Chapter 1

Part A: Markets and analysis

Equity markets and securities

Last updated November 20269 sectionsabout 7 min read

Key takeaways

The financial system channels savings into investment through financial markets, financial intermediaries and the regulatory infrastructure.
Intermediation routes funds through an institution, such as a bank loan; disintermediation lets savers and borrowers deal directly through securities markets, bypassing the intermediary.
A market order puts certainty of execution first, a limit order puts price first, and a stop order becomes a market order once its trigger price is reached.
Ordinary shares carry a residual claim on earnings and assets and usually voting rights; preference shares carry a fixed dividend paid before ordinary dividends and usually no votes.
Market value is what the share trades for, book value is a backward-looking historical-cost measure, and intrinsic value is the analyst's own estimate, compared against market value to judge mispricing.

Before valuing an equity security, the subject of the valuation chapters that follow, an analyst needs a clear picture of the market it trades in and the security itself, the subject of this opening chapter.

The financial system and intermediaries

Components of the financial system

Financial markets, financial intermediaries, and the regulatory infrastructure (covered in CIFA Regulation of Financial Markets) that together channel savings into investment.

Characteristics of a well-functioning financial system

Deep and liquid markets, low transaction costs, strong investor protection, transparent pricing, and efficient allocation of capital to its most productive use.

Role in the economy

Mobilises savings, allocates capital to its best uses, enables risk transfer and diversification, and provides price discovery.

Financial intermediaries: classification and services

Depository institutions (banks), insurance companies, and investment intermediaries such as brokers and fund managers, each transforming savers' funds into a form borrowers and issuers can use.

Financial intermediation versus disintermediation

Intermediation channels funds through an institution (a bank loan); disintermediation lets savers and borrowers transact directly, typically through securities markets (a corporate bond bought directly by an investor), bypassing the traditional intermediary.

Roles of financial intermediaries

Reducing search and transaction costs, providing maturity and risk transformation, pooling and diversifying risk, and supplying liquidity and price information to the market.

Primary and secondary markets

As established in CIFA Introduction to Finance and Investment, the primary market is where new equity is issued and sold to raise capital, while the secondary market is where already-issued shares subsequently trade between investors, providing the liquidity that makes primary issuance attractive to begin with.

Types of market orders

Market order

Instructs immediate execution at the best currently available price, prioritising certainty of execution over price.

Limit order

Sets a maximum price to pay (buy) or minimum price to accept (sell), prioritising price over certainty of execution.

Stop order

Becomes a market order once a specified trigger price is reached, commonly used to limit losses on an existing position.

Good-till-cancelled versus day order

A good-till-cancelled order remains open until executed or cancelled; a day order expires unfilled at the end of the trading day.

Types of equity securities

	Ordinary shares	Preference shares
Features	Residual claim on earnings and assets; typically carry voting rights	Fixed dividend, paid before ordinary dividends; typically no voting rights
Types	Single class, or multiple classes with different voting rights	Cumulative, non-cumulative, participating, convertible, redeemable
Advantages	Unlimited upside potential; voting control	Predictable income; priority over ordinary shares on dividends and in liquidation
Limitations	Residual claim: last to be paid; more volatile	Capped upside; typically no voting influence

Private companies are held by a small number of owners with no public market for their shares (developed fully in the chapter on private company valuation); public companies have shares available to the general investing public, typically listed on an exchange.

Investing in foreign equity securities

Factors to consider

Currency risk, differing accounting standards and disclosure quality, political and regulatory risk, and market liquidity.

Reasons for investing abroad

Diversification benefits, access to industries or growth opportunities underrepresented domestically, and exposure to different economic cycles.

Challenges

Higher information and transaction costs, currency risk, and, for some markets, weaker investor protection or lower liquidity.

Risk and return of equity securities

As established generally in CIFA Introduction to Finance and Investment and CIFA Portfolio Management, equities as a class carry higher expected risk and return than debt; within equities, ordinary shares carry more risk and return potential than preference shares (fixed dividend, priority claim), and smaller, less established or more cyclical companies typically carry more risk than larger, defensive ones.

Market value and book value

Market value

What the security actually trades for, reflecting the market's collective, forward-looking assessment of the company's prospects.

Book value

The accounting net asset value per share (the basis of the price-to-book ratio), a backward-looking historical-cost measure.

Importance

The gap between the two is the starting point for most of this paper's valuation work: intrinsic value estimates (see the chapter on the equity valuation process) are compared against market value to judge mispricing, while book value anchors asset-based approaches (see the chapter on private company valuation) and the residual income model.

Comparing measures of return

Cost of equity

The firm's own required return on equity capital, estimated via CAPM or the dividend growth model, the discount rate used throughout this guide's discounted cash flow models.

Accounting rate of return

A backward-looking, accrual-accounting measure of return actually earned (ARR, ROE, ROA), which can diverge from both the cost of equity and the investor's required return because it uses accounting profit rather than cash flow or market value.

Investors' required rate of return

The forward-looking minimum return an investor demands to hold the security, given its risk, conceptually the same figure as the cost of equity from the company's own perspective, but estimated independently by each investor.

Equity security and company value

A share's value is ultimately a claim on the company's own future value creation: this is the thread connecting company and industry analysis (the chapters on fundamental, company and industry analysis) through to the specific valuation models this guide builds toward, since no valuation model can substitute for understanding the underlying business generating the cash flows being valued.

Exam tip

Keep book value (accounting, historical cost) distinct from intrinsic value (an analyst's own fundamental estimate) and market value (what the security trades for); a scenario question naming any one of the three is usually testing whether you can identify which of the other two it should be compared against.

Self-check

(a) Distinguish a market order from a limit order. (2 marks)

(b) State two features of ordinary shares and two of preference shares. (4 marks)

(d) Distinguish financial intermediation from disintermediation, with an example of each. (3 marks)

Show worked answer

(a) A market order instructs immediate execution at the best currently available price, prioritising certainty of execution over price. A limit order sets a maximum price to pay or minimum price to accept, prioritising price over certainty of execution.

(b) Ordinary shares: a residual claim on earnings and assets, and typically voting rights. Preference shares: a fixed dividend paid before ordinary dividends, and typically no voting rights.

(c) Market value is what the security actually trades for. Book value is the accounting net asset value per share. Book value is backward-looking, a historical-cost measure.

(d) Intermediation channels funds through an institution, e.g. a bank loan. Disintermediation lets savers and borrowers transact directly, e.g. a corporate bond bought directly by an investor.