The financial system connects savers and borrowers and enables efficient allocation of capital.

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Main Functions

1. Save money for the future
2. Borrow money
3. Raise equity
4. Manage risk
5. Exchange assets
6. Facilitate information-motivated trades
7. Determine required rate of return
8. Allocate capital efficiently
   LM1 – Market Organization and S…

Analogy:

The financial system is like a highway system: investors (cars) need safe, efficient routes to move money from one place to another.

Money Market

Short-term securities (≤ 1 year).
Examples: T-bills, commercial paper

Capital Market

Long-term securities (> 1 year).
Examples: bonds, equities

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Primary Market

• Securities issued for the first time (IPO, new bond issuances)

Secondary Market

• Previously issued securities traded among investors

Analogy:

Primary market = buying a new car directly from the manufacturer
Secondary market = buying a used car from another owner

Fixed Income

• Regular interest + return of principal

Equities

• Common stock, preferred shares, warrants

Pooled Investments

• Mutual funds, ETFs, trusts

Derivatives

• Forward, futures, options, swaps, insurance
• Value derived from underlying asset price

Currencies

• Traded in FOREX (Foreign Exchange)  markets
• Spot or futures

Commodities

Agriculture, energy, metals

Real Assets

Real estate, machinery, equipment

Entities that facilitate trading, funding, and liquidity.

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Brokers

• Execute orders for clients
• Do NOT trade against clients

Analogy:

A broker is like a real estate agent—matches buyers with sellers.

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Dealers

• Trade using their own inventory
• Quote bid (buy) and ask (sell)
• Provide liquidity

Analogy:

Dealers are like car dealerships—buy low, sell high.

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Exchanges

• Centralized trading venues with rules

Alternative Trading Networks (ATNs) / ECNs

• Like exchanges, but no regulatory oversight

Investment Banks

• Capital raising, IPOs, mergers & acquisitions

Securitizers

• Bundle assets (e.g., mortgages) into securities

Depository Institutions

• Banks and credit unions

Arbitrageurs

• Exploit price differences across markets
• Risk-free profit

Clearing Houses

Provide counterparty risk protection

Settle trades

Long Position

• Own the asset
• Profit when price rises

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Short Position

• Borrow the asset → sell it
• Profit when price falls
• Unlimited loss potential

Analogy:

Short selling is like selling your friend’s concert tickets, hoping prices drop before you buy them back.

Investor borrows money to purchase securities.

Margin Loan

Amount borrowed

Call Money Rate

Interest paid

Leverage Ratio

$$\text{Leverage Ratio}=\frac{\text{Asset Value}}{\text{Investor Equity}}=\frac{1}{\text{Initial Margin Requirement}}$$

Margin Call Price

$$P_{call}=P_0\left(\frac{1-\text{initial margin}}{1-\text{maintenance margin}}\right)$$

When a trader places an order, they specify:

1. Buy or sell
2. Security
3. Quantity
4. Execution instructions
5. Validity instructions
6. Clearing instructions

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Execution Instructions

Market Order

• Immediate execution at best price
• May get unfavorable price

Limit Order

• Sets max buy or min sell price

All-or-Nothing

Entire order must be filled or not at all

Hidden Order

Visible only to broker/exchange

Iceberg Order

Only a portion is visible

Note: Investors ALWAYS get the worse end of spreads.

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Validity Instructions

• Day Order: expires end of day
• GTC (Good ’Til Canceled)
• Fill-or-Kill (immediate or cancel)
• Good-on-Close / Good-on-Open

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Stop Order

• Triggers when stop price reached
• Becomes market order
• Fill price may differ from stop price

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Limit Order vs Stop Order

Type	Trigger	Execution
Limit	Predefined price	Executes only at limit or better
Stop	Reaches stop price	Converts to market order

Primary

• New securities issued
• Investment banks manage:
  • Book building (finding investors)

Secondary

• Existing securities traded
• Includes seasoned offerings

Importance:

High liquidity allows firms to issue shares at a lower cost of capital.

