Equity Investments Analysis cheat sheet

Key terms

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.

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.

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.

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.

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.