The Equity Market

The Equity Market
By Ingrid Goodspeed
© I Goodspeed: 2008
The Registered Person Examination (RPE) has been designed as an entry-level
qualification for the South African financial markets. It is in modular form with
each module addressing a different market. The simplified framework in which
the markets are discussed is shown below:
Framework of the financial markets
Financial markets
Foreign exchange
Capital market Money market Commodities
market
Derivatives Derivatives Derivatives
Bond and long-term Interest-bearing markets

Equity market
debt market
Derivatives Derivatives
Hybrids
The objective of this module to introduce the student to the vocabulary and
mechanics of the equity market in South Africa and internationally and to prepare
the student for the South African Institute of Financial Market’s equity market
examination.
The guide is structured as follows: chapters 1 and 2 define shares and equity
markets respectively. Chapter 3 discusses the relationship between share prices
and the business cycle. Chapters 4, 5 and 6 focus on fundamental analysis
namely the interpretation of financial statements, equity valuation and company
analysis. Chapter 7 concentrates on risk and introduces portfolio theory and the
capital asset pricing model (CAPM). Chapter 8 deals briefly with technical
analysis. Chapter 9 outlines equity derivatives. Chapter 10 describes private
equity and private equity markets. Finally chapters 10 and 11 concentrate on the
South African equity market by discussing the JSE Ltd and Strate (share
transactions totally electronic).
Students are advised to keep up to date with local and international equity
market developments. The following Internet sites may prove useful:
South Africa JSE Ltd www.jse.co.za

Financial Services Board www.fsb.co.za
International New York Stock Exchange www.nyse.com
London Stock Exchange www.londonstockexchange.com
Euronext • LIFFE www.euronext.com
World Federation Of www.world-exchanges.org
Exchanges
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Table of contents
1. Equity defined ............................................................................................................ 4
1.1 Companies ............................................................................................................ 4
1.2 Financing of companies ........................................................................................... 5
2. Equity markets ......................................................................................................... 10
2.1 Characteristics of a good market ............................................................................. 10
2.2 Primary markets................................................................................................... 10
2.3 Secondary markets ............................................................................................... 11
2.4 Stock market indexes ............................................................................................ 13
3. Equity and the business cycle ................................................................................... 20
3.1 Business and stock market cycles ............................................................................ 20
3.2 Cyclical and defensive shares ................................................................................. 22
3.3 Industry performance ............................................................................................ 23
4. Financial statement interpretation ........................................................................... 26
4.1 Introduction ........................................................................................................ 26
4.2 Income statement ................................................................................................ 27
4.3 Balance sheet ...................................................................................................... 30
4.4 Cash-flow statement ............................................................................................. 32
4.5 Ratio analysis ...................................................................................................... 34
5. Equity valuation ........................................................................................................ 43
5.1 Approaches to valuation ........................................................................................ 43
5.2 Discounted cash-flow valuation ............................................................................... 43
5.3 Relative valuation ................................................................................................. 53
6. Company analysis ..................................................................................................... 57
6.1 Competitive strategy ............................................................................................. 57
6.2 Management – the qualitative element ..................................................................... 59
7. Portfolio theory ........................................................................................................ 62
7.1 Assumptions ........................................................................................................ 63
7.2 Security analysis .................................................................................................. 63
7.3 Portfolio analysis .................................................................................................. 68
7.4 Portfolio selection ................................................................................................. 72
7.5 Portfolio theory models.......................................................................................... 73
8. Technical analysis ..................................................................................................... 92
8.1 Technical and fundamental analysis ......................................................................... 92
8.2 Assumptions ........................................................................................................ 92
9. Equity derivatives ..................................................................................................... 96
9.1 Futures ............................................................................................................... 96
9.2 Options ............................................................................................................... 98
9.3 Swaps ................................................................................................................ 99
9.4 South African listed equity derivatives ..................................................................... 102
10. Private equity ...................................................................................................... 106
10.1 Private equity defined ....................................................................................... 106
10.2 Characteristics of private equity .......................................................................... 106
10.3 Structure of the private equity market ................................................................. 107
10.4 Secondary private equity market ........................................................................ 113
10.5 Size and regional analysis of the private equity market ........................................... 113
11. JSE Ltd ................................................................................................................ 116
11.1 The role of the JSE ........................................................................................... 116
11.2 JSE Membership............................................................................................... 117
11.3 Trading .......................................................................................................... 118
11.4 Listings .......................................................................................................... 122
12. Strate (share transactions totally electronic) ...................................................... 131
12.1 The roleplayers ................................................................................................ 131
12.2 Clearing and settlement .................................................................................... 132
13. Glossary .............................................................................................................. 136
14. Bibliography ........................................................................................................ 139
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1. Equity defined
Chapter learning objectives:

o To define equity;
o To differentiate between limited companies and sole traders and partnerships;
o To outline the most important types and features of limited companies;
o To describe and compare the main sources of long-term funds available to
companies.
Equity, also known as shares or stock, represents ownership in a business or

company. Chapter one defines equity within the context of the company and its
financing.
1.1 Companies
Generally sole traders and partnerships constitute the majority of businesses in
the private sector of an economy. However limited companies account for the
largest part of economic activity.
Limited companies differ from sole traders and partnerships in that ownership
and management of the business are separated. Ownership is in the hands of
shareholders that have the right to appoint the board of directors. Directors
select the managers of the firm to run the business in the best interests of the
shareholders. The directors have to report to shareholders at least annually on
the performance of the managers.
The most important types of limited companies are:

o Public limited companies: the shares of public limited companies are listed
(quoted) on and sold to the general public via stock exchanges.
o Private limited companies: the shares of private limited companies cannot be
sold on the stock exchange without the approval of other shareholders or
without first offering them to existing shareholders.
Important features of limited companies are:

o A legal existence separate from their owners i.e., companies can sue and be
sued; and
o Long-term business continuity i.e., life of the company is independent of the
owners’ lives.
Shareholders own the company through the purchase of shares in the company.
A share is one of a number of equal portions of the capital of a company. The
liability of shareholders for the debts of the company is limited to their
investment in the firm i.e., if the company is wound up the maximum
shareholders can lose is the amount paid for the shares.
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1.2 Financing of companies
Each year companies commit large sums of money to capital expenditure. In
2004 South African private business enterprises spent R143 185 million (at
constant 2000 prices) on various investments – see table 1.1.
Table 1.1: Gross fixed capital formation (in R million)

