Options Made Simple (1)

Call options

Call options give the buyer the right (but not the obligation) to buy the underlying stock at a specified price on or before a specified date (expiry date). The price specified in the option contract is referred to as a strike price or exercise price. As a buyer of call options, you are hoping for the value of the underlying stock to rise. An increase in the price of the underlying stock will result in an increase in the value of
your options.

The seller of call options receives a premium for taking on the obligation to sell the underlying stock to the buyer of the options at the strike price if the buyer decides to exercise the option before expiry. If the buyer exercises the option, the seller must sell the underlying stock to the buyer at the strike price. If the buyer does not exercise the option, the seller simply retains the premium and the obligation expires with the option on the expiry date.

Put options

Put options give the buyer the right (but not the obligation) to sell the underlying stock at a specified price (strike price) on or before the expiry date. As a buyer of a put option, you are hoping the value of the underlying stock will fall as this will result in an increase in the value of your options. The seller of a put option receives a premium for granting this right to the buyer. If the option is exercised, the option seller must buy the underlying stock at the strike price.

Options Basics

An option is the right, but not the obligation, to the underlying instrument at a particular price and particular time. The underlying instrument can be a stock, futures contract,  index security, interest rate, or other market-traded instrument.

There are two types of options traded on the market, call options and put options:

• A call option is the right, but not the obligation, to buy the underlying instrument at a particular price and particular point in time.
• A put option is the right to sell, or be short, the underlying instrument at a particular price and particular point in time.

Let’s look further at our definition of an option:

• An option is the right, but not the obligation—an option gives the option buyer the right to buy or sell (call or put) the underlying instrument.

• At a particular price—this price is determined by the option purchased and is referred to as the strike price.

 As an example, if ABC Company is trading at around $15.00 anthere is an option strike price at $16.00, then the $16.00 call option would give the call buyer the right, but not the obligation, to be long or buy ABC Company’s stock at $16.00. A buyer of the $16.00 put option would have the right, but not the obligation, to sell or be short ABC Company’s stock at $16.00.

• At a particular point in time—options are limited term instruments, meaning they have a set date at which they will expire. This term can be as short as a few days or a year or more into the future.
Each option is represented by the month of expiration, the strike price, and the type of option, for example the ABC Company, August, $16.00 call option.

Option Premium
Options have a cost commonly referred to as the option’s premium. Just like a car insurance policy has a premium for you to buy a certain amount of coverage for your car, an option has a similar theory. You are paying a premium for the right, but not the obligation, to the market. This premium is determined by supply and demand in the market. Like other securities, options are bid, offered, and traded actively on the market.

Writing Options

Option writers are investors who are willing to take the risk for a price or premium that the option will
have no value at expiration or that the premium will be reduced and that they can purchase back the option at a lower price.An option seller or writer is taking the risk and demanding premium for that risk. As
in most every investment, the more assumed risk the investor takes on, the more reward the risk taker wants in return.

ATM, ITM, and OTM

• At the money (ATM): This means that the strike price of the option is in very close proximity to the current underlying instrument pricing. If ABC Company is trading at 15.00, then the 15.00 call would be considered at the money.

• In the money (ITM): This refers to options for which the underlying instrument price has surpassed the option’s strike price in the direction of the option. If ABC company is trading at 15.00, then the 14.00 call option would be considered in the money.

• Out of the money (OTM): This refers to options for which the underlying instrument price has not yet reached the strike price of the option. Again this would be in the direction of the option, call versus put. If ABC Company is trading at 15.00, then the 14.00 put option would be out of the money.

Intrinsic and Extrinsic Value

Intrinsic value is present in options that are in the money. This value is related to the option’s strike price and the current price of the underlying instrument. A call option has intrinsic value when the underlying price is higher than the strike price of the option. A put option has intrinsic value when the underlying price is lower than the strike price of the option.

Here is how intrinsic value on a call option is calculated:

Underlying price – strike price = intrinsic value

This is how intrinsic value on a put option is calculated:

Strike price – underlying price = intrinsic value

Extrinsic value can be described as the risk value of the option.  When you purchase an option, you are compensating the writer for the risk and time of selling the option. Included in the time value of the option is the risk assumed from the volatility of the market. If the market price fluctuates wildly, the writer naturally assumes that there is more risk than if a price is very stable, so the time value of the option would be further increased on the more volatile options. The longer the time remaining until the option expires, the more the perceived risk of the option and therefore the higher the premium. More time, more risk, more premium.

Production Possibilities Frontier

The production possibilities frontier (PPF ) is the boundary between those combinations of goods and services that can be produced and those that cannot.

Let’s look at the production possibilities frontier for cola and pizza, which represent any pair of goods or services.The production possibilities frontier for cola and pizza shows the limits to the production of these two goods, given the total resources and technology available to produce them. Figure 2.1 shows this production possibilities frontier. The table lists some combinations of the quantities of pizza and cola that
can be produced in a month given the resources available. The figure graphs these combinations. The x-axis shows the quantity of pizzas produced, and the y-axis shows the quantity of cola produced. The PPF illustrates scarcity because we cannot attain the points outside the frontier. These points describe wants that can’t be satisfied. We can produce at any point inside the PPF or on the PPF. These points are attainable. Suppose that in a typical month, we produce 4 million pizzas and 5 million cans of cola.  Figure 2.1 shows this combination as point E and as possibility E in the table.

The figure also shows other production possibilities. For example, we might stop producing pizza and move all the people who produce it into producing cola. Point A in the figure and possibility A in the table show this case. The quantity of cola produced increases to 15 million cans, and pizza production dries up.
Alternatively, we might close the cola factories and switch all the resources into producing pizza. In this
situation, we produce 5 million pizzas. Point F in the figure and possibility F in the table show this case.

Production Efficiency
We achieve production efficiency if we produce goods nd services at the lowest possible cost. This outcome
occurs at all the points on the PPF. At points inside the PPF, production is inefficient because we are giving
up more than necessary of one good to produce agiven quantity of the other good.For example, at point Z in Fig. 2.1, we produce  3 million pizzas and 5 million cans of cola. But we have enough resources to produce 3 million pizzas and 9 million cans of cola. Our pizzas cost more cola than necessary. We can get them for a lower cost. Only when we produce on the PPF do we incur the lowest possible cost of production.
Production is inefficient inside the PPF because resources are either unused or misallocated or both.
Resources are unused when they are idle but could be working. For example, we might leave some of the
factories idle or some workers unemployed. Resources are misallocated when they are assigned to tasks for which they are not the best match. For example, we might assign skilled pizza chefs to work in a cola factory and skilled cola producers to work in a pizza shop. We could get more pizzas and more cola from these same workers if we reassigned them to the tasks that more closely match their skills.

