Founder write-up: Corporate Finance 101
The Basics of Portfolio Optimization, or What I need to know about corporate finance (101) By Jeffrey Cohen President, US Advanced Computing Infrastructure, Inc. September 2, 2020
This article explains the basics of building an equity investment portfolio from first principles. The intended audience is the global scientific and technical community, although specific examples from the United States will be used. The format is to share one paragraph to answer each question succinctly. If you, the reader, comment that you need more information then we may add another paragraph, or a reference. We intend to include a set of references at the end of each article for further information.
Section 1: Point of view of the corporation: managing cash What is a corporation? A corporation is a legal entity that is organized to pursue a purpose. They can be for profit, and can provide services, sell a product, or invent things. A corporation is like a person in the eyes of the law. How does a corporation fund itself? A corporation has choices on how to raise money to pay for operations. It can ask for contributions from key stakeholders, borrow money from a bank or bond holder, sell shares of stock, or use stock to make purchases or pay compensation to employees. So, stock can be used by a corporation to raise money to invest, operate, grow, or cover losses. What is a share of stock? A share of stock represents a fraction of the ownership of the company, after accounting for the debt and liabilities owed by the company. As an example, if a company has 100 shares of stock, then each share represents 1% of the value of the company after paying back any debt or IOUs it holds. How does a corporation make money from its own stock? A corporation can sell shares to the public in an initial public offering (IPO) or sell shares in the secondary markets. A corporation can also pledge to convert debt into shares of stock, which makes their debt less expensive to finance. Finally, some companies pay employees in shares of stock instead of cash for a portion of compensation, thereby saving cash. How does a corporation change the value, or price, of their stock? Corporations can indirectly impact the price of their stock. The easiest way for a company to change the price of their stock is to take an action that changes the long-term value of the firm. These are strategic actions such as inventing and launching a new product or service, releasing a marketing campaign, changing prices and cost structure, targeting new customer segments, and acquiring another firm and merging operations. What is a share buy-back? A share buy-back is when a corporation uses cash (whether owned or borrowed) to buy shares of stock in the open market and ‘retire’ those shares. It usually puts those shares into a category called ‘treasury stock’ so it can use them in the future. This is a way to reduce the number of shares of stock outstanding, which makes each share worth a larger portion of the corporation, but costs the current price of the stock. This is a financing action, as it does not impact the future value of the firm (unless the executives are acting on non-public information that the shares of stock are under-valued and worth more than the current price). Can a corporation own stocks of other corporations? Yes, a company can invest its cash into other companies. This is often true for insurance companies that need to grow assets to pay future liabilities. When you buy a share of a company that owns other companies, you are buying a portion of shares in those companies too.
Section 2: What are the different types of shares of stock? What is common stock vs. preferred stock? Most shares of stock are considered common. This gives them the right to receive any distributions of cash made by the company, including dividends. This gives them the right to vote on shareholder issues. Preferred stocks have extra rights associated with them, like a fixed, higher dividend, liquidation preference over common shares, or extra voting rights, which gives them a different price. Preferred shares are tracked, priced and traded separately. For example, AT&T on Feb 18, 2020 issued EUR 2 billion and USD 1.75 billion in additional preferred stock. What is equity in a corporation? Equity is the value of a corporation after all debts are paid in full. This is normally calculated by taking the total capitalization of a firm (total value to the market), and subtracting the market value of the debt and IOUs it holds). If a company stops operating, the debts are paid first, then the rest of the value is paid to shareholders. What are shares of stocks? A share of stock represents ownership of a percentage of the company’s equity.
Section 3: How do people buy, hold and sell stocks & bonds? How does somebody make money owning a stock? One can receive a dividend or other distribution from the company. For example, a holder of AT&T stock (price ~ $30) will pay $0.52 next quarter. One can sell the stock for more than one paid, or one can lend out the stock to somebody who wants to sell it. What is a capital gain? A capital gain is when one sells a share for more than one paid for it, including all direct expenses like sales commissions. This is a taxable event. What is a stock dividend? A stock dividend is money, or the equivalent value in shares, received from a company. It usually represents the portion of earnings not needed to fund future operations or investments. Dividends are taxable to the recipient. For example, if a company earns $100, after it pays corporate income taxes, and only needs $50 to invest, then it can pay out the remaining $50 in dividends. If the company has 100 shares, each share would receive $0.50 as a dividend. Can I buy shares directly from a company or another investor? No, not generally. Investors must buy their shares through a stock market or financial exchange, which is a third-party that ensures the trades are executed, reported and payments and shares are settled and cleared appropriately. The market or exchange helps to protect investors against counter-party risk (the risk that the person they are trading with does not perform their obligation). One exception is that some companies offer a dividend reinvestment plan (DRIP) that allows dividends to be invested, and paid out each quarter, as additional shares instead of cash.