Type of asset 2007 2006 ∆%
Residential buildings 26 344 23 821 10.6

Non-residentail buildings 16 136 13 183 22.4
Construction works 9 213 6 912 33.3
Transport equipment 41 286 32 931 25.4
Machinery and other equipment 89 208 80 660 10.6
Total 182 187 157 507 15.7
Source: South African Reserve Bank Quarterly Bulletin March 2008
One of the major decisions facing companies is whether to finance investment

opportunities by borrowing money (i.e., using debt) or raising funds from
shareholders (i.e., using equity). The main sources of long-term funds available
to firms are debt, preference shares and ordinary shares.
1.2.1 Debt
Debt is borrowed funds that must be repaid by the issuer. It can be short- or
long-term. Short-term debt includes: bank overdrafts; short-term loans; and
liabilities such as accounts payable and various accruals that arise out of the
company’s operations because of the time lag between when the liability is
incurred and when it is discharged or paid. Long-term debt such as a bond
involves a loan of a specific principal amount and a promise to repay the principal
plus interest.
Debt is discussed in depth in RPE module “The bond and long-term debt market”.
1.2.2 Ordinary shares (common stock)

Ordinary shares are a source of equity funding. Common shareholders are owners
of the company and have full participation in its success or failure.
The most important characteristics of ordinary shares are:

o Perpetual claim: ordinary shares have no maturity date. Individual
shareholders can liquidate their investments in the shares of a company only
by selling them to another investor;
o Residual claim: ordinary shareholders have a claim on the income and net
assets of the company after obligations to creditors, bondholders and
preferred shareholders have been met. If the company is profitable this could
be substantial - other providers of capital generally receive a fixed amount.
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The residual income of the company may either go to retained earnings or
ordinary dividends;
o Pre-emptive right: shareholders have the first option to buy new shares. Thus
their voting rights and claim to earnings cannot be diluted without their
consent. For example: Rex Ltd owns 10% or 100 of the 1 000 shares of Blob
Ltd. If Blob Ltd decides to issue an additional 100 shares, Rex Ltd has the
right to purchase 10% or 10 of the new shares issued to maintain its 10%
interest in Blob Ltd;
o Limited liability: the most ordinary shareholders can lose if a company is
wound up is the amount of their investment in the company.
Returns to ordinary shareholders consist of:

o Dividends: dividends are a portion of the company’s profits. They are not
guaranteed until declared by the board of directors;
o Capital gains (losses): capital gains (losses) arise through changes in the price
of a company’s shares.
A company’s authorised share capital is the number of ordinary shares that the
directors of the company are authorised to issue. When the shares are sold to
investors, they become issued i.e., issued share capital.
1.2.3 Preference shares

Preference shares are another source of long-term equity funding that have
features of both ordinary shares and debt. Like debt, preference shares pay their
holders a fixed amount (dividend) per year, have no voting rights and in the
event of non-payment of dividends, may have the cumulative dividend feature
that requires all dividends to be paid before any payment to common
shareholders. Like ordinary shares they are perpetual claims and subordinate to
bonds in terms of seniority.
Preference shares carry preferential rights over ordinary shares in terms of

entitlement to receipt of dividends as well as repayment of capital in the event of
the company being wound up.
Preference shares offer holders a fixed dividend each year (unlike ordinary
shares). For example if company has issued 40 000 preference shares at a par
value of R20 each and dividend of 7% p.a., the preference share dividend paid by
the company every year will be R56 000 i.e., 40 OOO x R20 x 7%. This is not
necessarily guaranteed (see non-cumulative preference shares).
There are a number of types of preference shares:

o Cumulative: dividend is cumulated if the company does not earn sufficient
profit to pay the dividend i.e., if a dividend is not paid in one year it will be
carried forward to successive years;
o Non-cumulative: if the company is unable to pay the dividend on preference
shares because of insufficient profits, the dividend is not accumulated.
Preference shares are cumulative unless expressly stated otherwise;
o Participating: participating preference shares, in addition to their fixed
dividend, share in the profits of a company at a certain rate;
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o Convertible: apart from earning a fixed dividend, convertible preference
shares can be converted into ordinary shares on specified terms;
o Redeemable: redeemable preference shares can be redeemed at the option of
the company either at a fixed rate on a specified date or over a certain period
of time.
1.2.4 Debt, preference shares and ordinary shares compared

The most important differences between debt, preference shares and ordinary
shares are summarised in table 1.2.
Table 1.2: Differences between debt, ordinary and preference shares

Debt Ordinary shares Preference shares
Maturity Finite maturity – debt Perpetual claim - Usually a perpetual
usually has a fixed ordinary shares have claim
maturity date. no maturity date
Seniority of A contractual claim A residual claim i.e., A residual claim.

claim i.e., an enforceable claim to what is left Claims of preference
contract. Claims of after contractual shareholders are
debt-holders have claims are settled. subordinate to debt
priority over ordinary Claims of ordinary but have priority over
and preference shares shareholders are ordinary shares.
subordinate to both
debt and preference
shares.
Tax treatment - Interest paid is usually Dividends paid are Dividends paid are
issuing company deductible for income usually not usually not
tax purposes deductible for income deductible for income
tax purposes tax purposes
Tax treatment - Income tax is usually Income tax is usually Income tax is usually
investor /debt payable on interest not payable on not payable on
holders received dividends received dividends received
Voice in Have no right to Have the right to Have a limited voice

management choose directors or choose directors and in management.
vote on matters of vote on matters of Voting rights usually
importance to the importance to the concern the issuance
company. company. of securities with
equal or higher
seniority.
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Questions for chapter 1
1. How do limited companies differ from sole traders and partnerships?
2. What are the most important types of limited companies?
3. What are the most important features of limited companies?
4 What is the maximum amount a shareholder can lose if a company is

wound up?
5. Name the main sources of long-term funds available to firms.
6. Define long- and short-term debt.
7. Define ordinary shares.
8 What are the most important characteristics of ordinary shares?
9. If a company has issued 10 000 preference shares at a par value of

