Introduction to Financial MarketsIntroduction to Financial Markets

Fixed Income SecuritiesFixed Income Securities

The Bond Markets

Characteristics of a Characteristics of a BondBond

• A Bond is simply a standardized loan agreement. It generally has the following characteristics:– Face ValueFace Value: Principal Amount repaid at Maturity.– Coupon Interest PaymentCoupon Interest Payment: Periodic Interest Payment

to holder over life of the Bond.– Maturity DateMaturity Date: Date at which “loan” is repaid.– Indenture ProvisionsIndenture Provisions: Legal restrictions on borrower.

• Main sources of risk for a Bond are:– Default RiskDefault Risk: Borrower not able to pay principal

and/or interest.– Interest Rate RiskInterest Rate Risk: Changes in interest rates affect

Bond value and reinvestment returns of coupons.

Valuing a 5-Year BondValuing a 5-Year Bond

Time = 0

1 2 3 4 5 6 7

Bond Price, Bt

Discounted Cash Flow ApproachDiscounted Cash Flow Approach• Current Bond Price = Present value

of all future Cash Flows (Interest & Principal) at required return,i.

BCP

i

CP

i

CP

i

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itt t t

1 22

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Coupon Interest, CPFace Value, FV

Calculating Yields for a Calculating Yields for a BondBond

• Coupon RateCoupon Rate= = Annual Coupon Interest PaymentAnnual Coupon Interest Payment

Face value of the BondFace value of the Bond

• Current YieldCurrent Yield= = Annual Coupon Interest PaymentAnnual Coupon Interest Payment Current Market Price of the BondCurrent Market Price of the Bond

• Yield-to-Maturity (YTM)Yield-to-Maturity (YTM)Interest rate that makes Present Value of Bond’s Cash Flows Interest rate that makes Present Value of Bond’s Cash Flows

equal to its Current Market Price if bond held to maturity & equal to its Current Market Price if bond held to maturity & no default.no default.

• One-Period Rate of ReturnOne-Period Rate of Return= = (Capital Gain/Loss) + Coupon Interest(Capital Gain/Loss) + Coupon Interest Purchase Price of the BondPurchase Price of the Bond

Money Market SecuritiesMoney Market Securities

• Money MarketsMoney Markets– Short-term, zero coupon debt purchased at

discount to Face Value.

• Types of Money Market SecuritiesTypes of Money Market Securities– U.S. Treasury BillsU.S. Treasury Bills: lowest risk, issued by U.S. gov’t

– Federal FundsFederal Funds: Deposits at Federal Reserve

– Certificates of Deposit (CD’s):Certificates of Deposit (CD’s): Issued by Banks.

– Eurodollar DepositsEurodollar Deposits: US$ deposits outside of U.S.

– Commercial PaperCommercial Paper: unsecured loan to large firms.

– Repurchase AgreementsRepurchase Agreements: collaterized loans

Corporate BondsCorporate Bonds

• Corporate BondsCorporate Bonds– More than one year to maturity.– Contain indenture provisionindenture provision (limits on issuer behavior)– Most bonds pay coupon interestcoupon interest based on Face Value.Face Value.– Quality Rated Quality Rated according to default risk default risk of corp. issuer.

• Bond ratings by Moody’s, Standard & Poor

• Depend on issuer’s financial conditionfinancial condition & indenture provisions.

• Highest ratingHighest rating: Moody’s Aaa, S&P AAA - “Blue Chip stocks”

• Adequate ratingAdequate rating: Moody’s Baa, S&P BBB - “economic risk”

• Poor qualityPoor quality: Moody’s Caa, S&P CCC - “danger of default”• Junk BondsJunk Bonds: Moody’s Ba, S&P BB or lower rated

U.S. Treasury & Agency U.S. Treasury & Agency BondsBonds

• Types of U.S. Treasury Bonds (very liquid)Types of U.S. Treasury Bonds (very liquid)– Treasury Bills (T-Bills):Treasury Bills (T-Bills): Short-term, sold at discount.

– Treasury NotesTreasury Notes: Mature 1-10 yrs, pay coupon interest.