Section 4: What is a stock market and how does it work? What is a stock market? A stock market is a place where shares are bought and sold, and where commitments to exchange shares and cash are made. Not all shares can be traded on all exchanges or markets. Some stocks are tradeable in one market, in one country, in one currency, while that market is open. Others trade in multiple markets (e.g., Alibaba in Hong Kong and New York). What is a market maker? In the old days, there was a member firm of a stock market that owned a ‘seat’ on the exchange, that was responsible for the orderly conduct of one or more stocks in that market. They matched up trades, ensuring the price moved to clear the supply and demand in the market. They would step in and buy or sell when nobody else wanted to. They were paid the spread between buyer and seller price for performing this role. This spread used to be $0.05, or five cents per share. There are still market makers that help ensure orderly markets, but the spread is no longer five cents, and can be under a penny per share. During a livestream working on this article we saw the spread on AT&T shares was $0.04 during morning trading. Can we see details of stock trades in each market? Is there a delay? Yes, there is an archaic term called a stock ticker, which used to play out on a ticker tape from telegraph lines. The tape contained every trade made in the New York Stock Exchange, and the delay was based on the time it took to enter, transmit, and print-out the trades. This was important for people not close to 11 Wall Street in NYC at the southern tip of the island of Manhattan (the actual location). Today trades can also be made electronically, via the exchange but not in person). Today there is still an obligation to report trades accurately and quickly from all market exchanges. What is a ‘dark pool’? A dark pool is a trading venue that is like a private stock market. Individuals come to the dark pool to buy and sell shares in privacy, typically at larger lot sizes (# of shares), where the trades are aggregated and reported out in a way that protects the trading parties. Why would this privacy help? Let’s say Alice (buyer) and Bob (seller) want to trade USD 1 billion worth of AT&T stock. Alice and Bob come to the dark pool, find each other, make the large transaction efficiently, and the market reports out the trade once completed. In the typical market where lot sizes may be hundreds or thousands of shares, it would take a long time to sell 33 million shares. Also, both the large buyer and seller would pay profits to the market (or incur trading costs), as the presence of a large buyer or seller would raise or lower the price while they are transacting. What are the names of some US stock exchanges? The two largest stock exchanges are the New York Stock Exchange (NYSE) and the National Association of Securities Dealers Automated Quotation System (NASDAQ). Other exchanges are the Boston, Chicago, Miami, Philadelphia and National Stock Exchanges, the Chiago Board Options Exchange (CBOE) Chicago Board of Trade (CBOT), and the International Securities Exchange (ISE). Who sets the price of a share of stock? Prices are set by those who submit trades to buy and sell shares, and are subject to continuous change, while the exchanges are open. There is no central pricing authority, nor do companies set the prices of their own shares. The one exception is during offerings of shares by companies directly to the public, such as during an initial public offering (IPO). They are normally managed through a broker, who sets an opening price in advance to ensure the shares are purchased in full. Is the price of a stock the same across stock markets all the time? No, but it should be the same. Sometimes there are differences in prices across exchanges and markets for the same security. This can be due to information delay, transaction costs, or other forms of ‘friction’ in the market. If the differences are great enough to offset ‘friction’ then arbitrage may take place where a trader will buy low and sell high until prices equalize across markets. Can we see how many shares of a specific stock are currently queued up to be traded (the book)? Yes, but I can no longer find it online. It typically has the buys on one side of the ledger (volume and price for each order), and the sells on the other side. I call it ‘the trading book’ and have used it in the past to understand the depth of supply or demand for a company’s shares at one time. Can we find out who bought and sold a stock? (no) No, we cannot see this in real-time. The SEC can see this through our stock broker, and the company is notified so it can send shareholders information (e.g., proxy vote materials). Of course the Federal Bureau of Investigations can see this in cases of alleged fraud and insider trading. Investors can see daily Securities and Exchange Commission (SEC) filings from a system called EDGAR which shows when insiders buy and sell (Form 4). We can also look for quarterly reports from registered mutual funds and investment managers. For example, my mutual funds from Vanguard either show their top 10 holdings, or all material holdings. There is also a reporting requirement for large holdings (e.g., enough to earn a seat on the board or to attempt an acquisition). How can I find out the current price of a share of stock? The easiest way to find this is from a free stock quote service. We use Yahoo Finance predominantly, along with Koyfin and Finviz for their visualizations. You type in the ticker symbol (for AT&T this is ‘T’) and you see the current