Tradeoff Along the PPF
Every choice along the PPF involves a tradeoff. On the PPF in Fig. 2.1, we trade off cola for pizzas.
Tradeoffs arise in every imaginable real-world situation in which a choice must be made. At any given
point in time, we have a fixed amount of labor, land, capital, and entrepreneurship. By using our available
technologies, we can employ these resources to produce goods and services, but we are limited in what
we can produce. This limit defines a boundary between what we can attain and what we cannot attain. This boundary is the real-world’s production possibilities frontier, and it defines the tradeoffs that we must make. On our real-world PPF, we can produce more of any one good or service only if we produce less of some other goods or services.All tradeoffs involve a cost—an opportunity cost.

Opportunity Cost
The opportunity cost of an action is the highest-valued alternative forgone. The PPF makes this idea precise
and enables us to calculate opportunity cost. Along the PPF, there are only two goods, so there is only
one alternative forgone: some quantity of the other good. Given our current resources and technology,
we can produce more pizzas only if we produce less cola. The opportunity cost of producing an additional
pizza is the cola we must forgo. Similarly, the opportunity cost of producing an additional can of cola is the quantity of pizza we must forgo. In Fig. 2.1, if we move from point C to point D, we get 1 million more pizzas but 3 million fewer cans of cola. The additional 1 million pizzas cost 3 million cans of cola. One pizza costs 3 cans of cola. We can also work out the opportunity cost of moving in the opposite direction. In Fig. 2.1, if we move from point D to point C, the quantity of cola produced increases by 3 million cans and the quantity of pizzas produced decreases by 1 million. So if we choose point C over point D, the additional 3 million cans of cola cost 1 million pizzas. One can of cola costs 1/3 of a pizza.

Opportunity Cost Is a Ratio 

Opportunity cost is a ratio. It is the decrease in the quantity produced of one good divided by the increase in the quantity produced of another good as we move along the production possibilities frontier.Because opportunity cost is a ratio, the opportunity cost of producing an additional can of cola is equal to the inverse of the opportunity cost of producing an additional pizza. Check this proposition by returning to the calculations we’ve just worked through. When we move along the PPF from C to D, the opportunity
cost of a pizza is 3 cans of cola. The inverse of 3 is 1/3. If we decrease the production of pizza and increase the production of cola by moving from D to C, the opportunity cost of a can of cola must be 1/3 of a pizza. That is exactly the number that we calculated for the move from D to C.

Increasing Opportunity Cost 

The opportunity cost of a pizza increases as the quantity of pizzas produced  increases. The outward-bowed shape of the PPF reflects increasing opportunity cost. When we produce a large quantity of cola and a small quantity of pizza— between points A and B in Fig. 2.1—the frontier has a gentle slope. An increase in the quantity of pizzas costs a small decrease in the quantity of cola—the opportunity cost of a pizza is a small quantity of cola. When we produce a large quantity of pizzas and a small quantity of cola—between points E and F in Fig. 2.1—the frontier is steep. A given increase in the quantity of pizzas costs a large decrease in the quantity of cola, so the opportunity cost of a pizza is a large quantity of cola. The PPF is bowed outward because resources are not all equally productive in all activities.

Market Equilibrium

The operation of the market clearly depends on the interaction between suppliers and demanders.
At any moment, one of three conditions prevails in every market:

(1) The quantity demanded exceeds the quantity supplied at the current price, a situation called  
excess demand.
(2) the quantity supplied exceeds the quantity demanded at the current price, a situation called excess supply; 
(3) the quantity supplied equals the quantity demanded at the current price, a situation called equilibrium. At equilibrium, no tendency for price to change exists.

Example: Excess demand

Example: Excess supply

Figure 3.10 illustrates another excess supply/surplus situation. At a price of $3 per bushel, suppose farmers are supplying soybeans at a rate of 40,000 bushels per year, but buyers are demanding only 20,000.With 20,000 (40,000 minus 20,000) bushels of soybeans going unsold, the market price falls. As price falls from $3.00 to $2.50, quantity supplied decreases from 40,000 bushels per year to 35,000. The lower price causes quantity demanded to rise from 20,000 to 35,000.At $2.50, quantity demanded and quantity supplied are equal. For the data shown here, $2.50 and 35,000 bushels are the equilibrium price and quantity, respectively.

Market equilibrium

In Figure 3.11, the new supply curve (the supply curve that shows the relationship between price and quantity supplied after the freeze of coffee) is labeled S1 at new equilibrium price 2.40$ .At the initial equilibrium price, $1.20, there is now a shortage of coffee . If the price were to remain at $1.20, quantity demanded would not change; it would remain at 13.2 billion pounds.

Shift of Supply versus Movement Along a Supply Curve

Movement along a supply curve  The change in quantity supplied brought about by a change in price.

Shift of a supply curve    The change that takes place in a supply curve corresponding to a new relationship between quantity supplied of a good and the price of that good. The shift is brought about by a
change in the original conditions.

Table 3.4 and Figure 3.7 describe this change. At $3 a bushel, farmers would have produced 30,000 bushels from the old seed (schedule in Table 3.4); with the lower cost of production and higher yield resulting from the new seed, they produce 40,000 bushels (schedule in Table 3.4). At $1.75 per bushel, they would have produced 10,000 bushels from the old seed; but with the lower costs and higher yields, output rises
to 23,000 bushels.

Increases in input prices may also cause supply curves to shift. If Farmer Brown faces higher fuel costs, for example, his supply curve will shift to the left—that is, he will produce less at any S1

Changes in Quantity Demanded Vs Shift the Demand curve

Quantity demanded The amount (number of units) of a product that a household would buy in a given period  if it could buy all it wanted at the current market price.

Law of demand The negative relationship between price and quantity demanded: As price rises, quantity demanded decreases; as price falls, quantity demanded increases.