– Treasury Bonds (T-Bonds):Treasury Bonds (T-Bonds): Mature 10 to 30 years, pay coupon interest, callablecallable prior to maturity by gov’t.

– Special IssuesSpecial Issues: sold only to gov’t agencies with cash.

• Types of U.S. Agency BondsTypes of U.S. Agency Bonds– Agency Securities:Agency Securities: FHA, FNMA, GNMA, SLMA, etc have

implicit or explicit gov’t guarantee

– Zero Coupon BondsZero Coupon Bonds: pay no interest, sell at discount.

Equity InstrumentsEquity Instruments

The Stock Markets

Common & Preferred Common & Preferred StockStock

• Common StockCommon Stock– Residual claimResidual claim (ownership) on firm earnings & assets.– Voting powerVoting power & Preemptive rightPreemptive right to new stock issues.– Receive Cash DividendsCash Dividends at management discretion.

• Preferred StockPreferred Stock– Preferential treatment to common stockPreferential treatment to common stock

• First claim to dividends up to set level.First claim to dividends up to set level.• First owner claim to assets (after bondholders) in First owner claim to assets (after bondholders) in

bankruptcy.bankruptcy.

– Little or no voting power but Preemptive rightLittle or no voting power but Preemptive right to new issues of stock.

– Receive stipulated Cash Dividendstipulated Cash Dividend amount each year.

Valuing Common Stock IValuing Common Stock I

• Annual Holding Period ReturnAnnual Holding Period Return

rt = [(Pt+1- Pt) + Dt]/Pt = Capital Gain/Loss + Dividend

Pt = Share Price at time t, Dt = Dividends in Period t

• Book Value of Common StockBook Value of Common Stock

= = Firm Assets - Firm LiabilitiesFirm Assets - Firm Liabilities

Total # Shares OutstandingTotal # Shares Outstanding– Easy to calculate but means very little because

Assets and Liabilities are carried at historic costs rather than current market values on Balance Sheet.

Valuing a Valuing a Company’s SharesCompany’s Shares

“Value based on a satisfactory trend must be wholly arbitrary and hence speculative, and hence inevitably subject to exaggeration and later

collapse”

Graham and Dodd, Security Analysis

Valuing Common StockValuing Common Stock

Time = 0

1 2 3 4 5 6 7

Stock Price, PSt

Uncertain Dividends, Dt

Dividend Discount Model (DDM)Dividend Discount Model (DDM)Current Stock Price = Present value of all future Expected Dividends at required return, rE.

n

E

en

E

e

E

e

Er

D

r

D

r

DP

111 22

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Constant Earnings & DividendsConstant Earnings & Dividends

1 2 3 4 5 6 7

Share Price,PS

• Assume firm has constant earnings per share (E) of $100 forever.

• It payouts half of these earnings each year (payout ration, k=.5) as dividends (D) of $50 per share.

What is one share of this company worth?

$50$50 $50 $50$50$50$50

Dividends per share, D = payout ratio, k x Earnings per Share, E

• Share price equals present value of $50 each year forever at required return.

• Assume required return on equity is 20%, i.e. rE = .20

• Can show PS = D/rE = kE/rE= $50/.20 = $250 or PS/E = k/rE = 2.5

Constant Earnings GrowthConstant Earnings Growth

1 2 3 4 5 6 7

Share Price,PS

• Firm has current earnings per share (E) of $100.• Earnings expected to grow at 10% a year forever (g = .10). • It payouts half of these earnings each year (payout ration,

k=.5) as dividends (D).

What is one share of this company worth?

Dividends per share, D = payout ratio, k x Earnings per Share, E

• Share price equals present value of constantly growing dividends.• Required return on equity is 20%, i.e. rE = .20

• Can show PS = D1/(rE – g) = kE1/(rE – g) = $55/(.20 - .10) = $550

$66.55$60.50

$73.20$88.58$80.53

$55

$97.44

Valuing Firm using Cash FlowsValuing Firm using Cash Flows

• Majority of firms do not issue dividends.• How to value these firms?

