. What are the implications of Random Walk for Technical And Fundamental Analysis?

b. How do Technicians and Random Walk advocates differ in their view of the stock market?

SOLUTION:

The random-walk theory is inconsistent with technical analysis. Whereas random-walk states that successive price changes are independent, the technicians claim that they are dependent – that is, that the historical price behaviour of the stock will repeat itself into the future and that by studying this past behvaious the technicians can in fact predict the future.

The empirical evidence in support of the random-walk hypothesis rest primarily on statistical tests such as runs tests, correlation analysis and filter tests. The results have been almost unanimously in support of the random walk hypothesis, the weak form of the efficient market hypothesis. The results of semi-strong form test have been mixed.

The Technician has done very little if anything to defend any of the technician’s theories against the onslaught of random walk.

All technicians have done is to claim that their various systems work. In the future, if their theories are to have widespread acceptance in the academic community, they will have to test and demonstrate that their methods can consistently outperform a simple buy-and-hold strategy. The fundamentalist needs also to show that his efforts in analyzing securities are successful enough that does a simplified strategy to justify his expenditure of time and effort.

QUESTION:

In what ways are Nigerian securities market inefficient?

SOLUTION:

Market efficiency refers to the ability of financial asset to quickly adjust and reflect all information that is relevant to the value in its price.

Nigerian security market is inefficient in the following ways:

a. Absence of trading over the internet

b. Absence of free flow of information

c. Market imperfection e.g. high transaction cost, taxes etc

d. The Nigerian security market is not globalized.

e. Corruption

QUESTION:

Explain briefly what you understand by the term “Beating the Market”

SOLUTION:

“Beating the Market” means doing better than the market average i.e. to outperform the market. It happens when your investment portfolio does better than the stock market overall. In other words, it average annual return is greater than 7-10% annual average the stock market has done over time. The capital market will be inefficient if the investor’s trading strategy could beat the market. “Beating the Market” does not mean that you achieved a higher return; it means that you achieved a better return per unit of risk.

Companies raise long term funds in the forms of equity and debt from the capital markets. Capital market facilitate the buying and selling of securities, such as shares and bonds or debentures. They perform two valuable functions: Liquidity and pricing securities.

Liquidity means the convenience and speed of transforming assets into cash, or transferring assets from one person to another without any loss of value. Cash is the most liquid asset as it can be readily converted into any other asset, or transferred to another person without any decline in value. Capital markets make the securities liquid. They help to reduce, if not eliminate transaction costs.

The demand and supply forces help in determining the prices of securities. Since all information is publicly available, and since no single investor is large enough to influence the security prices, the capital markets provide a measure of fair price of securities.

CAPITAL MARKET EFFICIENCY

The capital market efficiency may be defined as the ability of securities to reflect and incorporate all relevant information, almost instantaneously, in their prices.

Three levels or forms of capital market efficiency

i. Weak-Form of Market Efficiency

ii. Semi-Strong Form of Market Efficiency

iii. Strong – Form of Market Efficiency

Weak form efficiency: this is concerned with the adjustment of securities prices to historical price or returning information. If the market is weak form, no investor can earn any excess or abnormal return base on historical price or returning information.

Semi-Strong Form: Semi – strong form efficiency is concerned with whether security prices fully reflect or publicly available information. Semi – Strong form efficiency requires the market to be weak form efficiency.

Strong Form Efficiency: Strong form Efficiency is concerned with whether the security prices fully reflect all the information available to public or not.

TYPES OF MARKET EFFICIENCY

There are two types of market efficiency:

1. Internal Efficiency Market

2. External Efficient Market

Internal Efficient Market is one in which brokers and dealers compete fairly so that the cost of transacting is low and the speed of transacting is high.

External Efficient Market is one in which information is quickly and widely disseminated thereby allowing each security price to adjust rapidly in an unbiased manner to new information so that it reflects investment value.