price. Most of these services have a delay built in plus an additional delay for the transport and processing of the information on your screen. When I want a more valid quote, I use my brokerage account. It attempts to give me real-time pricing because I have been vetted by them as to the level of risk to be taken, and the information is to be used only to trade stocks on their platform. Professional investment managers can buy real-time Market Data Services from companies like Thompson Reuters, and some firms install an interconnection link directly into the trading floors / electronic exchanges to eliminate the transportation time. As an individual investor trading from home with a keyboard and mouse, even with the fastest eyes and hands, you will always be significantly behind the timing of the professionals in the market. Why is there a spread, or gap, between the buy ‘bid’ and sell ‘ask’ price of a share of stock? The spread is there because sometimes there is an imbalance between the price at which people want to buy and sell a stock. At other times, it could be that the market maker senses a significant imbalance in the market and wants to slow down the action (our opinion), or at least be paid more to take the risk of the less popular side. The market maker can earn a portion of that spread for themself. In the chart below, we see the bid / ask spread has dropped to $0.01 ($29.75 - $29.76). Does the spread change when the markets are closed? We noticed, anecdotally, that prices between the ‘bid’ and ‘ask’ are significantly higher when the markets are closed. There can still be trades made in ‘after hours’ trading, but most of the market participants are offline. Therefore, there is less liquidity in the markets and more of a chance of an imbalance. The hurdle for the investor can be, say $0.50 in spread, to buy a stock after hours.
Section 5: How do people invest in shares of a corporation? What is direct ownership? Direct ownership of shares is when an individual opens a brokerage account and buys shares of a company. Those shares are listed in the investor’s name. What are mutual funds? A mutual fund is a legal entity that invests in stocks and other investments on behalf of shareholders who own a portion of the assets of the fund. Each mutual fund publishes its net asset value (or NAV) daily at the market close. Mutual funds provide administrative, reporting, custodial, and investment management services in return for fees collected from the shareholders. What types of mutual funds are there (open & closed-end)? There are two types of mutual funds in wide use today. Open ended funds buy and sell assets to keep balance with the shareholders and investments made. So, if Alice and Bob decide to buy $1 million of shares in an open ended fund, the fund will attempt to invest that $1 million immediately into the fund’s objectives. Closed end funds have a certain amount of assets invested, say $100 million, and investors buy shares in the fund. The share price may not equal the net asset value of the fund, which can give rise to a premium or discount on those assets. What are exchange traded funds (ETFs)? An exchange traded fund is a tradable stock on a stock exchange that holds investment assets. So, you can buy, hold and sell one ETF share and it represents a holding of the underlying assets. I could imagine doing this when I want to buy and sell hard to find assets quickly, either in timing the market or doing precise strategies where the failure of a trade can upset the balance. Trading gasoline futures against an ETF of oil refineries, where you don’t want to miss a portion of a trade. What are stock options? A stock option is a way to bet on the movement of a stock without owning the stock itself. You can own a ‘call’ which is a right to buy a stock at a price, within a timeframe. You can own a ‘put’ which is a right to sell a stock at a price, within a timeframe. Once the timeframe reaches zero, your contract either expires worthless or ends up ‘in the money’ being settled, or you can take delivery. Most people buy and sell options as either a hedge against up or down moves in the stock, or as a source of revenue on the stocks (like lending them out), or to bet with leverage on a specific stock or index. As an example, a December 18, 2020 call option to buy AT&T at $34.00 a share (up from ~$30 now), trades for ($0.20 - $0.22). A Dec 18 $30 call trades for ($1.21 - $1.25). So, if you believe AT&T is going up this year (e.g., they are paying off debt by selling 50% of DirectTV), you could buy 1 share for $30, and profit if the share rises to $30.01 (on 1 share). You could control 24 shares through December 18 and sell at a profit at $31.25 (on 24 shares). You could control 136.36 shares through December 18, and sell at a profit at $34.25 on 136.36 shares. What are market indices and how are they used? A market index is a benchmark that includes certain stocks that meet a condition, at a certain weighting per stock. It does not imply that anyone actually holds those specific shares in that specific amount...but it is a reporting benchmark. These are useful to compare performance of a portfolio, and are passive in nature (require no intelligence or decision making to maintain the index). The S&P 500 is a market capitalization weighted index based on the largest 500 US stocks. The Dow Jones Industrial Average is a stock price weighted index based on a selection of 30 stocks that mirror the US economy. Multiple investment managers create funds that you can invest in that work to emulate the performance of the S&P 500, including my own 401K.