R10 each and a dividend of 10%, what preference share dividend will
the company pay each year?
10 Name the types of preference shares.
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Answers for chapter 1
1. Limited companies differ from sole traders and partnerships in that

ownership and management of the business are separated.
2. The most important types of limited companies are public limited

companies and private limited companies:
3. The most important features of limited companies are that they have:
a legal existence separate from their owners i.e., companies can sue
and be sued; and
Long-term business continuity i.e., life of the company is independent
of the owners’ lives.
4 The maximum amount a shareholder can lose if a company is wound

up is the amount he / she paid for the shares.
5. The main sources of long-term funds available to firms are debt,

preference shares and ordinary shares.
6. Long-term funds are funds with maturities longer than one year such
as bonds (source: RPE module “The bond and long-term debt
market”). Short-term debt has a maturity of less than one year and
includes bank overdrafts; short-term loans; and liabilities such as
accounts payable.
7. Ordinary shares are a source of equity funding i.e., a source of funds

raised from ordinary shareholders
8 The most important characteristics of ordinary shares are that they

are a perpetual claim, a residual claim, give shareholders pre-emptive
rights and limited liability.
9. R10 000 i.e., 10 000 x R10 x 10%
10 Types of preference shares are cumulative, non-cumulative,

participating, convertible and redeemable preference shares.
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2. Equity markets

o To describe the characteristics of a good equity market;
o To discuss primary and secondary equity markets;
o To differentiate between quote- and order-driven markets;
o To sketch the characteristics of equity markets internationally and in South
Africa;
o To outline the uses of and methods of constructing market indexes.
The stock market is the institutional framework through which:

o Public limited companies issue new share capital - the primary market; and
o The ownership of shares can change hands – the secondary market.
The objective of this chapter is to discuss primary and secondary equity markets.
It also deals with the uses and construction of market indictors or indexes. To
place the discussion in context, the characteristics of a good market are outlined
first.
2.1 Characteristics of a good market

Investors generally consider the following to be attributes of a quality equity
market:
(i) Timely and accurate price and volume information on past share
transactions and prevailing supply and demand for shares;
(ii) Liquidity i.e., the degree to which a share can be quickly and cheaply
turned into cash. Liquidity requires marketability, price continuity and
market depth. Marketability is a share’s ability to be sold quickly. Price
continuity exists when prices do not change from one transaction to
another in the absence of substantial new information. Market depth is
the ability of the market to absorb large trade volumes without a
significant impact on prices i.e., there are many potential buyers and
sellers willing to trade at a price above and below the current market
price;
(iii) Internal efficiency i.e., transaction costs as a percentage of the value
of the trade are low – even minimal;
(iv) External or informational efficiency i.e., share prices adapt quickly to
new information so that current market prices are fair in that they
reflect all available information on the share.
2.2 Primary markets

New share issues can be divided into two groups:
o Seasoned new issues: the issue of shares for which there is an existing public
market i.e., the company issuing the shares already has shares trading in the
market. Seasoned or rights issues are also known as privileged subscriptions
as existing shareholders are given the first right of refusal to purchase the
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shares. The rights are offered in a certain proportion to shareholders’ existing
holdings e.g., in a one-for-one rights issue, shareholders will be offered a
number of shares equal to the number they already hold. To ensure the offer
is taken up, shares are generally offered at below the market price of existing
shares i.e., at a discount. This may result in a fall in the price of existing
shares;
o Initial public offerings: the first-time issue of shares to the public by
companies that have no shares trading in the market i.e., there is no existing
public market for the share.
New issues (seasoned or IPOs) are usually underwritten by investment bankers

i.e., the investment banker buys the entire share issue from the company and re-
sells the shares to investors. In this way a large part of the risk of issuing shares
due to for example adverse reception due to overpricing or adverse market
conditions is borne by the underwriter. In large issues a number of underwriters
form a syndicate to spread the risk. Investment bankers are compensated for
their selling and risk-bearing services.
2.3 Secondary markets

Secondary markets are markets where existing shares are traded. The proceeds
from a sale of shares in the secondary markets do not go to the issuer of the
shares but to their sellers (i.e., previous owners).
Secondary markets are composed of stock exchanges (national and regional) and
over-the-counter markets. Before these are discussed trading systems and
methodologies will be outlined.
2.3.1 Trading systems

There are different ways to trade shares on exchange. Stock exchanges tend to
be either order- or quote-driven:
o Order-driven or auction markets are markets where buyers and sellers submit
bid and ask prices of a particular share to a central location where the orders
are matched by a broker. Prices are determined principally by the times of
orders arriving at the central marketplace. The JSE Ltd and most US securities
exchanges are order-driven; and
o Quote-driven or dealer markets are markets where individual dealers act as
market makers by buying and selling shares for themselves. In this type of
market investors must go to a dealer and prices are determined principally by
dealers bid/offer quotations. NASDAQ is a quote-driven market. The London
Stock Exchange has both an order-driven and quote –driven system – its
more liquid shares are traded on its order-driven system.
2.3.2 Trading methodology

Exchanges can be call or continuous markets:
o Call markets are markets in which individual shares trade at specific times.
Trades, bids and offers, are accumulated for a period and then a single price is
set to satisfy the largest number of trades. The method is used in smaller
markets and to establish the opening price in larger ones.
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o Continuous markets are markets in which shares trade any time the markets
are open.
Many exchanges such as the New York Stock Exchange and the Tokyo Stock
Exchange depend on call markets to establish the opening price of a share but
use continuous trading mechanisms the rest of the trading day.
2.3.3 National stock exchanges