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Types of Secondary Markets

Call Markets

Trading at specific times only

Continuous Markets

Trading whenever the market is open

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Quote-Driven Markets (Dealer / OTC)

Dealers post bid–ask quotes
Investors trade with dealers

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Order-Driven Markets

Rules prioritize:

1. Best price
2. Non-hidden orders
3. Earliest order

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Brokered Markets

Broker finds counterparty

Complete Markets

Financial instruments available to meet user needs

Operational Efficiency

Low transaction costs + high liquidity

Informational Efficiency

Market prices reflect fundamental value

Market Regulation Objectives

Prevent fraud
Control agency problems
Promote fairness
Set beneficial trading standards
Prevent excessive risk taking
Ensure long-term liabilities are funded

Topic	Summary
Financial system functions	Saving, borrowing, trading, risk mgmt, capital allocation
Market types	Money, capital, primary, secondary
Securities	Equity, fixed income, pooled, derivatives, currencies
Positions	Long / short / leveraged
Orders	Market, limit, stop, hidden, iceberg
Market structures	Quote-driven, order-driven, brokered
Efficiency	Complete, operational, informational
Regulations	Prevent fraud, ensure fairness, reduce risk

• Financial systems support capital allocation, trading, and risk management.
• Primary vs secondary markets differentiate issuance from trading.
• Order types determine execution price vs execution certainty trade-offs.
• Leverage magnifies gains/losses; margin calls protect lenders.
• Efficient markets require low costs, good information, and appropriate regulation.
• Market structures vary by who sets prices: dealers (quotes), investors (orders), or brokers (matching).

A security market index reflects the performance of a target market by tracking a group of constituent securities.

Used to track:

• A single security
• A market segment
• An asset class

Analogy:

An index is like a scoreboard—it summarizes how the whole team (market) is performing using a single number.

1. Price Return

• Considers only price changes
• Ignores dividends
  

2. Total Return

• Includes price changes + income (dividends, interest)

Total return is always higher than price return if the security pays dividends.

Before building an index, designers must decide:

1. What market the index represents
2. Which securities to include
3. How to weight each security
4. How often to rebalance
5. When to reconstitute (change composition)

1. Price-Weighted Index

Steps:

1. Sum the stock prices at start
2. Divide by number of stocks
3. Do the same for the end period
4. Compute return

Disadvantages

• Stocks with high prices dominate the index
• Stock splits must be adjusted so index value doesn’t change

Analogy:

A price-weighted index is like averaging people’s heights but giving extra influence to whoever is tallest. Height has nothing to do with importance—just like price.

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2. Equal-Weighted Index

Each stock receives the same dollar weighting.

Steps:

1. Calculate each security’s return
2. Average them

Disadvantages

• Requires constant rebalancing → high transaction costs
• Ignores market cap → small companies overweighted

Analogy:

Everyone gets the same vote regardless of size—fair but unrealistic.

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3. Market-Cap-Weighted (Value-Weighted) Index

Steps:

1. Calculate beginning market cap
2. Calculate ending market cap
3. Ending market cap ÷ beginning market cap

Advantages

• Most common method (S&P 500)
• Larger companies have larger influence

Disadvantages

• Overweights overpriced securities
• Underweights undervalued ones

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Float-Adjusted Market Cap

Only counts shares available for trading (excludes insiders & government holdings).
$$\text{Float-Adjusted Market Cap}=\text{Market Float}\times \text{Price}$$

Fundamental Weighting

Weights securities using financial metrics like:

• Earnings
• Book value
• Cash flow
• Dividends

Characteristics

• Has a value tilt
• Places more weight on high-earning-yield stocks

Analogy:

Instead of weighing students by height (price), you weigh them by GPA (fundamentals).

Rebalancing

Adjusting weights to maintain index methodology.

Especially important for equal-weighted indexes due to drift.

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Reconstitution

Adding or removing securities when they no longer meet criteria.

Analogy:

Rebalancing = adjusting your fantasy team lineup
Reconstitution = dropping/adding players

Indexes are used to:

• Measure a market’s performance
• Track investor sentiment
• Estimate beta, systematic risk, and market returns
• Benchmark active managers
• Serve as model portfolios for ETFs and index funds

Broad Market Index

Represents entire market
Example: Wilshire 5000

Multi-Market Index

Covers several countries
Example: Dow Jones World Index

Sector Index

Focuses on industries (tech, health care)

Style Index

Groups based on characteristics

• Value
• Growth
• Size (large, mid, small)

Harder to create due to:

• Huge number of securities
• Different maturities, coupons, embedded options
• Low liquidity
• Poor pricing transparency

Indexes classified by:

