Corporate Finance Essentials II, Certification link.
- Market Efficiency: ideal condition, and hard to beat market in higher risk-adjusted return in long term.
- Bonds: YTM & Risk.
- Stocks: valuation with multiples.
- Capital Structure: optimal mix of debt and equity.
- Dividend Policy: relevant decision variables.
1. Market Efficiency
- Market price = Intrinsic value.
- Price predictability - No ability to successfully/consistently forecast prices.
- All known information is incorporated in prices.
- Only new (unknown, unpredictable) information affects prices.
Market Efficiency is an “extreme hypothesis” - an ideal state, not strictly achievable. Market Efficiency applies to markets and companies.
1.1 Market Efficiency Levels
- Weak-form efficiency: Prices reflect all past trading information.
- Semi-strong form efficiency: Prices reflect all publicly available information, including financial reports and macroeconomic data.
- Strong form efficiency: Prices reflect all information, both public and private.
1.2 Fundamental and Technical Analysis
- Fundamental analysis (by analysis the company and market) : long-term oriented, produces long-term valuation (not timing) signals.
- Technical analysis (focus on data) : short-term oriented, produces short-term timing (not valuation) signals.
- The more efficient the market is the less effective the technical analysis will be.
1.3 Some Points
- Careful with Overfitting on history data.
- Correlation does not imply Causation.
- Careful with Backtesting.
- Successful strategies are self-defeating - Market Competition.
1.4 Beat the Market
Beating the market is obtaining a higher risk-adjusted return than the market consistently over time - very hard to maintain in the long term.
1.5 Investing
- Active management : require advance tech and more effort, to beat the market.
- Mutual funds.
- Passive management : to keep with market return.
- Index funds / EFTs.
2. Bonds
Bonds (债券) are contracts between a borrower and a lender, specifying the terms of borrowing, including the amount borrowed (principal or face value), interest rate (coupon), and maturity date.
- Indenture is the contract that outlines these terms.
- Principal (Face Value) is the nominal amount that will be repaid at maturity.
- Coupon (Interest Rate) refers to the interest payments made to the bondholder, typically expressed as a percentage of the principal.
- Types:
- Coupon Bonds: Pay periodic interest until maturity.
- $V_{0} = \frac{C}{(1+R)} + \frac{C}{(1+R)^{2}} + … + \frac{C + P}{(1+R)^{T}}$ (to compute V0)
- $p_{0} = \frac{C}{(1+YTM)} + \frac{C}{(1+YTM)^{2}} + … + \frac{C + P}{(1+YTM)^{T}}$ (to compute YTM)
- Zero-Coupon Bonds: Do not pay interest but are sold at a discount and repay the face value at maturity.
- $V_{0} = \frac{P}{(1+R)^{T}}$
- Perpetual Bonds (Consols) : Pay interest indefinitely without repaying the principal.
- $V_{0} = \frac{C}{(1+R)} + \frac{C}{(1+R)^{2}} + … = \frac{C}{R}$
- Coupon Bonds: Pay periodic interest until maturity.
- Discount Rate (折现率) of Bonds : $R = R_{f} + RP$ (see former course)
- RP : risk premium (default risk, interest rate risk, and liquidity risk)
- Yield to Maturity (YTM 到期收益率) annualized return from buying a bond at its market price and holding it until maturity. (see former course)
- Risk:
- Default (credit) Risk - Credit rating agencies: Standard & Poor’s / Moody’s / Fitch / …
- Relevant variables : (1) Debt ratio = Debt / (Debt + Equity); (2) Interest coverage = EBIT/Interest.
- Interest-rate (market) risk: Longer maturity bonds tend to have higher price volatility.
- Liquidity risk: The ease of buying or selling a bond at market price; well-known bonds are more liquid.
- Sovereign Risk: The reliability of different countries in terms of default risk.
- Currency Risk: Exposure to exchange rate fluctuations when investing in bonds priced in different currencies.