The characteristics of national stock exchanges internationally and in South Africa
are highlighted in table 2.1.
Table 2.1: Characteristics of stock exchanges

Australia Japan South United United
Africa Kingdom States
National Sydney Tokyo Johannesburg London New York
exchange (TSE) (JSE) (LSE) (NYSE)
Turnover (%) 88.4 125.8 48.9 124.8 134.3

(end 2006)
Listed
companies 1 829 2 416 389 3 256 2 280
(end 2006)
Market
capitalisation
1 095.9 4 614.1 711.2 3 794.3 15 421.1
(USD billion
end 2005)
S&P500
FTSE JSE
Principal All Dow Jones
Nikkei 225 All share FTSE 100
market index ordinaries industrial
index
average
Order-and Order- and
Trading Order- Order- Order-
quote quote-
system driven driven driven
driven driven
Trading
Continuous Mixed Continuous Continuous Mixed
methodology
Source: World Federation of Exchanges
2.3.4 Regional stock exchanges

Regional or local stock exchanges generally have less onerous listing
requirements than the national exchange. They list companies too small to
qualify for a listing on the national exchange. Regional exchanges also list shares
that are listed on the national exchange to give local brokers that are not
members of the national exchange access to the shares.
Examples of regional exchanges are Chicago and Boston in the US, Osaka and
Nagoya in Japan and Dublin, Belfast and Glasgow in the United Kingdom.
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2.3.5 Over-the-counter (OTC) market
Any share – listed or unlisted - can be traded on the over-the-counter market as
long as a dealer is willing to make a market in the share i.e., stand ready to buy
or sell the share outside the stock exchange.
The over-the-counter market is not a formal exchange with membership

requirements or list of shares that may be dealt in. It is a non-regulated market
and is simply a way of trading shares.
2.3.5.1 NASDAQ
NASDAQ (originally an acronym for National Association of Securities Dealers
Automated Quotations) is an electronic stock exchange in the U.S. that trades in
equities in almost 3 300 companies. It is owned and operated by The Nasdaq
Stock Market, Inc., which listed on its own stock exchange in 2002.
Although NASDAQ began as a system to store and display quotations on over-

the-counter securities it now has inter alia, like most other major national
exchanges, formal company listing requirements and electronic surveillance of
trading.
2.3.5.2 Third market

The third market describes the over-the-counter trading of exchange-listed
shares. It usually involves investment firms that are not members of the
exchange making a market in listed shares.
2.3.5.3 Fourth market

The fourth market describes the direct exchange of shares between investors
without a broker intermediary.
2.4 Stock market indexes

Market indexes attempt to reflect the overall behaviour of a group of shares.
They are used:

o As a benchmark to measure portfolio performance;
o To create and track index funds;
o To estimate market rates of return;
o In technical analysis to predict future share price movements; and
o As a proxy for the market portfolio when estimating systematic risk (see
chapter 7).
2.4.1 Constructing stock market indexes

The following factors are considered when building a stock market index:
(i) The sample of shares used must be representative of the whole

population or else the results may be biased;
(ii) What mathematical procedure should be used to combine the
component items into the index e.g., is an arithmetic or geometric
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average used; and
(iii) What weighting should be given to the individual items in the sample.
There are three predominant weighting schemes used in constructing indexes:

price, value and equal weighting.
2.4.1.1 Price-weighted series

A price-weighted series is an arithmetic average of current prices. This means
that the differential prices of the component shares influence movements in the
index e.g., a high-priced share carries more weight than a low-priced one, a large
price change for a small firm will have the same impact as a small price change
for a large firm.
A price-weighted index sums the market prices of each share in the index and
divides the total by the number of shares in the index. The index assumes that an
equal number (one) of each share is represented in the index. Once the index is
established the denominator must be amended to reflect changes in the sample
of shares and share splits. After a share split, the denominator is amended
downwards to ensure the index is the same before and after the share split. This
can put a downward bias on an index because when companies have share splits,
their prices decline and their weight in the index is reduced (even though they
may be large and important shares). Because high-growth companies tend to
split their shares more often than slow growing ones, they consistently loose
weight within the index.
Two major price-weighted indexes are:
(i) The Dow Jones Industrial Average is a price-weighted index of 30 shares.

Criticisms of the Dow include:
• The limited number of shares in the index – a sample of 30 out of a
population of 3 000;
• The shares in the index represent the largest shares listed on the New
York Stock Exchange and
• The downward bias in the computation of the index;
(ii) The Nikkei Dow Jones Average or Nikkei-225 is an arithmetic average of
225 shares in the first and largest of two sections of the Tokyo Stock
Exchange. The index is also a price-weighted index and has the same
computational problems as the Dow Jones Industrial Average.
2.4.1.2 Value-weighted series

A value-weighted series is calculated as follows:
(i) Sum the value of the shares in the index where value is current share
price multiplied by the number of outstanding shares;
(ii) Divide the total derived in (i) by a similar sum calculated in a selected
base period;
(iii) Multiply the result in (ii) by the index base’s beginning value.
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Symbolically:
Index t =
∑p qt t
× beginning index value
∑p qb b
where
pt = ending price of share on day t
qt = number of outstanding shares on day t
pb = ending price of share on base day
qb = number of oustanding shares on base day
A value-weighted index assumes that the value of a share in the index is held in
proportion to its value in the market. The index automatically adjusts for stock
splits because the decrease in the share price is offset by an increase in the
number of shares outstanding.
The major problem with a value-weighted index is that a firm with a large market
capitalisation will have a greater impact on the index than a firm with a small
market capitalisation i.e., changes in large market-value shares will dominate
changes in the value of the index.
Examples of value-weighted indexes are shown in table 2.2.
Table 2.2: Stock market indexes