Section 6: Valuation of stocks How can I find out the total value of a corporation to current or potential investors? The total value of a company is called the market capitalization. It includes the equity capitalization (number of shares * share price) + market value of debt (bonds outstanding * price) + (debt & IOUs not traded) For AT&T, a quick look on Yahoo Finance gives us the equity capitalization now, and we see the debt as of 12/31/2019. This is $211.7B + $190.5 = $402.2B How much is a company worth, or its valuation, to an accountant? An accountant sees the world as assets = liabilities + shareholder equity. Assets don’t have to be real, or tangible. Many firms hold ‘goodwill’ or ‘deferred tax credits’ on their asset register. Assets should be currently valued. Liabilities are current or future expenditures, and should be all inclusive. However, there are things called ‘off balance sheet financing’ and ‘special purpose entities’ that could keep liabilities off the balance sheet temporarily. For AT&T, another quick look on Yahoo Finance gives us the shareholder’s equity as of 12/31/2019: $551.7B - $347.7B = $184.2B. $146.2B of the shareholder equity is made up of goodwill, which is the excess purchase price of another company (purchase price - market value). So, had AT&T paid ~$150B less for their acquisitions, and paid only market value, their assets and liabilities would both be $150B lower, shareholder equity would remain the same, but the debt load would be almost zero.
This article explains the basics of building an equity investment portfolio from first principles. The intended audience is the global scientific and technical community, although specific examples from the United States will be used. The format is to share one paragraph to answer each question succinctly. If you, the reader, comment that you need more information then we may add another paragraph, or a reference. We intend to include a set of references at the end of each article for further information.
Section 1: Point of view of the corporation: managing cash What is a corporation? A corporation is a legal entity that is organized to pursue a purpose. They can be for profit, and can provide services, sell a product, or invent things. A corporation is like a person in the eyes of the law. How does a corporation fund itself? A corporation has choices on how to raise money to pay for operations. It can ask for contributions from key stakeholders, borrow money from a bank or bond holder, sell shares of stock, or use stock to make purchases or pay compensation to employees. So, stock can be used by a corporation to raise money to invest, operate, grow, or cover losses. What is a share of stock? A share of stock represents a fraction of the ownership of the company, after accounting for the debt and liabilities owed by the company. As an example, if a company has 100 shares of stock, then each share represents 1% of the value of the company after paying back any debt or IOUs it holds. How does a corporation make money from its own stock? A corporation can sell shares to the public in an initial public offering (IPO) or sell shares in the secondary markets. A corporation can also pledge to convert debt into shares of stock, which makes their debt less expensive to finance. Finally, some companies pay employees in shares of stock instead of cash for a portion of compensation, thereby saving cash. How does a corporation change the value, or price, of their stock? Corporations can indirectly impact the price of their stock. The easiest way for a company to change the price of their stock is to take an action that changes the long-term value of the firm. These are strategic actions such as inventing and launching a new product or service, releasing a marketing campaign, changing prices and cost structure, targeting new customer segments, and acquiring another firm and merging operations. What is a share buy-back? A share buy-back is when a corporation uses cash (whether owned or borrowed) to buy shares of stock in the open market and ‘retire’ those shares. It usually puts those shares into a category called ‘treasury stock’ so it can use them in the future. This is a way to reduce the number of shares of stock outstanding, which makes each share worth a larger portion of the corporation, but costs the current price of the stock. This is a financing action, as it does not impact the future value of the firm (unless the executives are acting on non-public information that the shares of stock are under-valued and worth more than the current price). Can a corporation own stocks of other corporations? Yes, a company can invest its cash into other companies. This is often true for insurance companies that need to grow assets to pay future liabilities. When you buy a share of a company that owns other companies, you are buying a portion of shares in those companies too.