• Credit rating
• Market
• Issuer
• Maturity
• Geography

Commodity Indexes

• Based on futures
• Futures prices ≠ spot prices

Real Estate Indexes

• Appraisals
• Repeat sales
• REITs

Hedge Fund Indexes

• Rely on self-reporting → survivorship bias

Asset Class	Difficulty	Reason
Equity Indexes	Easy	High liquidity, transparent prices
Fixed Income Indexes	Hard	Illiquidity, huge universe
Commodity Indexes	Medium	Futures-based pricing

Topic	Key Points
Index Returns	Price vs total return
Weighting Methods	Price, equal, market cap, float-adjusted, fundamental
Adjustments	Rebalancing vs reconstitution
Uses of Indexes	Benchmarking, tracking, market sentiment
Index Types	Broad, multi-market, sector, style
Fixed Income Issues	Illiquidity, pricing difficulty
Alternative Indexes	Commodity, real estate, hedge fund

Indexes serve as benchmarks, proxies for systematic risk, and basis for ETFs.

Total return = price + income; price return excludes dividends.

Market-cap weighting is most common, but overweight overpriced stocks.

Equal-weighting requires constant rebalancing (high cost).

Price-weighting gives too much influence to high-priced stocks.

Fixed-income index construction is difficult due to low liquidity.

Alternative index methodologies can create biases (e.g., hedge fund survivorship bias).

A market is informationally efficient if prices fully reflect all available information and adjust quickly to new information.

• Passive investing outperforms active strategies
• Active managers underperform after costs
• Prices already incorporate all information

Analogy:

If markets are perfectly efficient:

An efficient market is like a crowded auction—the moment a new fact is announced, everyone adjusts their bids instantly.

Intrinsic Value (Vᵢ):

• The asset’s true value
• What a fully informed investor would pay

Market Value (P):

• The price investors actually pay

Comparison

• If P = Vᵢ, asset is fairly valued
• If P > Vᵢ, asset is overvalued
• If P < Vᵢ, asset is undervalued

Analogy:

Intrinsic value is the blue book value of a car; market value is what it actually sells for. Divergences create opportunities.

High costs slow reaction to info → less efficient

# of Market Participants

More participants = more efficient

Information Availability & Disclosure

More transparency = higher efficiency

Trading Restrictions

More limits → less efficient

Transaction / Information Costs

1. Weak Form Efficiency

Prices reflect past trading data only (price & volume).

• Technical analysis cannot generate abnormal returns
• Fundamental analysis may work
• If someone profits from technical analysis → weak-form inefficient

Analogy:

Weak form means the market remembers only the scoreboard, not the playbook.

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2. Semi-Strong Form Efficiency

Prices reflect:

• All public information
• All market data

Implications:

• Neither technical nor fundamental analysis generates abnormal returns
• Only private information can give an edge

Automatically includes weak form.

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3. Strong Form Efficiency

Prices reflect all information—public and private.

Implication:

• No investor can consistently outperform
• Passive investing is optimal

Analogy:

Strong form is like everyone having access to everyone’s full medical records—nothing is secret.

1. Calendar Anomalies

January Effect

Small stocks often rise in January
Causes:

• Tax-loss selling (sell losers in December, rebuy in Jan)
• Window dressing (fund managers “clean up” portfolios)

Monthly Effect

Higher returns at end of month

Weekend Effect

High returns on Friday, low on Monday

Holiday Effect

High returns before holidays

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2. Momentum & Overreaction Anomalies

Overreaction

Poorly performing stocks (last 3–5 yrs) tend to outperform later

Momentum

Recent winners keep winning (short-term continuation)

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Cross-Sectional Anomalies

Size Effect

Small-cap stocks outperform large-caps

Value Effect

Value stocks outperform growth stocks

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Other Common Anomalies

Closed-End Fund Discount

Closed-end funds trade below NAV
Reasons: mgmt fees, taxes, illiquidity

Earnings Surprise Anomaly

Positive surprises → continued price momentum
Negative surprises → continued underperformance

IPO Anomaly

IPO stocks outperform initially but underperform long-term

Predictability of Returns

Use prior dividend yields, inflation, volatility
(Must ensure not due to data mining.)

Behavioural finance studies how investors actually behave, not how they should behave.