Name of index Number of shares Source of shares
S&P 500 Composite 500 NYSE, OTC
NYSE Composite 2 280 NYSE
NASDAQ Composite 3 168 OTC
Financial Times Actuaries Index:
692 LSE
All share (FTSE all-share)
FTSE100 100 largest LSE
Tokyo Stock Exchange Price Index
1 710 TSE
(Topix)
JSE Ltd FTSE/JSE All-share 164 JSE
*Top companies ranked by full market capitalisation before free-float weightings are applied
Source: World Federation of Exchanges
Shares included in value-weighted indexes are weighted according to market

capitalisation. This method is being criticised as over representing certain shares.
Blocks of shares including share incentive schemes, directors’ shares, cross
holdings or strategic holdings by companies are not available for trading. This
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affects the liquidity of the shares. The international trend is towards a free-float
weighting basis in terms of which only those shares available for trading (rather
than number of shares outstanding) are included in the index.
All FTSE / JSE indexes are free-float market capitalisation weighted indexes.
2.4.1.3 Unweighted or equally-weighted series

All shares in an unweighted index carry equal weight regardless of their price or
market value.
LSE’s Financial Times Ordinary Share Index is an example of an unweighted

index.
2.4.1.4 Portfolio performance measurement

To measure the performance of a portfolio use:
o A price-weighted index if the portfolio is constructed by including an equal
number of shares of each company;
o A value-weighted index if the portfolio is constructed by weighting the shares
according to company capitalisation;
o An unweighted index if the portfolio is constructed by investing equal rand
amounts in each share.
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1. What are the attributes of a good equity market?
2. Differentiate between seasoned new issues and initial public offerings.
3. What is a secondary market?
4 Differentiate between order-driven and quote-driven markets.
5. Differentiate between call and continuous markets.
6. Define over-the-counter markets.
7. State the uses of stock market indexes.
8 Name two major price-weighted indexes.
9. How is a value weighted index calculated.
10 When should a price-weighted index be used to measure portfolio

performance?
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1. The attributes of a good equity market are timely and accurate price and
volume information, liquidity, internal efficiency and external or informational
efficiency.
2. A seasoned new issue is the issue of shares for which there is an existing
public market i.e., the company issuing the shares already has shares trading
in the market. An initial public offering is the first-time issue of shares to the
public by a company that has no shares trading in the market i.e., there is no
existing public market for the shares.
3. A secondary market is a market where existing shares are traded.
4 Order-driven market Quote-driven market

Description A market where buyers and A market where individual
sellers submit bid and ask dealers act as market
prices of a particular share makers by buying and
to a central location where selling shares for
the orders are matched by themselves
a broker.
Price Prices are determined Prices are determined
determination principally by the times at principally by dealers’ bid /
which orders arrive at the offer quotations
central market place
Examples JSE Securities Exchange NASDAQ
5. A call market is a market in which individual shares trade at specific times. A

continuous market is a market in which shares trade any time the market is
open.
6. Over-the-counter markets are non-regulated markets. Any share, whether

listed or unlisted, can be traded on an over-the-counter market as long as a
dealer is willing to make a market in the share i.e., stand ready to buy or sell
the share outside the stock exchange.
7. Stock market indexes are used as a benchmark to measure portfolio

performance; to create and track index funds; to estimate market rates of
return; to predict future share price movements using technical analysis; and
as a proxy for the market portfolio when estimating systematic risk.
8 Two major price-weighted indexes are the Dow Jones Industrial Average and
the Nikkei Dow Jones Average.
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9. A value-weighted index is calculated as follows:
(i) Sum the value of the shares in the index where value is
current share price multiplied by the number of outstanding
shares;
(ii) Divide the total derived in (i) by a similar sum calculated in a
selected base period;
(iii) Multiply the result in (ii) by the index base’s beginning value.
10 A price-weighted index should be used to measure portfolio performance if the

portfolio is constructed by including an equal number of shares of each
company.
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3. Equity and the business cycle

o To discuss why stock market cycles anticipate business cycle turning points;
o To describe cyclical and defensive shares;
o To outline what industries perform well in different stages of the business
cycle.
“The stock market has predicted nine out of the last five recessions”
Paul Samuelson, 1991
The objective of this chapter is to highlight the general relationship between

share prices and the business cycle.
3.1 Business and stock market cycles
The level of the stock market is one of the best leading (short-term) economic
indicators. As shown in figure 3.1 the stock market cycle –anticipates business
cycle turning points.
Figure 3.1: The business and stock market cycles
Upper
Market turning
top point
Business cycle
Stock market cycle
t
rke
n
sio
Co
ma
an
n tr
Be
ll
act
Bu
Ex
ar
ion
ma
rke
t
Market Lower
bottom turning
point
Cyclical growth Cyclical value Defensive value Defensive growth

Banks Retailers Aerospace and Telecommunications
Energy Transport defense Pharmaceuticals
Media Property Food retailers and Insurance
IT hardware Household goods producers
Software Engineering and Utilities
Computer services Machinery Tobacco
Basic industries
Motor Vehicles
20
There are three possible explanations for this:
(i) Investors do not invest based on the present economic environment