Example

The data in Table 3.1 show that at lower prices, Alex buys more gasoline; at higher prices, she buys less. Thus, there is a negative, or inverse, relationship between quantity demanded and price.When price rises, quantity demanded falls, and when price falls, quantity demanded rises. Thus, demand curves always slope downward.

 Figure 3.2 that quantity (q) is measured along the horizontal axis and price (P) is measured along the vertical axis.

 Shift of Demand Curve:

A household’s decision about what quantity of a particular output, or product, to demand
depends on a number of factors, including:

1. The price of the product in question.
2. The income available to the household.
3. The household’s amount of accumulated wealth.
4. The prices of other products available to the household.
5. The household’s tastes and preferences.
6. The household’s expectations about future income, wealth, and prices.

Suppose that  Alex was receiving a salary of $500 per week after taxes. If Alex faces a price of $3.00 per gallon and chooses to drive 250 miles per week, her total weekly expenditure works out to be $3.00 per gallon times 10 gallons of $30 per week. That amounts to 6.0 percent of her income.



Suppose now she were to receive a raise to $700 per week after taxes. Then if she continued to buy only 10 gallons of gasoline a week it would absorb a smaller percentage of her income. The higher income may well raise the amount of gasoline being used by Alex regardless of what she was using before.Notice in Figure 3.3 that the entire curve has shifted to the right—at $3.00 a gallon the curve shows an increase in the quantity demanded from 10 to 15 gallons. At $5.00, the quantity demanded by Alex increases from 5 gallons to 10 gallons.The fact that demand increased when income increased implies that gasoline is a normal good
to Alex.

ECONOMIC SYSTEMS

Laissez-faire economy  Literally from the French: “allow [them] to do.” An economy in which individual people and firms pursue their own self-interest without any central direction or regulation.

Command economy  An economy in which a central government either directly or indirectly sets output targets,incomes, and prices.

There are no purely planned economies and no pure laissezfaire economies; all economies are mixed. Individual enterprise, independent choice, and relatively free markets exist in centrally planned economies; there is significant government involvement in market economies such as that of the United States.

One of the great debates in economics revolves around the tension between the advantages of free, unregulated markets and the desire for government involvement in the economy. Free markets produce what people want, and competition forces firms to adopt efficient production techniques. The need for government intervention arises because free markets are characterized by inefficiencies and an unequal distribution
of income, and experience regular periods of inflation and unemployment.

The Circular Flow of Economic Activity

Labor market
 The input/factor market in which households supply work for wages to firms that demand labor.

Capital market
The input/factor market in which households supply their savings, for interest or for claims to future profits,
to firms that demand funds to buy capital goods.



Land market 
 The input/factor market in which households supply land or other real property in exchange for rent.

Factors of production
The inputs into the production process. Land, labor, and capital are the three key factors of production.

Product or output
markets The markets in which goods and services are exchanged.

Input or factor markets
The markets in which the resources used to produce goods and services are exchanged.

Parameters that explain the value of beta

(a) Sensitivity of stock to the economy

The greater the effect of the state of the economy on a business sector, the higher is its β – temporary work is one such highly exposed sector. Another example is auto-makers, which tend to have a β close to 1. There is an old saying in North America, “As General Motors goes, so goes the economy”. This serves to highlight how GM’s financial health is to some extent a reflection of the health of the entire economy. Thus, beta analysis can show how GM will be directly affected by macroeconomic shifts in the economy.

(b) Cost structure

The greater the proportion of fixed costs to total costs, the higher the breakeven point, and the more volatile the cash flows. Companies that have high ratio of fixed costs (such as cement makers) have a high β, while those with a low ratio of fixed costs (like mass- market service retailers) have a low β.

(c) Financial structure

The greater a company’s debt, the greater its financing costs. Financing costs are fixed costs which increase a company’s breakeven point and, hence, its earnings volatility. The heavier a company’s debt or the more heavily leveraged the company is, the higher is the β of its shares. 

(d) Company performance 

The quality of management and the clarity and quantity of information the market has about a company will all have a direct influence on its beta. All other factors being equal, if a company gives out little or low quality information, the β of its stock will be higher as the market will factor the lack of visibility into the share price.

(e) Earnings growth

The higher the forecasted rate of earnings growth, the higher the ß. Most of a company’s value in cash flows are far down the road and thus highly sensitive to any change in assumptions. 

Advantages and risks in options trading

Summary

 

• 
  
  Ö  It is important to understand both the advantages
  and risks involved in trading options before you decide to include options as part of your trading or investment strategy.
  
  
• Ö  A risk for a buyer of an option can often translate into an advantage for the seller of the option.
• 
  
  Ö  The main advantages from trading options are: ˜ risk management
  ˜ speculation
  ˜ leverage
  
  
  ˜ diversification
  ˜ income generation.
• Ö  Options can provide an investor with the ability to manage risks on their current portfolio by creating a hedge against a potential adverse movement in the market price of their current share holdings.
• Ö  Options provide another financial instrument that can be used by traders to generate short-term profits on the stock marke
  
  
  • Ö  Options can provide the buyer with the advantage of leverage. This gives them exposure to a similar profit or loss if they had invested in the underlying stock at its full value, for only a fraction of the market price of the underlying stock.
  • Ö  As options cost only a fraction of the price of the underlying security, you can gain exposure to a large range of stocks with a relatively small outlay compared with investing in those stocks directly.
  • Ö  Premiums from selling options can provide a means of income generation for a savvy option trader.
  • 
    
    Ö  The main risks involved in trading options are: ˜ market risk
    ˜ risk of expiring worthless
    ˜ risk due to leverage
    
    
    
    ˜ potential for unlimited losses ˜ risk of margin calls
    ˜ liquidity risk.
    
    
  • Ö  Like all financial investments, there is the risk that the market price will move in a direction that results in a loss.
  • Ö  All options have a limited life determined by the expiry date. As a buyer of options, if the market price of the underlying security does not move sufficiently in your direction before the expiry date, your option may expire worthless.
  • Ö  Leverage can magnify your losses as well as your profits.
  • Ö  As a seller of uncovered call options, you are exposed to
    the potential of unlimited losses. 
    