Section 2: What are the different types of shares of stock? What is common stock vs. preferred stock? Most shares of stock are considered common. This gives them the right to receive any distributions of cash made by the company, including dividends. This gives them the right to vote on shareholder issues. Preferred stocks have extra rights associated with them, like a fixed, higher dividend, liquidation preference over common shares, or extra voting rights, which gives them a different price. Preferred shares are tracked, priced and traded separately. For example, AT&T on Feb 18, 2020 issued EUR 2 billion and USD 1.75 billion in additional preferred stock. What is equity in a corporation? Equity is the value of a corporation after all debts are paid in full. This is normally calculated by taking the total capitalization of a firm (total value to the market), and subtracting the market value of the debt and IOUs it holds). If a company stops operating, the debts are paid first, then the rest of the value is paid to shareholders. What are shares of stocks? A share of stock represents ownership of a percentage of the company’s equity.
Section 3: How do people buy, hold and sell stocks & bonds? How does somebody make money owning a stock? One can receive a dividend or other distribution from the company. For example, a holder of AT&T stock (price ~ $30) will pay $0.52 next quarter. One can sell the stock for more than one paid, or one can lend out the stock to somebody who wants to sell it. What is a capital gain? A capital gain is when one sells a share for more than one paid for it, including all direct expenses like sales commissions. This is a taxable event. What is a stock dividend? A stock dividend is money, or the equivalent value in shares, received from a company. It usually represents the portion of earnings not needed to fund future operations or investments. Dividends are taxable to the recipient. For example, if a company earns $100, after it pays corporate income taxes, and only needs $50 to invest, then it can pay out the remaining $50 in dividends. If the company has 100 shares, each share would receive $0.50 as a dividend. Can I buy shares directly from a company or another investor? No, not generally. Investors must buy their shares through a stock market or financial exchange, which is a third-party that ensures the trades are executed, reported and payments and shares are settled and cleared appropriately. The market or exchange helps to protect investors against counter-party risk (the risk that the person they are trading with does not perform their obligation). One exception is that some companies offer a dividend reinvestment plan (DRIP) that allows dividends to be invested, and paid out each quarter, as additional shares instead of cash.
Section 4: What is a stock market and how does it work? What is a stock market? A stock market is a place where shares are bought and sold, and where commitments to exchange shares and cash are made. Not all shares can be traded on all exchanges or markets. Some stocks are tradeable in one market, in one country, in one currency, while that market is open. Others trade in multiple markets (e.g., Alibaba in Hong Kong and New York). What is a market maker? In the old days, there was a member firm of a stock market that owned a ‘seat’ on the exchange, that was responsible for the orderly conduct of one or more stocks in that market. They matched up trades, ensuring the price moved to clear the supply and demand in the market. They would step in and buy or sell when nobody else wanted to. They were paid the spread between buyer and seller price for performing this role. This spread used to be $0.05, or five cents per share. There are still market makers that help ensure orderly markets, but the spread is no longer five cents, and can be under a penny per share. During a livestream working on this article we saw the spread on AT&T shares was $0.04 during morning trading. Can we see details of stock trades in each market? Is there a delay? Yes, there is an archaic term called a stock ticker, which used to play out on a ticker tape from telegraph lines. The tape contained every trade made in the New York Stock Exchange, and the delay was based on the time it took to enter, transmit, and print-out the trades. This was important for people not close to 11 Wall Street in NYC at the southern tip of the island of Manhattan (the actual location). Today trades can also be made electronically, via the exchange but not in person). Today there is still an obligation to report trades accurately and quickly from all market exchanges. What is a ‘dark pool’? A dark pool is a trading venue that is like a private stock market. Individuals come to the dark pool to buy and sell shares in privacy, typically at larger lot sizes (# of shares), where the trades are aggregated and reported out in a way that protects the trading parties. Why would this privacy help? Let’s say Alice (buyer) and Bob (seller) want to trade USD 1 billion worth of AT&T stock. Alice and Bob come to the dark pool, find each other, make the large transaction efficiently, and