but forecast economic variables and invest accordingly. This is because
they believe most current economic information has already been
incorporated into share prices;
(ii) Investors react to the current economic environment but the indicators
that they watch such as company profits and profit margins tend to
lead general business activity; and
(iii) By affecting business and consumer confidence and spending decisions,
share price reversals assist in causing subsequent economic reversals.
In the United States there have been bear markets that were not followed by
recessions. However there has never been a recession that was not preceded by
a bear market. The National Bureau of Economic Research (NBER) has
established that since 1854 there have been 33 recessions in the U.S. Each was
preceded by a bear stock market. In addition the stock market anticipated the
end of each recession with bear-market troughs six months on average before
the official end of those recessions.
A great deal of research has gone into identifying which industries typically
perform well in different stages of the business cycle. The broad findings of these
studies are:
(i) Industries that are sensitive to the expected turning of the business
cycle will outperform the broad market towards the end of a recession.
Credit-sensitive shares such as financial shares begin to rise as
investors expect banks’ earnings to increase as the economy and loan
demand recover;
(ii) Once the economy begins its recovery consumer durables become
attractive share investments because a reviving economy will increase
consumer confidence and personal income. These shares include
industries that produce expensive consumer items such as computer
equipment and white goods.
(iii) Once businesses realise the economy is recovering and that levels of
consumer spending are sustainable, they begin to consider expanding
capacity to meet rising consumer demand. Thus capital good industries
such as heavy equipment manufacturers become attractive
investments.
(iv) As the economy peaks and turns basic industries, such as gold and
timber industries become attractive investments. This is because the
rate of inflation, which is increasing, has less of an impact on these
industries.
(v) During a recession consumer staples such as pharmaceuticals and food
industries tend to perform better than other industries as consumers
still need to spend on necessities.
21
3.2 Cyclical and defensive shares
The earnings of cyclical companies fluctuate with the business cycle. As a result,
the price gains (losses) of cyclical shares typically exceed those of a rising
(falling) market.
The earnings of defensive firms display stable performance during both up- and
downturns in the business cycle. Consequently the prices of defensive shares do
not increase (decrease) as much as the overall market.
Cyclical and defensive shares can be growth or value. A growth share is a share
that has recorded a higher rate of return than shares with similar risk
characteristics. A growth company on the other hand is a company the sales,
earnings and market share of which are growing at a faster rate than the industry
average and overall economy. Growth shares are not necessarily synonymous
with growth companies.
Value shares are those that appear undervalued for reasons other than earnings-
growth potential. The characteristics of value shares include high dividend yields
and low price-to-earnings (P/E) or price-to-book (P/B) ratios (see chapter 4 and 5
for explanations of these terms).
22
3.3 Industry performance
Figure 3.1 and table 3.1 indicate which industries typically perform well in
different stages of the business cycle.
Table 3.1: Industry performance and the business cycle

Phase of cycle
Stock Business Industry Characteristics
market cycle
cycle
Market Late Banks o Declining interest rates and
bottom / contraction / Energy recovering credit demand.
early bull lower turning Media o Improving advertising spend.
market point IT hardware o Growing consumer confidence
Software and disposable income.
Computer services o Expenditure on expensive
consumer durables increasing.
Bull market Expansion Retailers o Recognition that economy is

Transport recovering and improving
Property consumer spending is
Household goods sustainable.
Engineering and o High capacity utilisation -
Machinery companies consider expansion
Motor Vehicles to satisfy rising demand.
o Interest-rate-sensitive and
cyclical industries (capital
goods or consumer durables)
become attractive.
Market top Late Aerospace and o Inflation increases as demand
/ expansion / defense outstrips supply.
early bear upper Food retailers and o Large companies with ample
turning point producers liquidity and operating stability
Utilities and companies producing non-
Tobacco volatile consumer goods
Basic industries become attractive.
Bear Contraction Telecommunication o High interest rates and

market s slowdown in demand.
Pharmaceuticals o Spending falls in all areas
Insurance except necessities.
23
1. Name five cyclical growth industry sectors.
2. Name seven cyclical value industry sectors.
3. Which industry sectors do well at the upper turning point of the

business cycle?
4 Why does the stock market cycle lead the business cycle?
5. Differentiate between cyclical and defensive shares.
6. What are the characteristics of value shares?
7. Describe a growth share.
8 What are the characteristics of the lower turning point of the business
cycle?
9. What are the characteristics of a bear market?
10 Name the industries that do well in the contraction phase of the

business cycle.
24
1. Five cyclical growth industry sectors are banking, media, IT hardware, IT

software and computer services.
2. Seven cyclical value industry sectors are retail, transport, property, household
goods, engineering and machinery, basic industries and motor vehicles.
3. The aerospace and defence food retailers and producers, utilities and tobacco
sectors do well at the upper turning point of the business cycle.
4 There are three possible explanations for why the stock market cycle leads
the business cycle:
(i) Investors do not invest based on the present economic environment
but forecast economic variables and invest accordingly. This is
because they believe most current economic information has already
been incorporated into share prices;
(ii) Investors react to the current economic environment but the
indicators that they watch such as company profits and profit margins
tend to lead general business activity; and
(iii) By affecting business and consumer confidence and spending
decisions, share price reversals assist in causing subsequent economic
reversals.
5. The earnings of cyclical companies fluctuate with the business cycle. As a

result, the price gains of cyclical shares typically exceed those of a rising
market and price losses typically exceed those of a falling market.
The earnings of defensive firms display stable performance during both up-
and downturns in the business cycle. Consequently the prices of defensive
shares do not increase or decrease as much as the overall market.
6. The characteristics of value shares include high dividend yields and low price-
to-earnings (P/E) or price-to-book (P/B) ratios
7. A growth share is a share that has recorded a higher rate of return than
shares with similar risk characteristics.
8 The characteristics of the lower turning point of the business cycle are:
declining interest rates and recovering credit demand, improving advertising
spend, growing consumer confidence and disposable income and increasing
spend on expensive consumer durables.
9. The characteristics of a bear market are high interest rates and slowdown in
demand and falling spending in all areas except necessities.
10 The industries that do well in the contraction phase of the business cycle are
telecommunications, pharmaceuticals and insurance.
25
4. Financial statement interpretation

o Understand financial statements – income statements, balance sheets and
cash flow statements
o Analyse financial statements by determining trends, industry comparisons and
common-size statements;
o Carry out and interpret a ratio analysis.
Fundamental analysis focuses on determining the intrinsic value of a share i.e.,

the present value of all future net cash flows derived from ownership of the
share. The starting point for the fundamental analysis of a share is the company’s
financial statements. The objective of this chapter is to outline the interpretation
of financial statements. Firstly the income statement, balance sheet and cash-
flow statement will be discussed. Then ratio analysis will be described.
4.1 Introduction
Financial statements provide descriptive and quantitative information about the

company’s current status and past financial performance. Descriptive information
on the company’s operating results over the past reporting period is provided by
the chairman’s, director’s and auditor’s reports while quantitative information is
contained in the balance sheet, income statement and cash-flow statement.
The income statement contains information on a company’s income and

