Stock and equity evaluation process in corporation

This chapter helps students to understand the dividend policy apply by students to understand the company behaviour. the stick and carrot Stock valuation is the process of determining the intrinsic value of a company's stock to assess whether it is overvalued, undervalued, or fairly priced in the market. Investors use stock valuation to make informed investment decisions and maximize returns.

There are two main approaches to stock valuation:

1. Absolute Valuation – This method determines a stock’s intrinsic value based on fundamental financial data such as earnings, dividends, cash flow, and growth potential. Common techniques include:

Discounted Cash Flow (DCF) Analysis – Estimates the present value of a company's future cash flows.

Dividend Discount Model (DDM) – Values a stock based on its expected future dividends.

Earnings Multiplier Approach – Uses price-to-earnings (P/E) ratios to estimate stock value.



2. Relative Valuation – This method compares a stock’s value to that of similar companies using financial ratios such as:

Price-to-Earnings (P/E) Ratio – Compares a stock’s price to its earnings per share (EPS).

Price-to-Book (P/B) Ratio – Compares the stock price to the company’s book value.

Enterprise Value-to-EBITDA (EV/EBITDA) – Evaluates a company’s value relative to its earnings before interest, taxes, depreciation, and amortization.

1. Hedge Funds A privately organized investment vehicle that manages a concentrated portfolio of public securities and derivative instruments on public securities, that can invest both long and short, and can apply leverage. Within this definition there are key elements of hedge funds that distinguish them from their more traditional counterpart, the mutual fund.

2. Hedge Funds First, hedge funds are private investment vehicles that pool the resources of accredited investors. One of the ways that hedge funds avoid the regulatory scrutiny of the SEC or the CFTC is that they are available only for high net worth investors. Mutual funds are regulated investment products offered to the public and available for daily trading. Hedge funds are known for using higher risk investing strategies with the goal of achieving higher returns for their investors.

3. Hedge Funds Second, hedge funds tend to have portfolios that are much more concentrated than their mutual fund brethren. Most hedge funds do not have broad securities benchmarks. Third, hedge funds tend to use derivative strategies much more predominately than mutual funds.

4. Hedge Funds Finally, hedge funds use leverage, sometimes, large amounts. Mutual funds, for example, are limited in the amount of leverage they can employ. Overall, hedge funds are usually managed much more aggressively than their mutual fund counterparts.

5. Hedge Funds Accredited investors are deemed to have advanced knowledge of financial market investing, typically with higher risk tolerance than standard investors. These investors are willing to bypass the standard protections offered to mutual fund investors for the opportunity to potentially earn higher returns.

6. Hedge Funds According to "BusinessInsider.com" as of May 2018, the three largest hedge fund managers included: Bridgewater Associates AQR Capital Management Renaissance Technologies

7. Hedge Funds Strategies Equity Long/ Short Global Macro Short Selling Convertible Bond Arbitrage Fixed Income Arbitrage Merger Arbitrage Relative Value Arbitrage Event Driven Market Neutral Market Timers

8. Equity Long/Short Equity long/short managers build their portfolios by combining a core group of long stock positions with short sales of stock or stock index options/futures. Their net market exposure of long positions minus short positions tends to have a positive bias. For instance, during stock market surge, these managers tended to be mostly long their equity exposure. However, as the stock market turned into a bear market, these managers decreased their market exposure as they sold stocks.

9. Equity Long/Short For example, consider a hedge fund manager, who had a 100% long exposure to tobacco industry stocks and had a 20% short exposure to semiconductor stocks. The beta of the S&P Tobacco index is 0.5, and for the Semi-Conductor index it is 1.5. The weighted average beta of the portfolio is: [1.0 × 0.5] + [ - 0.20 × 1.5] = 0.20 E (Return on Portfolio) = Risk-free rate + Beta × (Return on the Market - Risk-free rate) 6% + 0.20 × ( - 9.5% - 6%) = 2.9% The return on the market, represented by the S&P 500 was -9.5%, while the risk-free rate was about 6% .

10. Global Macro As their name implies, global macro hedge funds take a macroeconomic approach on a global basis in their investment strategy. These are top-down managers who invest opportunistically across financial markets, currencies, national borders, and commodities. They take large positions depending upon the hedge fund manager’s forecast of changes in interest rates, currency movements, monetary policies, and macroeconomic indicators.

11. Short Selling Investment/ trading strategy speculating on stock’s decline or other security’s price. It uses some form of market timing, t hat is, they trim their short positions when the stock market is increasing and go fully short when the stock market is declining Short selling hedge funds have the opposite exposure of traditional long-only managers. In that sense, their return distribution should be the mirror image of long-only managers: they make money when the stock market is declining and lose money when the stock market is gaining.

12. Convertible Bond Arbitrage Strategy that aims to capitalize on pricing between a convertible bonds and its underlying stocks. Here, arbitrageur seeks to generate return through a combination of long/short position in the convertible bond and underlying stocks. It is the purchase of a security for cash at one price and the immediate resale for cash of the same security at a higher price. Alternatively, it may be defined as the simultaneous purchase of security A for cash at one price and the selling of identical security B for cash at a higher price. Convertible arbitrage funds build long positions of convertible bonds and then hedge the equity component of the bond by selling the underlying stock.