    
    • Ö  As a seller of put options, you are exposed to losses equal to the value of the underlying security at the strike price of the option.
    • Ö  As a seller of options, you are required to provide a margin and may be exposed to margin calls that need to be met within a short time frame (often 24 hours).
    • Ö  Lack of liquidity in the options markets, particularly in times of high price volatility, may make it difficult to close or exit an option position. 

What is Gross domestic product or GDP ?

GDP, or gross domestic product, is the market value of the final goods and services produced within a coun- try in a given time period. This definition has four parts:

• Market value
  
• Final goods and services
  
• Produced within a country
  
• In a given time period
  
  
  
  0. Market Value 
     To measure total production, we must add together the production of apples and oranges, computers and popcorn. Just counting the items doesn’t get us very far. For example, which is the greater total production: 100 apples and 50 oranges or 50 apples and 100 oranges?
     
     GDP answers this question by valuing items at their market values—the prices at which items are traded in markets. If the price of an apple is 10 cents, then the market value of 50 apples is $5. If the price of an orange is 20 cents, then the market value of 100 oranges is $20. By using market prices to value production, we can add the apples and oranges together. The market value of 50 apples and 100 oranges is $5 plus $20, or $25.
     
     Final Goods and Services 
     To calculate GDP, we value the final goods and services produced. A final good (or service) is an item that is bought by its final user during a specified time period. It contrasts with an intermediate good (or service), which is an item that is produced by one firm, bought by another firm, and used as a component of a final good or service.
     
     For example, a Ford truck is a final good, but a Firestone tire on the truck is an intermediate good. A Dell computer is a final good, but an Intel Pentium chip inside it is an intermediate good.
     

  If we were to add the value of intermediate goods and services produced to the value of final goods and services, we would count the same thing many times—a problem called double counting. The value of a truck already includes the value of the tires, and the value of a Dell PC already includes the value of the Pentium chip inside it.
  Some goods can be an intermediate good in some situations and a final good in other situations. For example, the ice cream that you buy on a hot sum- mer day is a final good, but the ice cream that a restaurant buys and uses to make sundaes is an inter- mediate good. The sundae is the final good. So whether a good is an intermediate good or a final good depends on what it is used for, not what it is.
  Some items that people buy are neither final goods nor intermediate goods and they are not part of GDP. Examples of such items include financial assets— stocks and bonds—and secondhand goods—used cars or existing homes. A secondhand good was part of GDP in the year in which it was produced, but not in GDP this year.
  
  Produced Within a Country 
  Only goods and services that are produced within a country count as part of that country’s GDP. Nike Corporation, a U.S. firm, pro- duces sneakers in Vietnam, and the market value of those shoes is part of Vietnam’s GDP, not part of U.S. GDP. Toyota, a Japanese firm, produces automobiles in Georgetown, Kentucky, and the value of this produc- tion is part of U.S. GDP, not part of Japan’s GDP.
  
  In a Given Time Period 
  GDP measures the value of production in a given time period—normally either a quarter of a year—called the quarterly GDP data—or a year—called the annual GDP data.
  GDP measures not only the value of total produc- tion but also total income and total expenditure. The equality between the value of total production and total income is important because it shows the direct link between productivity and living standards. Our standard of living rises when our incomes rise and we can afford to buy more goods and services. But we must produce more goods and services if we are to be able to buy more goods and services.
  Rising incomes and a rising value of production go together. They are two aspects of the same phenome- non: increasing productivity. To see why, we study the circular flow of expenditure and income. 
  

What Is a Retention Ratio?

Retention Ratio Definition

Retention Ratio refers to the percentage of a company's earnings that are not paid out in dividends but credited to retained earnings. It is the opposite of the dividend payout ratio. Retention ratio is also called plowback ratio or retention rate.

Formula

The Retention Ratio calculation formula is as following:
 

Retention Ratio = 1 - Dividend Payout Ratio = (Net Income - Dividends) / Net Income

Most often, retention ratio refers to the percentage of a company’s earnings that are not paid out as dividends to stockholders and are held back by the company. The earnings that are reinvested in the business are called retained earnings or retained capital. To calculate the earnings retention ratio, deduct the dividends from the company’s net income, and divide that total by the net income. The result is the retention ratio.

Investors are interested in learning a company’s retention ratio. A higher ratio means that more money is put back into the company. This can mean the company is poised for growth. Retained earnings can also be held back to pay for planned expenses, such as purchasing a building or new equipment. Since money is plowed back into the business, the retention ratio is sometimes called the plowback ratio.

Investors can use the retention ratio to calculate the maximum sustainable growth rate of a company. This growth rate is determined by multiplying the company’s return on equity by the retention ratio. The return on equity can usually be found in the company’s annual report. The maximum sustainable growth rate can be a factor when an investor decides whether or not to invest in a particular company.

A low retention ratio means that more money is paid out to stockholders. Investors looking for stocks to provide income generally look for companies with lower ratios. Companies with a history of such low numbers usually try to maintain these ratios, since investors come to expect dividends each year.

The term can also refer to a customer retention ratio or insurance retention ratio. Customer retention ratio is the percentage of customers that keep purchasing products and services from a particular company. A high figure can indicate quality goods or service. In other words, a high customer ratio equals satisfied customers.

Insurance retention ratio is the amount of business an insurance company retains. This is calculated based on premiums, or the amount each person pays for insurance coverage. Paid premiums represent sales. The insurance retention ratio is the percentage of invoiced, or written, premiums compared to the number of premiums that are actually paid, called gross premiums.

While retention ratio can refer to different numbers in various industries, it maintains a common theme. Retention refers to something a company keeps. Retention can refer to sales, customers, or earnings, depending on the context in which retention ratio is used.

Difference Between Cash Flow and Net Income

Investment Advisor: Share Market

Investment in share market is by far the most profitable form of investment till date. But still you will find news and rumors going around that share market is very risky. Actually people like me and you have made this form of investment so risky. Share market investment needs at least a basic training before a person can start investing in shares. I would recommend that an investment advisor is a must for a novice to start this most technical form of investment.

An investment advisor will be helpful to make us understand what factors needs to be looked into before buying and selling of shares. The purpose of this article is to work as a fool proof investment advisor for all share market investors. So the starting point of any share market investment will be identification and evaluation of profitable companies suitable for share trading. We will list down here few key logical steps of share market investment that will work as an investment advisor for all new investors.