Behavioral Biases

Loss Aversion

Investors feel losses more strongly than gains

Overconfidence

Investors overestimate their abilities
Leads to excessive trading

Herding / Information Cascades

Investors follow others’ trades
(Copying perceived informed investors)

Key Point:

• Markets do not require every investor to be rational—only the average behavior must be rational.

Analogy:

Behavioral biases are like optical illusions for the brain—they distort how we perceive market information.

Topic	Key Idea
Weak Form	Prices reflect past market data only
Semi-Strong	Prices reflect all public info
Strong Form	All info (public + private) priced in
Calendar Anomalies	January, weekend, holiday effects
Momentum/Overreaction	Winners keep winning; losers rebound
Cross-Sectional	Size & value effects
Behavioral Biases	Loss aversion, overconfidence, herding
Market Efficiency Factors	Participants, information, costs

• If markets are efficient, active management underperforms after fees.
• Technical analysis fails under weak-form efficiency.
• Fundamental analysis fails under semi-strong efficiency.
• Even in strong-form efficiency, insiders would not outperform.
• Calendar anomalies are weak-form violations.
• Behavioral biases help explain why anomalies occur.
• EMH does not require all investors to be rational—just markets overall.

Equities are attractive because of:
✔ High potential returns
✔ Inflation protection
✔ Diversification benefits

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Common Shares

Represent direct ownership in a company.

Benefits

• Receive dividends
• Voting rights (elect directors, vote on major issues)
• Residual claim on assets upon liquidation (last in line)

Share Classes (Example: Class A)

• Higher seniority in dividends
• More voting power
• Higher claim on assets

Analogy:

Common shares are like being a partner in a business—you share in the upside, but you’re also the last to get paid if the business collapses.

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Preferred Shares

Hybrid between equity & debt.
Receive dividends before common shareholders, but usually no voting rights.

Types of Preferred Shares

1. Cumulative Preferred

• Guaranteed fixed dividend
• Missed dividends accumulate
• Must be paid before common dividends

2. Convertible Preferred

• Can be converted into common shares
• Allows investor to benefit from upside

3. Participating Preferred

• Receive extra dividends if earnings reach a certain level
• the idea is a preferred share but you also participate in some of the upside of equities

Analogy:

Preferred shares are like “VIP tickets”—you get paid first, but you don’t get to vote on how the concert is run.

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Private Equity Securities

Compared to public equity, private equity firms are:

• Smaller
• Less liquid
• Under less investor pressure
• Lower reporting requirements
• Potentially higher returns due to inefficiencies

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Types of Private Equity

Venture Capital

• Funding early-stage companies
• Goal: IPO or acquisition
• Downside: can take many years

Leveraged Buyouts (LBOs)

• Investors borrow money to purchase 100% equity of a company
• If management team executes the buyout → Management Buyout (MBO)

Private Investment in Public Equity (PIPE)

• Public company sells shares to private investors
• Usually offered at a discount

Technological innovations & electronic networks have made it easier for firms to raise foreign capital.

Some countries restrict foreign investment to:

• Limit foreign ownership
• Protect domestic firms
• Reduce capital flow volatility

1. Direct Investing

Buying shares directly in the foreign market.

Challenges:

• Currency risk
• Regulatory differences
• Additional taxes

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2. Depository Receipts (DRs)

Represent ownership in a foreign firm but trades in local currency.

Sponsored DRs

• Company participates in issuance
• Voting rights belong to the investor

Unsponsored DRs

• Issued by depository bank alone
• Voting rights belong to the bank, not the investor

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Types of DRs

Global Depository Receipts (GDRs)

• Issued outside home country & outside US
• Usually denominated in USD
• Fewer restrictions compared to home market
  LM4 – Overview of Equity Securi…

American Depository Receipts (ADRs)

• Trade in the US, in USD
• Underlying shares are called ADSs
• Not subject to home-country restrictions

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Global Registered Shares (GRS)

• Trade on multiple exchanges, multiple currencies

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Basket of Listed Depository Receipts (BLDR)

An ETF containing DRs from multiple countries.

Analogy:

DRs are like “international movie subtitles”—you get access to foreign companies in your local language and format.

Sources of Returns

1. Price appreciation
2. Dividends
3. FX gains/losses (for international investing)

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Sources of Risk

• Overall market risk (std deviation)
• Type of security

Risk Ranking (Low → High)

1. Putable shares (lowest risk)
2. Preferred shares (cumulative safer than non-cumulative)
3. Common shares
4. Callable shares (highest risk)

Why?