CALCULATIONS START FROM HERE:

Like I said, this is exam question. So, pay keen attention to the formula and workings – there is nothing wrong with you cramming formulas and steps. Honestly, the examiners will not penalize you for cramming formulas and steps. Once the answer sheet is shared, write down all the formulas you have crammed at the end of your answer sheet. Then you can strike it off later after you have finish with the paper.

INVESTMENT ANALYSIS – AREAS OF CONCENTRATION (TOPIC: (H-MODEL)

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Topic: HISA & Fuller’s Model (H – Model)

We going straight to calculation of this.

Here is the formula: Sorry, the computer did not give me exactly want I want so I have to handwrite it.

Were:

r=the weight of return or the expected rate of return

Do = current dividend per shares

Po= current market price

g3=Long run growth in dividend for the final phase

g1=growth rate in dividend for phase 1

H= A+B

A = number of years in phase 1

B = the last year at the end of period 2

ILLUSTRATION:

Suppose that the M & M Corporation has just paid a dividend of N1.5k and the dividend is expected to grow at a rate of 20% in the first 5 years followed by 16% in the next 5 years and 10% indefinitely thereafter, if the current market price per share is N40, calculate the investor’s expected rate of return using the HISA AND FULLER’S MODEL OR H-MODEL.

SOLUTION:

Here is the formula again:

First let’s solve for H which is A+B

H = 5+10

H= 15

H=7.5

r= 1.5 [(1+10%) + 7.5 (20% - 10%)] + 10%

r= 0.0375 (1.1) + (0.75) + 0.1

r= 0.0375 (1.85) + 0.1

r= 16.94%

The common stock of M & M Corporation is currently selling for N60 per share, dividend per share have grown from N1.5k to the current level of N4 over the past 10 years. This dividend growth is expected to continue in the future. What is the required rate of return for the M & M Corporation.

SOLUTION:

k = Do (1 + g) + g

Where:

K = The required rate of return

Do=Current Dividend per share

1 = is constant

g = Growth rate

k = Do (1 + g) + g

Note that g here is (future value) 1/n

Present value) - 1

g= 4

1.5 raised to power 1/10 – 1. See the formula above.

g= 0.1031

k = 4 (1 + 0.1031) + 0.1031

k = 0.17664

k = 17.7%

Explanation:

g has its own formula in this question. That is, you have to solve for g before you can substitute it in the main formula. That is why we have;

(future value) 1/n

Present value) - 1

Now read the question again. The future value is 4 while the present value is 1.5. That is how we got:

g= 4

1.5

Then you have to raised the answer you get to 1/n. n is 10 years. 1/10 will give you something like 0.1. now 4/1.5 raised to 0.1 – 1. Will give you 0.1031.

Then we can now go back to the main formula and solve since we have gotten the g we are looking for. So, substitute g figures any where there g.

If you don’t understand, you can always call me for the steps or workings of this question.

DETERMINATION OF RETURNS FROM BOND AND EQUITY BOND

BOND

Under bond, we have the following:

Coupon Rate
Current Yield
Yield to Maturity

COUPON RATE – this refers to the normal rate of interest that is charged on the nominal value of a bond. Coupon is therefore the product of the Coupon rate which denote by small letter (i) and the face value of the bond which symbolically is written fcv. The amount of Coupon on the bond issued is represented as i(fcv). Where i is the Coupon weight or the nominal interest of the bond. Fcv is the face value of the bond.

THE CURRENT YIELD – this refers to the actual rate of return on the bond issued and it is calculated as Y=C

Where y is the current yield of the bond issued, c is the annual coupon. Then Po is the market value or price of the bond.