(1) Investment Advisor will always to buy share of companies which are traded very frequently

It might happen at times that a new investor end up buying a share of almost a dead company whose market price of share neither moves up or down. I can tell you this is very much possible. The investment advisor will boldly suggest that investors shall blindly go for the the shares which has the highest ‘market capitalization’. The value of market capitalization can be calculated very simple, multiply the number of shares issued in the market ,Example (10,000,000 shares with market price $10/share). So ithe market capitalization will be 10,000,000 X $10 = $100 million.

Investment advisor use this value of ‘market capitalization’ to judge the “total value” of the company. By total value the investment advisor means that if somebody wants to buy 100% ownership of the company what money he should ideally pay. Suppose after doing financial analysis of a company A, the ‘total value’ of the company comes out to be $75 million instead of $100 million as suggested by the market capitalization formulae. In this case the company per share price shall be $75 million / 10,000,000 = $7.5 instead of $10.

This suggests that the present market price of the company’s share is overpriced by $2.5 ($10 minus $7.5). The companies which are not traded very frequently, the market capitalization figures of such company cannot be trusted. But for companies whose shares are traded very aggressively, the market capitalization figures over a period of time (say two years) gives an idea of that what can can be the average “value of the company”. Investment advisor will suggest that all investors shall have a list of top 100 most traded companies and should track the price movements of these companies. As soon as the market price becomes undervalued, go for it and buy.

(2) Investment Advisor will always have a look into the book value of the company and compare it with its present market price.

If we will look into the financial reports (balance sheets) of companies we will find a value called book value per share. Book value is nothing but audited “total value” of company called as its “net worth’. In simple language we can say that the book value is the worth of the company as per its financial managers who run the business. Investment advisor very frequently use book value to know the value of business. Suppose the book value of a company is $75 million and number of shares outstanding in the market is 10 million.

Then book value per share will be equal to $7.5; on the other hand if the market price per share of the company is $10, then it means that the share is over priced by $2.5. It is a common phenomenon that the companies in the list of top 100 market capitalization list will generally have a market price higher than the book value figures. In case the stock market is seeing a bull phase then the investor can have a general idea about the range of value of business, Market Capitalization will give the Max Value and Book Value will give the Min Value. It is always best to buy shares playing very close of book value. This is the strategy of long term investors.

Book value is a term used to refer to a company's accounting net worth (assets minus liabilities). Book value, or shareholder equity as it is sometimes called, is used to calculate the profitability of a firm using something called return on equity

(3) Investment Advisor will always have a look into the return of capital (ROC) figures.

Why return on capital is important? Investment advisor has already suggested to buy shares of companies whose market capitalization is high and also whose market price is close to or below its book value. High market capitalization ensures that the business is in demand and is among the most preferred shares in the market, whereas market price close to book value helps in deciding that the shares are not overpriced. But these two parameters does not say anything about how the good the business is? 

Investment advisor will always recommend share market investors to look into return on capital figures of a business and compare it with risk free return. What is the reference of risk free return in Cambodia ?

How to Calculate Working Capital:

Working capital measures how much in liquid assets a company has available to build its business.

The working capital ratio is calculated as: Working Capital = Current Assets – Current Liabilities

The number can be positive or negative, depending on how much debt the company is carrying. If a company’s current assets do not exceed its current liabilities, then it may run into trouble paying back creditors in the short term. The worst-case scenario is bankruptcy. A declining working capital ratio over a longer time period could also be a red flag that warrants further analysis. For example, it could be that the company’s sales volumes are decreasing and, as a result, its accounts receivables number continues to get smaller and smaller.

Return on capital can be measured by knowing the following:

(1) EBIT

(2) Net Working capital

(3) Net Fixed Assets

Return On Capital = Operating Earnings Before Interest and Taxes (EBIT) devided by Tangible capital invested in the business (Net working capital + Net Fixed Assets).

or (EBIT)/(Net working capital + Net Fixed Assets).

Generally companies do report and publish their Net Profit or Profit After Tax (PAT) in their Annual business reports

In simple terms, return on capital measures how much capital is need to conduct the company’s operations or business. And like Earnings Yield, we use a simple back of the envelope calculation using free resources. In this case, Net working capital is simply Current Assets -Current Liabilities.

Net Fixed Assets is simply Plant, Property & Equipment or commonly known as “PP&E”.

We will continue with our Lorillard example in which it has EBIT of 1.629 billion. We will then go to the company’s balance sheet to get out necessary data.



Current Assets: 2.504 Billion

Current Liabilities: 1.786 Billion

PP&E: .238 Millions

So our math looks something like this: (2.504-1.786) +.238 = .956 Millions
So now we simply divide our 2 numbers to arrive at return on capital.

1.629/ .956 = 170.40%

A return on capital of 170% is a bit high. From experience, many of the magic formula stocks have return on capital numbers of 20%+ and sometimes in the hundreds but once we get into the 150%+ numbers, we have to ask ourselves why this number is high.

In this example, there isn’t a lot of PP&E invested in the business. 238 million worth of equipment is producing 1.659 billion worth of operating income. Not a bad business to be in. And historically, tobacco companies have been high return on capital businesses. For example, Another large tobacco company Phillip Morris International (PM) has return on capital of 104%.

Putting the two numbers together we arrive at whether the business is worth investing our money into. It tells us how much the business earns relative to the current valuation and how much it earns on tangible capital. The best part about doing these calculations is that you could literally do them on the back of an envelope without using any Greek letters and complicated math.

Conclusion

Investment Advisor would like to conclude with these important words that share market investment is a risky venture but if followed with a bit of investment basics then profits in long term horizon becomes almost certain. Invest with a close watch on (1) market capitalization, (2) Book value per share and (3) Return on capital figures of the company. Investment advisor is sure that these three parameters can help investors to select a good company.

By CAMFinancialmarket

Structure of Financial Markets

Editor Piseth Mao

A firm can obtain funds in a financial market in two ways. 

1. To issue a debt instrument, such as a bond or a mortgage that is a contractual agreement by the borrower to pay the holder of the instrument fixed dollar amounts at regular intervals (interest and principal payments) until a specified date (the maturity date),

Types of Debt instrument 

• A short-term debt instrument for the maturity is less than a year 
• Long-term for the maturity is ten years or longer. 
• Debt instruments with a maturity between one and ten years are said to be intermediate-term.