• Put options = downside protection
• Callable shares = issuer can call them away if interest rates drop

Analogy:

Security features are like car insurance options—more protection lowers risk but lowers potential reward.

Equity is used to:

• Raise capital
• Increase liquidity
• Fund acquisitions
• Offer employee compensation (stock options, RSUs)
• Finance operations and growth

Book Value

$$BV=A-L$$

• Reported on balance sheet
• Influenced directly by management decisions

Market Value

• Determined by investor expectations
• Represents total market capitalization
• Indirectly influenced by management through performance

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Price-to-Book Ratio

$$P\mathrm{/}B=\frac{\text{Market Cap}}{\text{Book Value}}$$

Used to identify undervalued or overvalued stocks.

Return on Equity (ROE)

$$ROE=\frac{NetIncome}{AvgBookValue}$$

Where:$$AvgBookValue=\frac{BegBV+EndBV}{2}$$

Interpretation

• Higher ROE → more efficient management
• But need to analyze why ROE is high

Examples of misleading ROE:

1. Shrinking equity due to losses → denominator falls, ROE rises artificially
2. Share buybacks financed with debt → equity falls, ROE rises but leverage increases

Analogy:

ROE is like a student’s GPA—a high value is good, but you must check how they achieved it.

Required Rate of Return

• Investor perspective
• Minimum acceptable return based on expected cash flows

Cost of Equity

• Company perspective
• Rate it must offer to investors to attract capital

Same number, different viewpoint.

Topic	Key Details
Common Shares	Voting rights, dividends, residual claims
Preferred Shares	Fixed dividends, types: cumulative, convertible, participating
Private Equity	VC, LBOs, PIPE
DR Types	ADR, GDR, Sponsored, Unsponsored
Return Sources	Price, dividends, FX changes
Risk Ranking	Putable < Preferred < Common < Callable
ROE	NI / Avg Book Value
P/B Ratio	Market Cap / Book Value
Market vs Book Value	Market = investor expectations; Book = balance sheet

• Preferred shares behave like a hybrid of equity and debt.
• Depository receipts allow access to foreign markets without foreign exchanges.
• Callable shares are riskier; putable shares are safer.
• ROE must be interpreted carefully—high ROE is not always good.
• Book value reflects accounting reality; market value reflects investor expectations.
• Equity returns come from price, dividends, and FX movements.
• Required rate of return (investor) = cost of equity (company).

Industry analysis helps investors:

• Understand the economic environment
• Perform performance attribution
• Identify sources of return
• Find investment opportunities
• Conduct sector rotation (overweight/underweight industries during business cycle phases)

1. By Sector

• Standard commercial classifications (e.g., GICS, ICB)

2. By Sensitivity to the Business Cycle

• Cyclical: earnings highly correlated with business cycle
• Non-Cyclical: earnings less sensitive

Further Non-Cyclical Breakdown

• Defensive: stable earnings (utilities, consumer staples)
• Growth: strong earnings growth, even during downturns—but still vulnerable

Analogy:

Cyclical companies are like roller coasters, while defensive companies are like slow-moving trains—steady and predictable.

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Industry Classification Systems

GICS (Global Industry Classification Standard)

Hierarchy:
Sectors → Industry Groups → Industries → Sub-Industries

ICB (Industry Classification Benchmark)

Hierarchy:
Industries → Super Sectors → Sectors → Sub-Sectors

Both systems help analysts identify peer groups.

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Forming a Peer Group

1. Check formal classifications (GICS/ICB)
2. Identify competitors in company filings
3. Review competitor annual reports
4. Confirm similar revenue sources & markets

Analogy:

A peer group is like forming a sports league—teams must play the same sport and follow similar rules.

Industry analysis focuses on:

Porter’s Five Forces

External factors

Strategic group positioning

Industry life cycle

Experience curve

1. Industry Rivalry

• Concentrated industries (few firms) → more pricing power
• Fragmented industries → intense competition

2. Threat of New Entrants

• High barriers = fewer entrants
• Low barriers = more competition

3. Threat of Substitutes

• Consumer can easily switch → pricing power ↓

4. Bargaining Power of Buyers

• Buyers demand lower prices or higher quality

5. Bargaining Power of Suppliers

• Strong suppliers ↑ input prices or limit supply

Important Clarifications

• High barriers to entry do NOT guarantee high pricing power
• High concentration also does NOT guarantee high pricing power
• High barriers to exit can worsen competition

Market Stability

If market shares are stable → low competition → higher pricing power

Capacity Tightness

• Tight capacity (demand > supply) → high pricing power
• Overcapacity (supply > demand) → low pricing power

Analogy:

Capacity is like restaurant seating—too few tables increases prices; too many tables forces discounts.