1. Look at cash flows generated by firm in excess of what is needed to operate

• Called Free Cash Flows, FCF

2. Total value of firm (Debt + Equity) equals present value of these future FCF’s.

3. Analyst forecasts these FCF’s, arrives at estimate of firm’s total value.

4. Subtract off value of firm’s debt. What remains is value for shareholders.

5. Divide by # of shares outstanding to arrive at share price.

Financial StatementsFinancial Statements

How do Accounting Statements help us in thinking about a Share’s value?

What Does The Investment What Does The Investment Analyst Scrutinize?Analyst Scrutinize?

• The Balance Sheeto Assets vs. Liabilities & Shareholder Equity

• The Income Statemento Revenues vs Costs

• The Cash Flow Statemento Sources and Uses of cash

"Financial statements are like fine perfume: to be sniffed but not swallowed.“ Abraham Brilloff

Sources of InformationSources of Information

Company issues: – Annual & quarterly reports; Press releases;

investor relations materials

SEC Filings for the Company:– 10K, 10Q, Form 4

Online Filings with Edgar:– www.edgar-online.com or www.sec.gov

Balance SheetBalance Sheet“Own & Owe Statement”“Own & Owe Statement”

Assets

• Current Assets:Cash Accounts ReceivableInventoriesMarketable Securities

• Non-current Assets:Land & PropertyEquipment

- Accumulated Depreciation

Liabilities

• Current Liabilities:Accounts PayableAccrued Expenses, e.g.

taxesShort-term BorrowingsDividends

• Non-current Liabilities:

Long-term Borrowings

Shareholders’ Equity

Capital StockRetained Earnings

Assets = Liabilities + Shareholders’ Equity

The Pepsi Bottling Group, Inc.

Condensed Consolidated Balance Sheets in millions, except per share amounts

(Unaudited) June 16, Dec. 30, Assets 2001 2000 Current Assets Cash and cash equivalents................................................ $191 $318 Accounts receivable, less allowance of $42 at June 16, 2001 and December 30, 2000, respectively..........…………….......

1,013

796

Inventories................................……………............................ 367 281

Prepaid expenses and other current assets............................

159

189 Total Current Assets.................................…………............ 1,730 1,584

Property, plant and equipment, net...................................... 2,432 2,358 Intangible assets, net...................................……................. 3,689 3,694 Other assets...............................................………................ 102 100

Total Assets..........................................…………………..... $7,953 $7,736

(Unaudited) June 16, Dec. 30,

Liabilities and Shareholders' Equity 2001 2000 Current Liabilities

Accounts payable and other current liabilities...………...................... $972 $941

Short-term borrowings.......................……………............................. 173 26

Total Current Liabilities....................…………………….................... 1,145 967

Long-term debt................................………………........................... 3,282 3,271

Other liabilities................................…………………......................... 505 474

Deferred income taxes...................……………................................. 1,058 1,072

Minority interest.............................………………............................. 322 306

Total Liabilities............................………………………................... 6,312 6,090

Shareholders' Equity

Common stock, par value $.01 per share:

authorized 300 shares, issued 155 shares............................ 2 2

Additional paid-in capital.......................................………………...... 1,736 1,736

Retained earnings.............................................……………….......... 491 355

Accumulated other comprehensive loss.................…….................. -287 -254

Treasury stock: 12 shares & 10 shares at June 16, 2001

and Dec. 30, 2000, respectively............................................... -301 -193

Total Shareholders' Equity.........................………………............. 1,641 1,646

Total Liabilities and Shareholders' Equity......…………............. $7,953 $7,736

Income StatementIncome Statement“Ability to Make Sales & Control Expenses…“Ability to Make Sales & Control Expenses…

Revenues/Sales + Other Income - Costs

= Operating Income (EBIT) - Provisions for income tax

= Net Earnings (Income) ÷ # of common shares

= Earnings per Share (EPS) - Dividends

= Retained Earnings

Costs include:COGSR&DS G & ADepreciationAmortizationInterest Expense

… and earn Profits over Time.”

The Pepsi Bottling Group, Inc.

