Chapter 11: Valuation Chapter 12: Microstructure ECN 324 Financial Markets & Institutions Dr. David P. EchevarriaAll Rights Reserved1

Benjamin Graham The essence of Graham's value investing is that any investment should be worth substantially more than an investor has to pay for it. He believed in thorough analysis, which we would call fundamental analysis. He sought out companies with strong Balance sheets, or those with little debt, above-average profit margins, and ample cash flow. (Securities Analysis, 1934, written with David Dodd) He coined the phrase "margin of safety" to explain his common-sense formula that seeks out undervalued companies whose stock prices are temporarily down, but whose fundamentals, for the long run, are sound. The margin of safety on any investment is the difference between its purchase price and its intrinsic value. The larger this difference is (purchase price below intrinsic), the more attractive the investment - both from a safety and return perspective - becomes. The investment community commonly refers to these circumstances as low value multiple stocks (P/E, P/B, P/S). All Rights Reserved2Dr. David P. Echevarria

John Burr Williams One of the first economists to view stock prices as determined by “intrinsic value”, is recognized as a founder and developer of fundamental analysis. He is best known for his 1938 text "The Theory of Investment Value", based on his Ph.D. thesis, which was amongst the first to articulate the theory of Discounted Cash Flow (DCF) based valuation, and in particular, dividend based valuation. All Rights Reserved3Dr. David P. Echevarria

Nassim Taleb “The Black Swan” The black swan theory or theory of black swan events is a metaphor that describes an event that comes as a surprise, has a major effect, and is often inappropriately rationalized after the fact with the benefit of hindsight. 1.The disproportionate role of high-profile, hard-to-predict, and rare events that are beyond the realm of normal expectations in history, science, finance, and technology 2.The non-computability of the probability of the consequential rare events using scientific methods (owing to the very nature of small probabilities) 3.The psychological biases that make people individually and collectively blind to uncertainty and unaware of the massive role of the rare event in historical affairs All Rights Reserved4Dr. David P. Echevarria

MPT and CAPM MPT: Modern Portfolio Theory Two Sources of Risk: Variance & Covariance CAPM: Capital Asset Pricing Model Two Sources of Risk: Market, Firm-Specific Valuation Models Gordon Growth: Dividend growth, RROR Price/Earnings ratio: attractiveness of earnings Dr. David P. EchevarriaAll Rights Reserved5

Questions to Answer What is the difference between the MPT and CAPM in terms of risk measurement? What are the principal determinants of stock price movements? Dr. David P. EchevarriaAll Rights Reserved6

7Dr. David P. Echevarria BROKERS  Brokerage Accounts Cash account Pay full cost of all securities purchased 3 business day settlement Margin account Finance portion of purchases (interest charges) Same day settlement Margin Calls Securities Investor Protection Corporation SIPC Insures brokerage accounts up to $500,000 Does not cover market losses

All Rights Reserved8Dr. David P. Echevarria MARKET TRADING DYNAMICS Market Order Buy or sell at the best current price Settlement in three business days Round lot = 100 shares, Block = 10,000+ Limit Order Puts a limit on price Time period can vary: day, GTC Stop Order Becomes order if price reaches specified price No guarantee of execution at specified price

All Rights Reserved9Dr. David P. Echevarria MARKET TRADING DYNAMICS  Long Position Expectation - market heading higher Purchase stock via market order at the Ask Purchase stock via limit order at specified price  Selling Short Expectation - market heading lower Stock borrowed from broker Profits on drop in prices NYSE uptick rule discontinued

All Rights Reserved10Dr. David P. Echevarria REGULATION OF FINANCIAL MARKETS Securities Act of 1933 Registration of securities Prospectus required - full and fair disclosure Securities Act of 1934 Securities and Exchange Commission (SEC) Insider trading prohibited Reporting requirements - form 10-K (EDGAR) State regulations Blue sky laws - vary by state

All Rights Reserved11Dr. David P. Echevarria HOMEWORK QUESTIONS 1.How cash accounts differ from margin accounts? 2.What happens when you get a margin call from your broker? 3.How does a trader earn profits in a short sale? Long position? 4.What was the primary purpose of the 1933 Securities Act? 1934 Act? 5.What does the SEC’s EDGAR system do?