  2. To issue equities, such as common stock, which are claims to share in the net income   and the assets of a business. If you own one share of common stock in a company that has issued one million shares, you are entitled to 1 one-millionth of the firm’s net income and 1 one-millionth of the firm’s assets. 

Equities often make periodic payments (dividends) to their holders and are considered long-term securities because they have no maturity date. To own stock means that you own a portion of the firm and have the right to vote on issues important to the firm and to elect its directors.

Disadvantages  of  owning equities

• An equity holder is a residual claimant; the corporation must pay all its
  debt holders before it pays its equity holders.

The advantage of holding equities 

• Equity holders benefit directly from any increases in the corporation’s profitability or asset value because equities confer ownership rights on the equity holders. Debt holders do not share in this benefit, because their dollar payments are fixed.

Primary market:  A primary market is a financial market that new issues of a security, such as a bond or a stock, are sold to initial buyers by the corporation or government agency or the public investors.

Secondary market:  A financial market that securities have been previously issued (and are thus secondhand) can be resold.

An important financial institution that assists in the initial sale of securities in the primary market is the investment bank or underwriters, for the case in Cambodia, there are 7 underwriters that can assist any company that want to raise fund in financial market. They do this by underwriting securities: It guarantees a price for a corporation’s securities and then sells them to the public. Or we can say Initial Public Offering (IPO).

The New York stock exchanges, NASDAQ, Cambodia Securities Exchange in which issued stocks are traded, are examples of secondary markets, 

Other examples of secondary markets are foreign exchange markets, futures markets, and options markets. Securities brokers and dealers are crucial to a well-functioning secondary market. Brokers are agents of investors who match buyers with sellers of securities; dealers link buyers and sellers by buying and selling securities at stated prices.

When an individual buys a security in the secondary market, the person who has sold the security receives money in exchange for the security, but the corporation that issued the security acquires no new funds. A corporation acquires new funds only when its securities are first sold in the primary market. 

Secondary markets serve two important functions. 

1. They make it easier and quicker to sell these financial instruments to raise cash; so they make the financial instruments more liquid. The increased liquidity of these instruments makes them more desirable and easier for the issuing firm to sell in the primary market. 
2. They determine the price of the security that the issuing firm sells in the primary market. The investors that buy securities in the primary market will pay the issuing firm or corporation no more than the price they think the secondary market will set for this security. The higher the security’s price in the secondary market, the higher will be the price that the issuing firm will receive for a new security in the primary market, and the greater the amount of financial capital it can raise. Conditions in the secondary market are the most relevant to corporations issuing securities.

Reference: 

         The Economic of Money,Banking and Financial market by

• Frederic S. Mishkin

What is Financial Market and Financial Intermediaries ?

Editor Piseth Mao

Financial markets perform the essential economic function of channeling funds from households, firms, and governments that have saved surplus funds by spending less than their income to those that have a shortage of funds because they  spend more than their income.

Those (Household,Firms,Government) are the lender or savers  at the left, and those who borrow funds to finance their spending, (the borrower or spenders) are at the right. 

The principal lender or savers are households, but business enterprises and the government (particularly state and local government), as well as foreigners and their governments, sometimes also find themselves with excess funds and to lend them out.

The financial system matches savers and borrowers through two channels: 

• Financial intermediaries
• Financial markets.

Function of Financial Intermediaries  It  stands between the lender-savers and the borrower-spenders and helps transfer funds from one to the other. A financial intermediary does this by borrowing funds from the lender-savers and then using these funds to make loans to borrower-spenders.

Function of Financial Market Financial markets are places or channels for buying and selling stocks, bonds, and other securities. Traditionally, financial markets have been physical places, such as the New York Stock Exchange, the London Stock Exchange. On these exchanges, stocks and bonds were traded by dealers who would meet face-to-face. Today most securities trading takes place electronically between dealers linked by computers and is referred to as OTC “over-the-counter” trading. NASDAQ, originally stood for the National Association of Securities Dealers Automated Quotation System, is an over-the-counter market on which the stocks of many high tech firms such as Apple and Intel are traded. 

In Financial Market  borrowers borrow funds directly from lenders selling securities (also called financial instruments), which are claims on the borrower’s future income or assets. Securities are assets for the person who buys them but liabilities (IOU's or debts) for the individual or firm that sells (issues) them.

Reference: 

         Money, Banking, and the Financial System by

• R. GLENN HUBBARD and ANTHONY PATRICK O’BRIEN

       The Economic of Money,Banking and Financial market by

• Frederic S. Mishkin

PPWSA closed KHR6,250 this week

Researched by Piseth Mao

 PPWSA Daily

Technical Indicators and Chart Analysis

 

PPWSA closed KHR6,300 this week

Researched by Piseth Mao

 PPWSA Daily

Technical Indicators and Chart Analysis

Data source: www.csx.com.kh

Cambodia is mourning for the death of His Majesty King Father Norodom Sihanouk

There are  many achievements during his leadership ,the description below is just some of  His Majesty King Norodom Sihanouk's Great Achievements

His Majesty King Norodom Sihanouk's biography:
 
+Birth Date: 31/10/1922
+Birthplace: Phnom Penh, Cambodia
+Parents: King. Norodom Suramarit & Queen Sisowath Monivong Kossomak Nearyroth Sereivathana
+Death Date: 15/10/2012 by a heart attack

+Death Place: Beijing, China

+Education:
-Initially educated by his great-grandmother, Nak Mneang Chao Khun Pat, and then by his grandfather, Prince Sothearoth, known as a Khmer linguist and a poet
- Studied at Francois Baudoin Primary School in Phnom Penh (1930-1940)
-Studied at Lycée Chasseloup Laubat in Saigon, Vietnam

+ Reign:
- Selected to be the king by the Crown Council (23/04/1941)

- Officially crowned as the king (28/10/1941) in his age of 18

- Returned the national independence to Cambodia (09/09/1953)

The monument was inaugurated in 1958 to celebrate the independence of Cambodia from foreign rule.

- Abdicated in favor of his father establishing Sangkum Reastr Niyum (02/03/1955) 

- Win the court case in International Court of Justice (ICJ) which ruled that the temple was situated in a territory under the sovereignty of Cambodia and not Thailand . 