Condensed Consolidated Statements of Operations in millions except per share amounts, unaudited

12 Weeks Ended March 24, March 18, 2001 2000

Net Revenues..................................................……............ $1,647 $1,545 Cost of sales...................................................……............ 882 845

Gross Profit.......................................................………....... 765 700 Selling, delivery and administrative expenses ……..…….. 675 625

Operating Income..........................................….................. 90 75 Interest expense, net.....................................….................. 44 45 Minority interest..........................................……................ 5 3

Income before income taxes......................……................. 41 27 Income tax expense...........................….............................. 15 10

Net Income.........................................………...................... $26 $17

Basic Earnings per Share.................................................... $0.18 $0.11 Weighted-Average Shares Outstanding...........................… 145 149

Diluted Earnings per Share.................................................. $0.17 $0.11 Weighted-Average Shares Outstanding.............................. 150 149

Cash Flow StatementCash Flow Statement“The Ins and Outs of Money ...“The Ins and Outs of Money ...

Net Income+/– Changes in Assets and Liabilities+ Depreciation and Amortization Expenses

= Operating Cash Flow– Investing Activities+ Financing Activities

= Increase / (Decrease) in Cash … Over a Set Period

of Time.”

The Pepsi Bottling Group, Inc. 12 Weeks Ended Condensed Consolidated Statements of Cash Flows March 24, March 18,

in millions, unaudited 2001 2000 Cash Flows - Operations

Net income...................................................................... $26 $17

Adjustments to reconcile net income to net cash provided by operations:

Depreciation.............................................................. 81 76

Amortization.............................................................. 30 30

Deferred income taxes..................................................... 1 -11

Other non-cash charges and credits, net................................... 40 33

Changes in operating working capital:

Trade accounts receivable............................................... 2 -8

Inventories............................................................. -33 -7

Prepaid expenses and other current assets............................... 2 -13

Accounts payable and other current liabilities.......................... -120 -115

Net change in operating working capital .................................. -149 -143

Net Cash Provided by Operations................................................... 29 2

Cash Flows - Investments

Capital expenditures........................................................... -114 -85

Other, net..................................................................... -7 -4

Net Cash Used for Investments..................................................... -121 -89

Cash Flows - Financing

Short-term borrowings - three months or less................................... 9 19

Payments of third-party debt................................................... -1 -8

Dividends paid................................................................. -3 -3

Treasury stock transactions.................................................... -54 -29

Net Cash Used for Financing....................................................... -49 -21 Effect of Exchange Rate Changes on Cash and Cash Equivalents...................... -4 -1

Net Decrease in Cash and Cash Equivalents......................................... -145 -109

Cash and Cash Equivalents - Beginning of Period................................... 318 190

Cash and Cash Equivalents - End of Period......................................... $173 $81

Supplemental Cash Flow Information

Third-party interest and income taxes paid........................................ $100 $139

What’s Important To A What’s Important To A Company?Company?

To show:1. Consistent earnings growth2. Positive public image3. Efficient

management/process/service4. Perception of market savvy5. Ahead of its competition

What Are the Clues?What Are the Clues?

The “Easy” ones:

Asset Turnover: Sales / Assets

Profitability:Income / Sales

Financial Leverage: Assets / Equity

Return on Equity: Income / Equity

The “Hard(er)” Ones

Investments for the Future, e.g. R&D, M&A strategy

Trends in sales, costs, unit growth, margins

Accounting Practices (a “black hole” into which much can be hidden)

The Secret: Much of this is in the Notes to the Financial Statements

How Is It All Tied Together?How Is It All Tied Together?

1. A dose of skepticism never hurts. 2. Hidden costs (deception) and fraud are different

and have brought more than one company down.

3. Extrapolation of the past is good but not enough.

4. Not all investors are the same: “Different strokes for different folks.”

5. Read the Notes to Financial Statements6. Accept that - in general - Markets are Efficient.

Financial MarketsFinancial Markets

Primary & Secondary Markets

Primary MarketsPrimary Markets

• When a firm sells new securities to raise funds, offering is called a primary issue.

• Generally employ an agent to find buyers for the securities; investment banker or underwriter.– Advisory:Advisory: Determine financing strategy – Administrative:Administrative: Satisfy regulations & red tape. – Underwriting:Underwriting: Guarantees certain minimum price or cash.

– Distribution servicesDistribution services: Finds investors to purchase issue.

– Market stabilizationMarket stabilization: Stabilizes new issue price for some period by “making market” .