expenditure over a period of time i.e., the past reporting period of usually one
quarter, 6 months or one year. The balance sheet is a snapshot of the financial
situation of a company at a specific time. It is divided into two main sections: the
source of funds i.e., capital (or equity) and liabilities and the application of funds
i.e., assets. The cash-flow statement shows the cash flows in and out of the
company during the reporting period. It is made up of net cash flows from
operating, financing and investing activities.
Value can be added to the analysis of a company’s financial statement by:

o Determining trends: comparing the company’s financial statement numbers
over a number of years;
o Industry comparisons: evaluating the company’s figures against those for
similar companies or the relevant industry group;
o Normalized or common-size statements: a normalised balance sheet
expresses all balance sheet items as a percentage of total assets. A
normalised income statement expresses all income statement items as a
percentage of sales.
26
4.2 Income statement
An income statement summarises a company’s operating activities over its past

reporting period. The statement starts with revenues i.e., inflows from selling
goods and services. Expenses or outflows required to generate revenues such as
cost of sales, depreciation and any selling or administration expenses are
deducted to obtain operating profit. Interest is subtracted from operating profit to
arrive at net income before taxes. Thereafter taxes are taken away to get net
income/earnings/profits attributable to shareholders. Then preference share
dividends are deducted to arrive at net earnings attributable to ordinary
shareholders. This is distributed to shareholders in the form of dividends or re-
invested in the company as retained earnings.
Table 4.1 shows the income statement of Rex Ltd. Comparative figures for the
year ending 31 December 2004 and 2003 as well as the percentage change
between 2004 and 2003.
Table 4.1: Income statement for the year ended 31 December 2004
2004 2003
R 000 R 000 ξ%
Sales 81 000 76 950 5.3

Operating costs 73 818 69 822 5.7
Earnings before interest and tax (EBIT) 7 182 7 128 0.8
Interest paid 1 782 1 269 40.4
Earnings before tax (EBT) 5 400 5 859 -7.8
Tax 1 620 1 758 -7.8
Net profit after tax 3 780 4 101 -7.8
Dividends to preferred shareholders 270 270 0.0
Net income attributable to ordinary shareholders 3 510 3 831 -8.4
Dividend to ordinary shareholders 2 100 2 000 5.0
Addition to retained earnings 1 410 1 831 -23.0
Per share (R)

Earnings per share 3.51 3.83 -8.4
Dividends per share 2.10 2.00 5.0
Book value per share 22.47 21.06 6.7
Share price 36.82 38.82 -5.2
Number of shares 1 000 000 1 000 000
Additional information:
Purchases 6 750 4 752 42.0
Cost of goods sold (cogs) 69 282 65 691 5.5
Depreciation 2 700 2 440 10.7
Lease payments 756 756 0.0
Rex Ltd has not done as well as expected because their operations were
interrupted by strikes during the year. Labour issues were amicably resolved
towards the end of 2004. Management is confident that the company will achieve
earning growth of at least 30.0% in 2005.
27
A report on earnings, dividends and book value per share is given at the end of
the income statement.
4.2.1 Earnings per share
Earnings per share (EPS) is one of the most frequently-used and widely reported
measures of corporate performance. It is commonly combined with the share’s
market price in the price/earnings (P/E) ratio (see chapter 5). EPS – using Rex
Ltd’s 2004 figures as an example - is calculated as follows:
net income attributable to ordinary shareholders

Earnings per share ( EPS ) =
number of ordinary shares
3 510 000
=
1 000 000
= R3.51
Rex Ltd earned EPS of R3.51 in 2004 – down 8.4% from R3.83 in 2003.
4.2.2 Dividends per share
Dividends per share (DPS) expresses the dividends paid to ordinary shareholders
on a per share basis. Using Rex Ltd’s 2004 DPS as an example, it is calculated as
follows:
dividends to ordinary shareholders

Dividends per share ( DPS ) =
2 100 000
=
1 000 000
= R 2.10
Rex Ltd paid dividends to ordinary shareholders of R2.10 per share in 2004 – up
5.0% from R2.00 in 2003.
4.2.3 Book value per share
Book value per share (BVPS) expresses ordinary shareholders equity on a per
share basis. It is combined with the share’s market price in the market-to-book
ratio (see chapter 5). It is also often compared to the share’s market price to
establish if the share is trading at a discount or premium to the book value. BVPS
is calculated as follows:
28
ordinary shareholders equity
Book value per share ( BVPS ) =
22 470 000
=
1 000 000
= R 22.47
In 2004 Rex Ltd’s BVPS increased by 6.7% to R22.47. Rex Ltd’s share price on 31
December 2004 was R36.82 – trading at a 63.9% premium to book value (i.e.,
(36.82-22.47)/22.47).
4.2.4 Normalised income statement
In 2004 Rex Ltd earned net profit after tax of R3 510 000. Very little about Rex
Ltd’s performance can be deduced from this number alone. A normalised income
statement – see table 4.2 – shows that operating costs has increased compared
to previous years. However the majority of this increase is in items other than
cost of goods sold. Interest has also increased due to growth in debt –
debentures and notes payable.
Table 4.2: Normalised income statement Percentage of sales

2004 2003 forecast in R'000
R'000 % of sales R'000 % of sales 2005
Sales 81 000 100.0 76 950 100.0 101 250

Operating costs 73 818 91.1 69 822 90.7 92 239
Earnings before interest and tax (EBIT) 7 182 8.9 7 128 9.3 9 011
Interest paid 1 782 2.2 1 269 1.6 2 160
Earnings before tax (EBT) 5 400 6.7 5 859 7.6 6 851
Tax 1 620 2.0 1 758 2.3 2 055
Net profit after tax 3 780 4.7 4 101 5.3 4 796
Dividends to preferred shareholders 270 0.3 270 0.4 270
Net income attributable to ordinary
3 510 4.3 3 831 5.0 4 526
shareholders
Dividend to ordinary shareholders 2 100 2.6 2 000 2.6 2 716
Addition to retained earnings 1 410 1.7 1 831 2.4 1 810
Other operating costs 4 536 5.6 4 131 5.4 5 670