13. Convertible Bond Arbitrage E xample: A hedge fund manager purchases 10 convertible bonds with a par value of $1,000, a coupon of 7.5%, and a market price of $900. The conversion ratio for the bonds is 20. The conversion ratio is based on the current price of the underlying stock, $45, and the current price of the convertible bond. The delta, or hedge ratio, for the bonds is 0.5. Therefore, to hedge the equity exposure in the convertible bond, the hedge fund manager must short the following shares of underlying stock: 10 bonds x 20 conversion ratio x 0.5 hedge ratio = 100 shares of stock To establish the arbitrage, the hedge fund manager purchases 10 convertible bonds and sells 100 shares of stock.

14. Fixed Income Arbitrage Fixed income arbitrage involves purchasing one fixed income security and simultaneously selling a similar fixed income security. Typically, the two securities are related such that they move similarly with respect to market developments. Generally, the difference in pricing between the two securities is small, and this is what the fixed income arbitrageur hopes to gain. It can be nothing more than buying and selling U.S. Treasury bonds.

15. Merger Arbitrage Merger arbitrage is perhaps the best-known arbitrage among investors and hedge fund managers. Merger arbitrage generally entails buying the stock of the firm that is to be acquired and selling the stock of the firm that is the acquirer. Merger arbitrage managers seek to capture the price spread between the current market prices of the merger partners and the value of those companies upon the successful completion of the merger.

16. Merger Arbitrage The stock of the target company will usually trade at a discount to the announced merger price. The discount reflects the risk inherent in the deal; other market participants are unwilling to take on the full exposure of the transaction based risk. Merger arbitrage is then subject to: Event Risk R isk that the two companies will fail to come to terms and call off the deal R isk that another company will enter into the bidding contest, ruining the initial dynamics of the arbitrage R egulatory Risk.

17. Relative Value Arbitrage It is an actively managed investment fund that seeks to exploit temporary differences in the prices of related securities. Pair-trading, consist of long and short position for a pair of assets that are highly correlated. This strategy of relative value managers is to invest in spread trades, the simultaneous purchase of one security and the sale of another when the economic relationship between the two securities (the “spread”) has become mispriced.

18. Relative Value Arbitrage The mispricing may be based on historical averages or mathematical equations. In either case, the relative value arbitrage manager purchases the security that is “cheap” and sells the security that is “rich.” It is called relative value arbitrage because the cheapness or richness of a security is determined relative to a second security. Consequently, relative value managers do not take directional bets on the financial markets. Instead, they take focused bets on the pricing relationship between two securities regardless of the current market conditions.

19. Event Driven Event driven hedge funds attempt to capture mispricing associated with capital market transactions. These transactions include mergers and acquisitions, spinoffs, tracking stocks, reorganizations, bankruptcies, share buy-backs, special dividends, and any other significant market event. By their nature, these special events are non-recurring. Consequently, the market may take time to digest the information associated with these transactions, providing an opportunity for event driven managers to act quickly and capture a premium in the market

20. Event Driven Additionally, some of these events may be subject to certain conditions such as shareholder or regulatory approval. Therefore, there is event risk associated with this strategy. The profitability of this type of strategy is dependent upon the successful completion of the transaction within the expected time frame. We should not expect event driven strategies to be influenced by the general stock market, since these are company specific events, not market driven events.

21. Market Neutral Market neutral hedge funds also go long and short the market. The difference is that they maintain integrated portfolios which are designed to neutralize market risk. This means being neutral to the general stock market as well as having neutral risk exposures across industries. Market neutral hedge fund managers generally hold equal positions of long and short stock positions. Therefore, the manager is dollar/rupee neutral; there is no net exposure to the market either on the long side or on the short side.

22. Market Neutral Generally, market neutral managers follow a three-step procedure in their strategy. The first step is to build an initial screen of “investable” stocks. These are stocks traded on the manager’s local exchange, with sufficient liquidity so as to be able to enter and exit positions quickly. Second, the hedge fund manager typically builds factor models. These are linear and quadratic regression equations designed to identify those economic factors that consistently have an impact on share prices.

23. Market Neutral Generally, market neutral managers follow a three-step procedure in their strategy. The last step is portfolio construction. The hedge fund manager will use a computer program to construct his portfolio in such a way that it is neutral to the market as well as across industries.

24. Market Timers Market timers, as their name suggests, attempt to time the most propitious moments to be in the market, and invest in cash otherwise. More specifically, they attempt to time the market so that they are fully invested during bull markets, and strictly in cash during bear markets. Unlike equity long/short strategies or market neutral strategies, market times use a top-down approach as opposed to a bottom-up approach. Market timing hedge fund managers are not stock pickers. They analyze fiscal and monetary policy as well as key macroeconomic indicators to determine whether the economy is gathering or running out of steam.

25. Market Timers Once market timers have their forecast for the next quarter(s) they position their investment portfolio in the market according to their forecast. When a market timer’s forecast is bullish, he may purchase stock index futures and when the hedge fund manager is bearish, he will trim his market exposure by selling futures contracts. If it is completely bearish, he will sell all of his stock index futures and call options and just sit on his cash portfolio. In general though, market timers have either long exposure to the market or no exposure.