- Default (credit) Risk - Credit rating agencies: Standard & Poor’s / Moody’s / Fitch / …
The Essential Finantial Tooklit - Bonds
2.1 Case Study
High risk <-> High YTM:
| US-08 | GE Captial | Motorla | Trump | |
|---|---|---|---|---|
| Annual YTM | 3.43% | 4.95% | 6.77% | 25.68% |
| Rating | AAA | AAA | BBB+ | CC |
3. Stocks Valuation
Value (subjective) is not Price (objective).
(1) Absolute Valuation (DCF models)
(2) Relative Valuation (Multiples).
- Two critical Issues:
- Determining a benchmark
- Historical benchmark. (of the same company)
- Cross-sectional benchmark. (with other companies of the similar circumstances)
- Why the multiple and the benchmark may differ?
- Fundamentals explain the difference (trivial) - No trading opportunity.
- Fundamentals cannot explain the difference - Trading opportunity.
- Critical fundamentals : begin with growth and risk.
- Determining a benchmark
- P/E ratio - Price divide by some measure of the company.
- P : stock price, E : could change to be any value.
- PEG ratio = (P/E)/g. (price - earnings to growth ratio)
- Trailing PE (use history E) & Forward PE (use future E).
The Essential Finantial Toolkit - Multiples
3.1 Case Study
P/E ratio using Earnings per share;
| Hilton Historical | 2001 | previous 5y | previous 10y |
|---|---|---|---|
| P/E | 14.2 | 23.7 | 23.4 |
Estimate price by reference P/E ratio \(P^{*} = (P/E)^{*} * E\)
| Cross-sectional | Hilton | Sector | Marriott | Starwood |
|---|---|---|---|---|
| P/E | 14.2 | 22.9 | 23.7 | 18.5 |
Value Trap. “Hilton is cheap” ? Never conclude with only the upper two models.
4. Capital Structure
Capital Structure:
- Proportions of sources of financing. Right-hand side of the balance sheet.
- Objective : Finding the best (cheapest) way to finance the long-term projects of a company.
- What financial instruments, and in that proportions, minimize a company’s cost of capital.
- Optimal capital structure - find the best $x_{D}$ and $x_{E}$
Debt Ratios and Required Returns:
- Higher Debt Ratio - Worse credit rating - higher the cost of debt - higher the required return on (cost of) debt.
- Higher Debt Ratio - higher the beta - higher the cost of equity - higher the required return on (cost of) equity.
4.1 Case Study
| Debt ratio | 0% | 10% | 20% | 30% | 40% | 50% | 60% |
|---|---|---|---|---|---|---|---|
| Equity ratio | 100.0% | 90.0% | 80.0% | 70.0% | 60.0% | 50.0% | 40.0% |
| Cost of debt | 2.0% | 2.1% | 2.5% | 3.2% | 4.0% | 5.3% | 7.0% |
| After-tax cost of debt | 1.6% | 1.7% | 2.0% | 2.6% | 3.2% | 4.2% | 5.5% |
| Cost of equity | 5.0% | 5.2% | 5.5% | 6.0% | 7.0% | 8.2% | 10.0% |
| Cost of capital | 5.00% | 4.85% | 4.80% | 4.96% | 5.46% | 6.19% | 7.32% |
4.2 Final Points
- Credit Ratings: AAA ratings are rare. Companies with AAA ratings have low debt levels, which can limit their ability to finance operations.
- Financial Flexibility: CFOs prioritize financial flexibility, which allows companies to raise debt quickly for investment opportunities. This flexibility is crucial for maintaining a healthy capital structure.
5. Dividend Policy
- Trade-off : The decision involves a trade-off between paying out dividends and reinvesting in the company for growth.
- Optimal Dividend Payout Ratio (DPR = DPS/EPS): The ideal scenario is to find a payout ratio that maximizes the share price, though this is challenging to determine.
- Relevant variables : environment, clienteles (shareholders), growth opportunities, smoothing, signals, taxes, ...
- how the environment is.
- what shareholders really want.
- managers tend to make the dividend smooth.
- dividend is a (good/bad) signal to the public.
Share Buybacks. Dividends tend to be stable, buybacks can fluctuate significantly.