the market reports out the trade once completed. In the typical market where lot sizes may be hundreds or thousands of shares, it would take a long time to sell 33 million shares. Also, both the large buyer and seller would pay profits to the market (or incur trading costs), as the presence of a large buyer or seller would raise or lower the price while they are transacting. What are the names of some US stock exchanges? The two largest stock exchanges are the New York Stock Exchange (NYSE) and the National Association of Securities Dealers Automated Quotation System (NASDAQ). Other exchanges are the Boston, Chicago, Miami, Philadelphia and National Stock Exchanges, the Chiago Board Options Exchange (CBOE) Chicago Board of Trade (CBOT), and the International Securities Exchange (ISE). Who sets the price of a share of stock? Prices are set by those who submit trades to buy and sell shares, and are subject to continuous change, while the exchanges are open. There is no central pricing authority, nor do companies set the prices of their own shares. The one exception is during offerings of shares by companies directly to the public, such as during an initial public offering (IPO). They are normally managed through a broker, who sets an opening price in advance to ensure the shares are purchased in full. Is the price of a stock the same across stock markets all the time? No, but it should be the same. Sometimes there are differences in prices across exchanges and markets for the same security. This can be due to information delay, transaction costs, or other forms of ‘friction’ in the market. If the differences are great enough to offset ‘friction’ then arbitrage may take place where a trader will buy low and sell high until prices equalize across markets. Can we see how many shares of a specific stock are currently queued up to be traded (the book)? Yes, but I can no longer find it online. It typically has the buys on one side of the ledger (volume and price for each order), and the sells on the other side. I call it ‘the trading book’ and have used it in the past to understand the depth of supply or demand for a company’s shares at one time. Can we find out who bought and sold a stock? (no) No, we cannot see this in real-time. The SEC can see this through our stock broker, and the company is notified so it can send shareholders information (e.g., proxy vote materials). Of course the Federal Bureau of Investigations can see this in cases of alleged fraud and insider trading. Investors can see daily Securities and Exchange Commission (SEC) filings from a system called EDGAR which shows when insiders buy and sell (Form 4). We can also look for quarterly reports from registered mutual funds and investment managers. For example, my mutual funds from Vanguard either show their top 10 holdings, or all material holdings. There is also a reporting requirement for large holdings (e.g., enough to earn a seat on the board or to attempt an acquisition). How can I find out the current price of a share of stock? The easiest way to find this is from a free stock quote service. We use Yahoo Finance predominantly, along with Koyfin and Finviz for their visualizations. You type in the ticker symbol (for AT&T this is ‘T’) and you see the current price. Most of these services have a delay built in plus an additional delay for the transport and processing of the information on your screen. When I want a more valid quote, I use my brokerage account. It attempts to give me real-time pricing because I have been vetted by them as to the level of risk to be taken, and the information is to be used only to trade stocks on their platform. Professional investment managers can buy real-time Market Data Services from companies like Thompson Reuters, and some firms install an interconnection link directly into the trading floors / electronic exchanges to eliminate the transportation time. As an individual investor trading from home with a keyboard and mouse, even with the fastest eyes and hands, you will always be significantly behind the timing of the professionals in the market. Why is there a spread, or gap, between the buy ‘bid’ and sell ‘ask’ price of a share of stock? The spread is there because sometimes there is an imbalance between the price at which people want to buy and sell a stock. At other times, it could be that the market maker senses a significant imbalance in the market and wants to slow down the action (our opinion), or at least be paid more to take the risk of the less popular side. The market maker can earn a portion of that spread for themself. In the chart below, we see the bid / ask spread has dropped to $0.01 ($29.75 - $29.76). Does the spread change when the markets are closed? We noticed, anecdotally, that prices between the ‘bid’ and ‘ask’ are significantly higher when the markets are closed. There can still be trades made in ‘after hours’ trading, but most of the market participants are offline. Therefore, there is less liquidity in the markets and more of a chance of an imbalance. The hurdle for the investor can be, say $0.50 in spread, to buy a stock after hours.