Secondary Markets ISecondary Markets I

• Organized Security ExchangesOrganized Security Exchanges– provide continuous market where investors can buy

or sell securities immediately at fair market prices.• provide liquidity and marketability to securities & investors.

– Largest Organized ExchangesLargest Organized Exchanges• New York Stock Exchange (NYSE)• American Stock Exchange (AMEX)• Regional Exchanges

– NYSENYSE• Voluntary association with memberships.• Trading floor with member market-makers quoting prices.• Listing Requirements for Corporations.

Secondary Markets IISecondary Markets II

• Over the Counter (OTC) MarketsOver the Counter (OTC) Markets– provide continuous market where investors can buy

or sell securities immediately at fair market prices.• No organized central exchange.• Broker-Dealers linked by phone or computer.• Securities traded cover gov’t bonds through speculative

stocks.

• OTC MarketsOTC Markets• Broker-DealersBroker-Dealers make markets (buy/sell) in certain security.• Nat’l Assoc. of Security Dealers (NASD)Nat’l Assoc. of Security Dealers (NASD)

– NASDAQNASDAQ: Automated Quote System with current bid/ask prices.

– Competition among market-makers is setting quoted prices.

Security Market Security Market IndexesIndexes

• Market IndexesMarket Indexes: Pure numbers indexed to a base year.

• Normally a weighted average ratio calculated from an average of a large number of securities of interest.– Weights chosen as either Value-weights or Equal-weights on

prices of securities included in index.– Denominator is the weighted average value in a chosen base

year.

• Many different indices used depending on interest– Dow Jones Industrial Average (DJIA)Dow Jones Industrial Average (DJIA)– Standard & Poor’s 500 composite stocks averageStandard & Poor’s 500 composite stocks average– NYSE indexNYSE index– Dow Jones 40 bond indexDow Jones 40 bond index– Dow Jones indices of spot commodity prices.Dow Jones indices of spot commodity prices.

Efficient Markets HypothesisEfficient Markets Hypothesis

Information & Expectations

Market EfficiencyMarket Efficiency

• Generally assume that financial markets are “efficient”.

• Financial market is efficient if it fully and correctly reflects all available information in determining security prices.

• Formally, a market is efficient with respect to some set of information.– In an efficient market, no no systematicsystematic excess profitsprofits are

made by investors trading on this information.

– An investor may beat the market this year, but very few investors will beat the market in several consecutive years.

Forms of Market EfficiencyForms of Market Efficiency• Weak Form Market EfficiencyWeak Form Market Efficiency

– Information includes only history of past prices or returns.

– Technical AnalysisTechnical Analysis

• Semi-Strong Form Market Efficiency Semi-Strong Form Market Efficiency – Information includes all information known to market,

i.e. “all publicly available information”. – Fundamental AnalysisFundamental Analysis

• Strong Form Market EfficiencyStrong Form Market Efficiency– Information set includes all information known to any

market player, “all publicly & privately available information”.

– Insider TradingInsider Trading

• Tend to find markets are Weak & Semi-Strong efficient but not Strong efficient.

Deviations from EfficiencyDeviations from Efficiency

• Most studies support Weak or Semi-Strong efficiency but there are some anomalies to efficient securities markets.

– Weekend EffectWeekend Effect: Monday returns slightly lower.

– January EffectJanuary Effect: Small firm returns higher in January.

– Low P/E StocksLow P/E Stocks: Low P/E stocks outperform market.

– Small-Firm EffectSmall-Firm Effect: Small firm stocks beat the market.

– Unexpected Quarterly EarningsUnexpected Quarterly Earnings: Firms whose earnings beat estimates have positive excess returns.

– Neglected Firm EffectNeglected Firm Effect: Stocks with little analyst coverage have abnormal returns.

Technical AnalysisTechnical Analysis

• Technical analysts reject efficient markets.• They believe important information about future

price moves can be found from past price moves.– Market value determined by Demand and Supply.– Supply & Demand governed by many factors.– Security prices tend to move in trends that persist.– Changes in the trend are caused by changes in

demand and supply.– Shifts in demand or supply can be detected from

market transactions.– Some price patterns tend to repeat themselves.