1. Embryonic Stage

• Slow growth
• High prices (no economies of scale)
• High risk of failure
• High investment requirements

2. Growth Stage

• Rapid demand growth
• Prices begin to fall
• Limited competition
• Increasing profitability

3. Shakeout Stage

• Slowing growth
• Overcapacity
• Intense competition
• Declining profits
• Price wars

4. Mature Stage

• Slow growth
• High barriers to entry
• Few dominant firms
• Stable profits and prices

5. Decline Stage

• Negative growth
• Falling prices
• Industry consolidation
• Exit or merge

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Limitations of the Life-Cycle Model

• Industries may skip stages
• Pace differs by industry
• External shocks (tech, regulation, demographics) may disrupt progression

Areas to Analyze

• Firm financial position
• Products & services
• Competitive strategy

Competitive Strategies

1. Low-Cost Strategy

• Focus: lowest price in industry
• Relies on scale efficiencies & cost control

2. Product Differentiation Strategy

• Focus: unique features, superior quality, strong branding

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Comprehensive Company Analysis Should Include:

• Company profile
• Industry characteristics
• Demand & supply drivers
• Pricing strategy
• Financial ratios
• Spreadsheet forecasting of cash flows (DCF)

Analogy:

Company analysis is like scouting a sports player—you consider the league (industry), the team (market), and the player’s individual stats (company fundamentals).

Topic	Summary
Company Grouping	Sector, cyclical sensitivity, statistical similarity
Industry Systems	GICS: Sectors → Subindustries; ICB: Industries → Subsectors
Peer Groups	Firms with similar revenue sources & structures
Porter’s 5 Forces	Rivalry, entrants, substitutes, buyer power, supplier power
Life Cycle	Embryonic → Growth → Shakeout → Mature → Decline
External Factors	GDP, inflation, tech, demographics, regulation
Company Strategy	Low cost vs differentiation
Key Analysis Areas	Profile, pricing, supply/demand, ratios, forecasting

• Industry analysis improves portfolio allocation and performance attribution.
• GICS and ICB are the two main classification frameworks.
• Peer groups require careful validation—don’t rely only on classifications.
• Porter’s Five Forces evaluates industry competitiveness.
• Life-cycle stages reveal pricing power, profitability, and competitive pressures.
• Company analysis follows industry analysis and evaluates strategy + financials.
• Low-cost firms rely on scale; differentiators rely on uniqueness.

Equity valuation compares market value vs intrinsic value.

Valuation Rule

• If Market Value < Intrinsic Value → Underpriced (Buy)
• If Market Value > Intrinsic Value → Overpriced (Sell)

Before Investing, Consider:

• Size of mispricing
• Confidence in model forecast
• Accuracy of assumptions
• How many analysts cover the stock
• Probability price moves toward intrinsic value

1. Discounted Cash Flow (DCF) Models

Discount future cash flows → today’s price.
Common DCF models:

• Dividend Discount Model (DDM)
• Free Cash Flow to Equity (FCFE)

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2. Multiplier (Market Multiple) Models

Use valuation ratios:

• P/E
• P/CF
• P/S
• EV/EBITDA

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3. Asset-Based Models

$$\text{Equity}=A-L$$

Use market values of assets and liabilities.

Analogy:

DCF = appraising a building based on future rent
Multiples = comparing house price per square foot
Asset-based = valuing the land + building directly

Cash Dividends

Paid periodically (regular) or as a special one-time payout.

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Stock Split

More shares issued, but total value same.

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Stock Dividend

Shareholders receive additional shares; per-share value drops proportionally.

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Share Repurchases (Buybacks)

Reasons firms repurchase shares:

• Belief stock is undervalued
• Increase EPS or ROE
• Reduce outstanding shares

1. Declaration Date – board approves dividend
2. Ex-Dividend Date – stock price drops; buy on/after → no dividend
3. Record Date – shareholders on record get dividend
4. Payment Date – cash transferred

Analogy:

It’s like a concert guest list: the date the list is printed (record date) determines who gets access.