Section 5: How do people invest in shares of a corporation? What is direct ownership? Direct ownership of shares is when an individual opens a brokerage account and buys shares of a company. Those shares are listed in the investor’s name. What are mutual funds? A mutual fund is a legal entity that invests in stocks and other investments on behalf of shareholders who own a portion of the assets of the fund. Each mutual fund publishes its net asset value (or NAV) daily at the market close. Mutual funds provide administrative, reporting, custodial, and investment management services in return for fees collected from the shareholders. What types of mutual funds are there (open & closed-end)? There are two types of mutual funds in wide use today. Open ended funds buy and sell assets to keep balance with the shareholders and investments made. So, if Alice and Bob decide to buy $1 million of shares in an open ended fund, the fund will attempt to invest that $1 million immediately into the fund’s objectives. Closed end funds have a certain amount of assets invested, say $100 million, and investors buy shares in the fund. The share price may not equal the net asset value of the fund, which can give rise to a premium or discount on those assets. What are exchange traded funds (ETFs)? An exchange traded fund is a tradable stock on a stock exchange that holds investment assets. So, you can buy, hold and sell one ETF share and it represents a holding of the underlying assets. I could imagine doing this when I want to buy and sell hard to find assets quickly, either in timing the market or doing precise strategies where the failure of a trade can upset the balance. Trading gasoline futures against an ETF of oil refineries, where you don’t want to miss a portion of a trade. What are stock options? A stock option is a way to bet on the movement of a stock without owning the stock itself. You can own a ‘call’ which is a right to buy a stock at a price, within a timeframe. You can own a ‘put’ which is a right to sell a stock at a price, within a timeframe. Once the timeframe reaches zero, your contract either expires worthless or ends up ‘in the money’ being settled, or you can take delivery. Most people buy and sell options as either a hedge against up or down moves in the stock, or as a source of revenue on the stocks (like lending them out), or to bet with leverage on a specific stock or index. As an example, a December 18, 2020 call option to buy AT&T at $34.00 a share (up from ~$30 now), trades for ($0.20 - $0.22). A Dec 18 $30 call trades for ($1.21 - $1.25). So, if you believe AT&T is going up this year (e.g., they are paying off debt by selling 50% of DirectTV), you could buy 1 share for $30, and profit if the share rises to $30.01 (on 1 share). You could control 24 shares through December 18 and sell at a profit at $31.25 (on 24 shares). You could control 136.36 shares through December 18, and sell at a profit at $34.25 on 136.36 shares. What are market indices and how are they used? A market index is a benchmark that includes certain stocks that meet a condition, at a certain weighting per stock. It does not imply that anyone actually holds those specific shares in that specific amount...but it is a reporting benchmark. These are useful to compare performance of a portfolio, and are passive in nature (require no intelligence or decision making to maintain the index). The S&P 500 is a market capitalization weighted index based on the largest 500 US stocks. The Dow Jones Industrial Average is a stock price weighted index based on a selection of 30 stocks that mirror the US economy. Multiple investment managers create funds that you can invest in that work to emulate the performance of the S&P 500, including my own 401K.
Section 6: Valuation of stocks How can I find out the total value of a corporation to current or potential investors? The total value of a company is called the market capitalization. It includes the equity capitalization (number of shares * share price) + market value of debt (bonds outstanding * price) + (debt & IOUs not traded) For AT&T, a quick look on Yahoo Finance gives us the equity capitalization now, and we see the debt as of 12/31/2019. This is $211.7B + $190.5 = $402.2B How much is a company worth, or its valuation, to an accountant? An accountant sees the world as assets = liabilities + shareholder equity. Assets don’t have to be real, or tangible. Many firms hold ‘goodwill’ or ‘deferred tax credits’ on their asset register. Assets should be currently valued. Liabilities are current or future expenditures, and should be all inclusive. However, there are things called ‘off balance sheet financing’ and ‘special purpose entities’ that could keep liabilities off the balance sheet temporarily. For AT&T, another quick look on Yahoo Finance gives us the shareholder’s equity as of 12/31/2019: $551.7B - $347.7B = $184.2B. $146.2B of the shareholder equity is made up of goodwill, which is the excess purchase price of another company (purchase price - market value). So, had AT&T paid ~$150B less for their acquisitions, and paid only market value, their assets and liabilities would both be $150B lower, shareholder equity would remain the same, but the debt load would be almost zero.
“The only perfect hedge is in a Japanese garden”
Eugene Rothberg, a lawyer and international investment banker, is an expert on risk taking, interest and exchange rates, financial market regulation, and the role of international development institutions. He served as vice president and treasurer of the World Bank from 1968 to 1987, responsible for overall funding and investment operations.