YIELD TO MATURITY – this represent the rate of return on the nominal value of the bond adjusted for the amortization of premium i.e. the discount rate that equates the future cash flow from the bond issued with the current market price of the bond. Note that, if the market price is higher than the nominal value, then it means that the bond issued is selling at a premium. But if the market price is lower than the nominal value, then the bond is selling at a discount. Yield to maturity can be calculated thus:

YTM = C + FCV – Po

N_____

½ (FCV + Po)

Where:

YTM is yield to maturity

C = annual coupon

FCV = the face value of the bond

Po = Market value of the bond

N = holding period or number of years to maturity

ILLUSTRATION:

Suppose a 10% bond with a face value of N100,000 is currently selling for N80,000, what is the current yield and the approximate yield to maturity if it is due to mature in 20 years?

First of all, we need to the Coupon rate before we can calculate for Yield to Maturity.

So, Coupon Rate is i (fcv) = 10% (100,000) = N10,000.

Hope we all know how I got that. i, is the 10% in the question, fcv is the face value of the bond which is 100,000. 10%x100,000 = N10,000. Now that we know our Coupon Rate, we can go ahead to solve.

The Current Yield of the bond is Y= C

Y = 10,000

80,000 = 0.125 or 12.5%

While the yield to maturity is:

YTM = C + FCV – Po

N_____

½ (FCV + Po)

YTM = 10,000 + (100,000 – 80,000)

20_______

½ (100,000 + 80,000)

YTM = 10,000 + 1,000

½ (180,000)

YTM = 11,000

90,000

YTM = 0.122 or 12.2%

Pls, if you don’t understand this, just call for 07069373637 for clarification. I would have love to explain a little.

From the formula

YTM = C + FCV – Po

N_____

½ (FCV + Po)

You have to calculate the figure of FCV – Po then divide them by N. which is like this 100,000 – 80,000 = 20,000 divide by n which is 20. You will get 1,000.

Then C is 10,000. 10,000 of C added to the 1,000 that you have calculated out of FCV-Po/N will give you 11,000.

Finally, you have 11,000 at the top and you still have to calculate for ½ (FCV +Po) which will give you 100,000 FCV + 80,000 of Po =180,000. ½ multiply by 180,000 will give you 90,000. So we have 11,000 at the top and 90,000 below. So divide 11,000/90,000. That is how we got 0.122. if you multiply 0.122 you will get 12.2%. You answer have to be in percentage that is why we have to multiply by 100.

EARNING MODEL

Some investors like to use an earning approach for common stock valuation.

He did not say much about theory – he told us that this will be calculation. So, straight to it guys.

D= E (1-b)

Where:

D = dividend per share

E = Earning per share

1-b = Earning retention rate

Earning retention 1-b is the dividend payout ratio. Therefore an equivalent earning based valuation.

Po = E1 (1-b)

K-g

Where:

Po = is the stocks present value

E₁ = Earning expected at the end of year 1

g= expected earnings growth rate

k = stock required rate of return

note that E₁ = Eo(1+g).

So, we have to substitute Eo (1+g) into the E1.

So where have something like this.

Po = Eo(1+g) (1-b)

K-g

ILLUSTRATION:

The M & M Corporation currently has earnings that are N4 per share. In recent years, earnings have been growing at a rate of 7.5% and this rate is expected to continue in the future, if M & M Corporation has a retention rate of 40% and a required rate of retune of 14%, what is M & M current value?

SOLUTION:

Po = Eo(1+g) (1-b)

K-g

Eo= N4

(1+g) = 1+ 7.5%

(1-b)= 1 - 40%

K= 14%

Po = 4(1 + 0.075) (1-0.4)

0.14 – 0.075

Po= 4 (1.075)(0.6)

0.14-0.075

Po= 2.58

0.065

Po = N39.69

Explanation:

I have to do some explanation here: The 4 is earnings per share. The 1 is constant, while the 0.075 is the 7.5% when divided by 100. Then 0.4 is the 40% in the question.

Now below it, we have 0.14 which is 14% minus 0.075 which is the same 7.5% that represent (g) in our question. Now you have to solve the ones in bracket then multiply with 4 before you solve the one below and divided your answer.