                                                      (Climbing to Preah Vihea Temple)

- Deposed by Marshal Lon Nol (18/03/1970)
- Returned to Cambodia (14/09/1991)

 -Restore peaces by mobilizing all political parties to stop fighting and signed  the Paris Peace Agreement on 23 October 1991   and have a general election to Cambodia in 1993

                   (Signing of the Paris Peace Agreement on 23 October 1991) (Photo: AFP)

- Crowned again (24/09/1993 – 07/10/2004)

Researched by Piseth Mao

Managerial Finance concepts summary

(Thirteenth Edition, Lawrence J. Gitman, Chad J. Zutter), 2012

• 1.       The internal rate of return( IRR) is the rate that causes The net present value( NPV) to be zero
• 2.       Discounted cash flow method and Net Present value method means the same, it’s a tool in capital investment budgeting.
• 3.       The slop of yield curve is affected by
  -1)interest rate expectation
  -2)liquidity preference
  -3)the comparative of supply and demand in the short and long term market segment .
• 4.       Inverted yield curve Vs normal yield curve.
• 5.       Market efficiency means the flow of new information is almost constant, stock price fluctuate and continuously moving toward a new equilibrium that reflex the most recent information available.
  Market efficiency has 3 stage:
  1.Weak-form
  2.Semi-strong form
  3.Strong-from
• 6.       The value of a share of common stock is equal to the present value of all future cash flow( dividends ) that is expected to provide.
  -basic commons stock valuation model
  1)zero- growth model
  2)constant growth model or Gordon growth model
  3)variable-growth model
• 7.       Alternative way to value a share of common stock is Free cash flow valuation model
  
  -it determines the value of an entire company as the present value of its expected future free cash flows discounted at its weighted average cost of capital which is its expected average future cost of funds over the long run.
• 8.       Other approaches to common stock valuation is:
  -Book value per share
  -Liquidation value per share
  -price/ earning (P/E) ratio
• 9.      Two Categories of Valuation Models:
  
  1)Absolute valuation models attempt to find the "true" value of an investment based only on fundamentals such as dividends, cash flow and growth rate for a single company, and not worry about any other companies. The Valuation models include the dividend discount model, discounted cash flow model, residual income models and asset-based models.
  
  2) Relative valuation models operate by comparing the company in question to other similar companies. These methods involve calculating multiples or ratios, such as the price-to-earnings multiple, and comparing them to the multiples of other comparable firms. For instance, if the P/E of the firm you are trying to value is lower than the P/E multiple of a comparable firm, that company may be said to be relatively undervalued. Generally, this type of valuation is a lot easier and quicker to do than the absolute valuation methods that are why many investors and analysts start their analysis with this method.

• 1.       A decrease in the required return will increase the share value, whereas an increase in the required return will decrease share value.
• 2.       -Risk is a measure of an uncertainty surrounding the return that an investment will earn.
  Example: $1000 government bond that guarantee it's holder 5$ interest after 30 days have no risk, but $1000 invest in common stock, the value of it within 30 days may move up or down a great deal and is very risky because the high variability of its return.
• 3.       A risk- adverse investor will not make a riskier investment unless it offers a high expected return to compensate investor for bearing additional risk.
• 4.       However, a risk- neutral investor will always choose the investment with the higher expected return regardless of its risk.
• 5.       Finally, a risk seeking investor is the one who prefer investment with higher risk and may sacrifice the expected return. such as Gambler,Casinoer ...
• 6.       -Fiscal policy is conducted by a nation's government such as Expansionary fiscal policy is to increase government spending and/or decreases the tax rates, while contractionary policy is the opposite (lower government spending and/or higher tax rates).
  
  -Monetary policy is handled by a country's central banks, in the U.S it is largely conducted through three mechanisms – open market operations, reserve requirements and interest rates (in the form of discount rates)
• 7.       The most common statistical indicator of asset's risk is standard deviation; it measures the dispersion around expected return.
  -the expected value of a return (r) is the average returns that an investment is expected to produce over time.
• 8.       -The higher the standard deviation, the greater the risk.
  -A higher coefficient of variation means an investment have more volatility relative to its expected return.
• 9.       -When assets are perfectly negatively correlated ,the combination of the two assets result the portfolio's returns are risk free, it’s suitable a risk- averse investor
  - however, combining two assets that are perfectly positively correlated, because they always move together in a portfolio does nothing to reduce the risk.
• 10.   Total security risk= diversifiable risk (unsystematic risk) + nondiversifiable risk (systematic risk).
  -the capital assets pricing (CAPM) model links nondiversifiable risk to expected return.
• 11.   The security market line (SML) is the line that reflects an investment's risk versus its return, the line begins with the risk-free rate (with zero risk) and moves upward to the right
  
  -An investor with a low risk would choose an investment at the beginning of the security market line. An investor with a higher risk would choose an investment higher along the security market line.
  
  -If the risk premium required by investors was to change, the slope of the SML would change also. The risk premium such as Expected real growth in the economy, Capital market conditions and Expected inflation rate.
• 12.   Cost of capital is the minimum required rate of return that a project must earn to increase firm value and is derived from the expected average future cost of fund over the long run.
  
  -source cost of fund such as
  1)cost of long term debt( sale of corporate bond)
  2)cost of preferred stock
  3)cost of common stock, it is the return required by investors in market place and there're two form of common stock financing:
  -retained earning
  -new issues of common stock
  
  Two technique to measure cost of common stock:
  -constant dividend growth ( Gordon ) model
  -Capital asset pricing model(CAPM)
•  
  1.       Weighted average cost of capital (WACC) is the expected average future cost of capital (cost of long term debt, cost of preferred stock, and cost of common stock...) and it depends on the firm capital structure.
  2.       NPV = (present value of cash outflow - present value of cash inflow) and EVA (economic value added) = (project cash flow - (cost of capital)*invested capital) method reach the same conclusion.
  3.       Risk and cash inflow
  -to access the risk of a proposed capital expenditure, the analyst need to evaluate the probability that the cash inflow will be large enough to produce a positive NPV; the tools to evaluate are scenario analysis and simulation.
  4.       One of the Most common scenario analysis approach is to estimate the NPV, associated with pessimistic (worse) ,most likely( expected),and optimistic( best) estimates of cash inflow. The rang is determined by subtracting from pessimistic-outcome NPV and optimistic-outcome NPV
  5.       International risk that affect capital budgeting are: exchange rate risk and political risk
  - the approach for dealing with these risk is to determine risk-adjusted discounted rate( is the rate of return that must be earn on a given project to compensate the firm's owners adequately , that is to maintain the firm share price)
  6.       The higher the risk of a project, the higher risk adjusted discount rate (RADR), so the lower the net present value for a future stream of cash inflow.
  7.       CAPM (capital asset pricing model) and SML (securities market line) in capital budgeting
  
  CAPM (require return on asset) =risk free rate of return + beta coefficient for asset*(rate of return on market portfolio of assets -risk free rate of return)
  
  -If any Project have IRR above SML would be accepted because its IRR exceed the require return on assets (CAPM), but would be rejected if IRR below SML.
  