Dividend Discount Model (DDM)

Discount dividends to find intrinsic value.

Key Formula

$$P_0=\sum _{t=1}^{\mathrm{\infty }}\frac{D_t}{(1+r{)}^t}$$

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Free Cash Flow to Equity (FCFE) Model

$$FCFE=NI+Dep-\mathrm{\Delta }WC-FCInv+NetBorrowing$$

Or equivalently:$$FCFE=CFO-FCInv+NetBorrowing$$

Analogy:

FCFE is the “cash available to owners after everyone else is paid.”

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Gordon Growth Model (Constant Growth DDM)

Used for mature firms with stable dividends.$$P_0=\frac{D_1}{r-g}$$

Where:$$D_1=D_0(1+g)$$

Growth rate:$$g=ROE\times RR$$

Retention rate:$$RR=1-\text{Dividend Payout Ratio}$$

Conditions:

• Works only if r > g
• Best for stable, mature companies

Analogy:

Constant growth DDM is like valuing a tree that grows at the same rate forever.

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Multi-Stage GGM (2-Stage / 3-Stage)

Used when:

• Firm is in growth stage → high g
• Transition stage → moderate g
• Maturity → stable g

Terminal Value (end of high-growth phase):$$P_n=\frac{D_{n+1}}{r-g_{long}}$$

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Preferred Share Valuation

$$P_0=\frac{D}{r}$$

Used for fixed, perpetual preferred dividends.

1. DCF Models

✔ Pros

• Based on fundamentals
• Widely used
• Theoretically sound

✘ Cons

• Highly sensitive to assumptions
• Requires many estimates
• Small changes in r or g → large changes in value

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2. Multiplier Models

✔ Pros

• Easy to compute
• Comparable across companies
• Used in practice (cross-sectional time series)

✘ Cons

• May conflict with DCF values
• Ratios depend on accounting methods
• Multiples vary by industry
• Negative denominators distort results

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3. Asset-Based Models

✔ Pros

• Provide a floor value
• Useful when assets are tangible
• Good for liquidation analysis

✘ Cons

• Market values may be unavailable
• Asset-heavy firms fit better
• Ignore intangible value (brand, goodwill)
• Inflation distorts values

Multiples = “Relative Pricing”
Similar assets should trade at similar prices (Law of One Price).

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P/E Ratio (Forward P/E)

$$P\mathrm{/}{E}_1=\frac{D_1\mathrm{/}{E}_1}{r-g}$$

Interpretation:

• ↑ r → ↓ P/E
• ↑ g → ↑ P/E
• ↑ payout ratio → ↑ P/E

Dividend displacement of earnings

A firm cannot boost valuation simply by increasing payout.

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Enterprise Value (EV)

Measures total firm value (entire capital structure).$$EV=\text{MV of Equity}+\text{MV of Preferred}+\text{MV of Debt}-\text{Cash}$$

Useful when comparing firms with different leverage.

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EV/EBITDA

Most commonly used enterprise multiple.

• Ignores capital structure
• Useful for comparing operating performance

Equity Value from EV

$$EquityValue=EV-Debt+Cash$$

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Asset-Based Valuation

$$EquityValue=M{V}_{Assets}-M{V}_{Liabilities}$$

Best used when:

• Tangible assets dominate
• Liquidation value matters

Model Type	What It Does	Best For	Weakness
DCF (DDM, FCFE)	Discounts cash flows	Stable cash flow firms	Sensitive to assumptions
Multiples (P/E, EV/EBITDA)	Compares ratios	Peer comparison	Accounting differences
Asset-Based	Values net assets	Tangible-asset firms	Poor for intangible-heavy firms
GGM	Constant-growth dividends	Mature firms	Requires r > g
Multi-Stage DDM	Multiple growth periods	Growth → mature firms	Complex forecasts

• DCF gives intrinsic value, multiples give relative value, asset-based gives floor value.
• Gordon Growth Model only valid when r > g.
• FCFE models reflect cash available to equity holders.
• P/E ratios rise with higher growth, lower required return, higher payout.
• EV/EBITDA adjusts for leverage differences.
• Asset-based methods fail for firms with large intangibles.
• Mispricing must be large enough & likely to converge to intrinsic value.