ILLUSTRATION

Suppose that the following portfolios are lying on the efficienct or an efficiencet frontier of an opportunity sets, determine the best (Optimal) portofolio if the investement risk tolerance is 40%

PORTFOLIO:-	A	B	C	D	E
Expected Return	7.60	9.13	9.43	9.73	9.85
Expected Variance	0.19	0.52	0.61	0.74	0.75
Standard Deviation	4.32	7.24	7.79	8.59	8.67

According to Prof. Williams, to slect an Optimal Portfolio from a given sets of portfolios, emphasis should be given to the porfolio with the highest risk utility adjusted return.

Solution:

To determine the utility;

Utility = expected Return – Risk Pnealty

Risk Penalty = Risk²______

Risk Tolerance

Risk = Standrd deviation

Solving for portfolio (A) Risk Penalty:

(4.32)² = 18.66

40% 40

=0.47

I hope we all know how we got 4.32? That is the Standard Deviation of Portfolio A in the Table Above. Then the 40% was given in the question as the Risk Tolerance. Pls, don’t convert the %.

Now let’s solve for Portfolio B.

(7.24)² = 52.42

40% 40

=1.3

Solving for portfolio (C) Risk Penalty:

(7.79)² = 60.68

40% 40

=1.82

Solving for portfolio (D) Risk Penalty:

(8.59)² = 73.79

40% 40

=1.84

Solving for portfolio (E) Risk Penalty:

(8.67)² = 75.17

40% 40

=1.88

UTILITY:

A : 7.06-0.47=7.13

B : 9:13-1.30=7.83

C : 9.43-1.52=7.91

D : 9.73-1.84=7.90

E : 9.85-1.88=7.97

Therefore: We will choose E since it has 7.97 as the highest.

THE QUESTION:

The Other Woman In Marriage Corporation has a 12 PERCENT Semi-Annual Bond issue with F=N1,000 that matures in 15 years but is called in 6 YEARS at N1,200. If the CURRENT PRICE OF BOND is N900, determine the YIELD – TO – CALL.

Note: You need a calculator, pen and paper by your side to ascertain how I got the answer below:

SOLUTION:

Given that i=12%

Number of years to maturity = 15 years

Number of years to first call date = 6 years

Current Price of Bond = N900

Call Price of the Bond = N1,200

To determine the Yield – To – Call, here is the formula:

YTC = Annual Coupon Payment + (Call Price – Market Price)

Number of Years To Call Date

½ (Call Price + Market Price)

Pls, take note of the above long line and the short one. It demarcates our working/calculations.

YTC = 120 + (1,200 – 900)

6_____

½ (1,200 + 900)

Before we continue, let me do a little explanation here: YTC = 120. I got the 120 from i, which is 12% multiply by Face Value which is N1,000. The Face Value was shorten to F in the question.

N1,200 is the Call Price of the Bond which I have explained before and it is in the question. You must read the question very well to understand how the figures are picked.

N900 is the Current Price of the Bond. 6 is the Number of Years to First Call Date. ½ is constant in the formula. While (1,200+900) is still the same figures of the Call Price of the Bond and Current Price of Bond.

Now let’s ride on from where we stop.

YTC = 120+50 = 170 = 0.1619 = 16.19%

The Yield-To-Call is 16.19%.

CLARIFICATION: - You know how I got 120 right? If you don’t have explained that above. The 50 is gotten from 1,200 – 900 = 300. 300/6=50. Remember, I said you should pay attention to one long line below in the formula, that means answer gotten above will be divided by the answer below that long line. So now we have at the top 120+50.

But we are yet to explain the ½ (1,200 +900). When You add 1200+900, it gives you 2,100. Now divide ½ x 2,100 you will have 1,050. That is how we got;

120 + 50 = 170

1,050 1,050

170

1,050 will give you 0.1619. Then convert it to percentage by doing this 0.1619 x 100 = 16.19%. That is it - Simple huh?

NOTE:

Check out the book “The Other Woman In Marriage” at www.okadabooks.com. Also, don’t forget to search the blog archive by your left hand side for past different topics treated.