  -in terms of NPV any project that NPV above SML would have a positive NPV, but if it fall below SML would be negative NPV.
  8.       Project analysis techniques
  
  Sensitivity Analysis
  Scenario Analysis
  Break Even Analysis
  Decision Trees
  
  
  COMPARING PROJECTS WITH UNEQUAL LIVES
  
  -annualized net present value (ANPV) approach: An approach to evaluating unequal-lived projects that converts the net present value of unequal-lived, mutually exclusive projects into an equivalent annual amount (in NPV terms)
  
  Step 1 Calculate the net present value of each project j, NPVj, over its life, nj,
  using the appropriate cost of capital, r.
  
  Step 2 Convert the NPVj into an annuity having life nj. That is, find an annuity
  that has the same life and the same NPV as the project.  Step 3 Select the project that has the highest NPV.
• 1.       The greater the IRR above cost of capital, the desire for the project is..
  2.       STOCK PRICE REACTIONS TO CORPORATE PAYOUTS
  
  - when a firm pays a dividend, the stock price should fall by exactly
  the amount of the dividend rate.
  
  - if the firm buys back shares at the going market price, the reduction in cash
  is exactly offset by the reduction in the number of shares outstanding, so the market
  price of the stock should remain the same.
  3.       3 methods of buying back shares by corporation
  -Open market share repurchase
  -Tender offer repurchase
  -Dutch auction repurchase
  4.      When the stock begin trading ex dividend , the stock usually fall exactly the same amount of dividend because the cash formerly held by the firm now in the hand of investor( asset of the firm fall)
  
  -Example: firm have asset 1$ billion, share outstanding 10 millions => each share worth (1$ billion /10,000,000)=$100
  Suppose company pay 1$/share of 10 million share outstanding ,so total dividend payout is 10$ million =>asset of the company fall to 990$ million with the same outstanding share 10 million, each share should worth 99$ or stock price should fall by 1$ exactly the amount of dividend
  
  However, the stock price react to cash dividend payout ( share price fall) may be different than an announcement of an upcoming dividend payout ( Example: firm announce it will increase its dividend ,so share price increase by the news)
  5.       Dividend payout policy
  -residual theory of dividend (the amount left-over after acceptable investment was undertaken)
  -dividend irrelevant theory (the firm value is unaffected by dividend policy)
  -dividend relevant theory( direct relationship between a firm's dividend policy and its market value)
  -bird-in-the-hand argument (investor see current dividend as less risky than future dividend or capital gain)
  6.       Factors affect dividend policy
  -Legal constrain
  - contractual constrain
  -The firm's Growth prospect
  -Owner consideration
  -Market consideration
  7.       Types of dividend policy
  -Constant -pay-out ratio
  -Regular dividend policy
  -Low-regular-and-extra dividend policy
  8.       The goal of working capital ( or short term financial ) management is to manage the firm current assets(inventory, account receivable, marketable security, and cash) And current liability( account payable ,accrual, note payable) to achieve a balance between profitability and risk that contribute to the firm's value .
  9.       Cash conversion cycle (CCC)
  The length of time required for a company to convert cash invested in its operation to cash received as a result of its operation.
  
  CCC=Average age inventory(AAI)+average collection period(ACP) - Average payment period(APP)
  10.   Strategies for managing the cash conversion cycle
  
  1)Turn over inventory as quickly as possible without stockouts that result in lost sale
  2) collect account receivable as quickly as possible
  3) Manage mail, processing and clearing time to reduce them collecting from customer and to increase them when paying suppliers
  4) Pay account payable as slowly as possible without the firm credit rating
  11.   Common technique of inventory management
  
  1)ABC system ( divide into A,B,C by its important and level of important on the basis of dollar investment each.
  
  2) Economic order quantity model (EOQ) model (to determine optimal item order size, which is the size that minimize its order cost and carry cost.
  
  3) Just in time inventory
  4) computerized for resource control
  12.   - Hybrid security (Preferred stock, financial leases, convertible
  securities, and stock purchase warrants) A form of debt or equity financing that possesses characteristics of both debt and equity financing.
  
  -Derivative security A security that is neither debt nor equity but derives its value from an underlying asset that is often another security; called “derivatives,” for short.
  
  13 .Strategic merger versus Financial merger
  
  - Strategic merger :A merger transaction undertaken to achieve economic of scale and synergies ( ex. Intel + McAfee) both high tech firm , (Norwest and wells Fargo ) both bank
  
  -Financial merger:A merger transaction undertaken with the goal of restructuring the acquired company to improve it cash flow and unlock its unrealized value.
   
  14  Four types of merger
  
  - horizontal merger: A merger of two firms for the same line of business ( this merger may eliminate the competitor)
  
  - vertical merger: when a firm acquire a supplier or customer( increase control over raw material or the distribution of finished product)
  
  -con-generic merger: A merger that one firm acquire another firm that in the same general industry but is neither in the same line of business nor a supplier or customer( increase ability to use the same sale and distribution channel to reach customers of both business )
  
  -Conglomerate merger: A merger combine unrelated business (to reduce risk by merging firm that have different seasonal or cyclical sales pattern or earnings)
  
  15 -Leverage buy out(LBO)
  
  The acquisition of another company using a significant amount of borrowed money (bonds or loans) to meet the cost of acquisition. Often, the assets of the company being acquired are used as collateral for the loans in addition to the assets of the acquiring company
  
  -Divestiture  The selling some of the firm's asset for various strategic reason