Cost of goods sold (cogs) 69 282 85.5 65 691 85.4 86 569
As shown in table 4.2, the normalised income statement can be used to forecast
a future period’s results. Rex Ltd’s results for 2004 have been calculated
assuming sales growth of 25.0% in 2005 i.e. 81 000 000 x (1+ 0.25) =
101 250 000. Those income statement items that vary directly with sales have
been forecasted - for example operating costs for 2005 are estimated as R92 238
750 i.e., 101 250 000 x 0.911. The forecast in table 4.2 has been rounded to the
neared thousand.
29
The items that do not move with sales are forecasted separately. For example:
o Interest expenses have been calculated on long-term debt and debentures at
an interest rate of 10.0%;
o A tax rate of 30.0% is assumed; and
o It has been assumed that dividends will be paid out in the same ratio to
earnings as in 2004 i.e., the dividend payout rate is 60% i.e., 2.10 / 3.51.
EPS of R4.53 (i.e., 4 526 000 / 1 000 000) and DPS of R2.71 (i.e., 2 716 000 /
1 000 000) is expected in 2005.
4.3 Balance sheet
The balance sheet records all the assets (what is owned) and liabilities (what is
owed) of a company at a point in time. Table 4.3 gives the balance sheet for Rex
Ltd. as at 31 December 2004. Comparative figures as at 31 December 2003 as
well as the percentage change between 2004 and 2003 are shown.
As at 31 December 2004 Rex Ltd had total assets of R54 870 000 and liabilities of
R29 700 000. The difference between the two is shareholders equity i.e., 25 170
000 = 54 870 000 – 29 700 000. Shareholders equity is also referred to as the
company’s net worth. In as much as the balance sheet shows the net worth of
shareholders at a point in time, the income statement measures the change in
net worth.
The first section of Rex Ltd’s balance sheet details the assets of the company. It
begins with fixed assets – plant and equipment – reported at a value of
R35 100 00 net of depreciation of R2 700 000. Next current assets (i.e., assets
that will be converted into cash within one year) are listed from most liquid –
cash – to least liquid – inventories.
The first liability on Rex Ltd’s balance sheet is its long-term debt – a loan of R13
500 000 and debentures of R8 100 000. Rex Ltd’s current liabilities (i.e.,
liabilities that must be paid within a year) total R8 100 000 made up of:
Accounts payable – what Rex Ltd owes its suppliers;
Short-term debt (notes payable);
Amounts owed to employees (wages) and receiver of revenue (taxes).
The difference between Rex Ltd’s current assets and current liabilities is referred
to as working capital and equals R11 670 000.
30
Table 4.3: Balance sheet as at 31 December 2004
R 000 R 000
2004 2003 ∆%
Assets
Fixed assets
Plant and Equipment 35 100 28 890 21.5
Current assets 19 770 16 470 20.0
Cash 2 220 1 485 49.5
Marketable securities 0 675 -100.0
Accounts receivable 9 450 8 505 11.1
Inventories 8 100 5 805 39.5
Total assets 54 870 45 360 21.0
Capital and liabilities

Ordinary shares 1 350 1 350 0.0
Share premium 2 430 2 430 0.0
Retained earnings 18 690 17 280 8.2
Ordinary shareholders equity 22 470 21 060 6.7
Preferred shares 2 700 2 700 0.0
Total shareholders equity 25 170 23 760 5.9
Long-term loans 13 500 14 040 -3.8

Debentures 8 100 1 620 400.0
Current liabilities 8 100 5 940 36.4
Accounts payable 1 620 810 100.0
Notes payable 2 700 1 620 66.7
Accrued wages 270 270 0.0
Accrued taxes 3 510 3 240 8.3
Total liabilities 29 700 21 600 37.5
Total capital and liabilities 54 870 45 360 21.0
In the same way as a normalised income statement was drawn up, so too can a
normalised balance sheet i.e., all balance sheet items are shown as a percentage
of total assets. An analysis of Rex Ltd’s normalised balance sheet (see table 4.4)
reveals that:
o Long-term debt (long-term loan plus debentures) has increased to 39.4%
(i.e., 24.6% + 14.8%) of total assets in 2004 from 34.6% in 2003. This
explains why in the normalised income statement interest paid increased to
2.2% of sales in 2004 compared to 1.6% in 2003;
o Plant and equipment increased to 64.0% of total assets in 2004 up from
63.7% in 2000. Therefore the long-term debt was raised to finance the
purchase of plant and equipment.
31
Table 4.4: Normalised balance sheet
2004 2003
R'000 % of assets R'000 % of assets
Assets 0
Fixed assets 0
Plant and Equipment 35 100 64.0 28 890 63.7
Current assets 19 770 36.0 16 470 36.3
Cash 2 220 4.0 1 485 3.3
Marketable securities 0 0.0 675 1.5
Accounts receivable 9 450 17.2 8 505 18.8
Inventories 8 100 14.8 5 805 12.8
0
Total assets 54 870 100.0 45 360 100.0
0
0
Capital and liabilities 0
Ordinary shares 1 350 2.5 1 350 3.0
Share premium 2 430 4.4 2 430 5.4
Retained earnings 18 690 34.1 17 280 38.1
Ordinary shareholders equity 22 470 41.0 21 060 46.4
Preferred shares 2 700 4.9 2 700 6.0
Total shareholders equity 25 170 45.9 23 760 52.4
0
Long-term loans 13 500 24.6 14 040 31.0
Debentures 8 100 14.8 1 620 3.6
Current liabilities 8 100 14.8 5 940 13.1
Accounts payable 1 620 3.0 810 1.8
Notes payable 2 700 4.9 1 620 3.6
Accrued wages 270 0.5 270 0.6
Accrued taxes 3 510 6.4 3 240 7.1
0
Total liabilities 29 700 54.1 21 600 47.6
0
Total capital and liabilities 54 870 100.0 45 360 100.0
4.4 Cash-flow statement
In contrast to the income statement that shows a company’s revenue and

expenses, the cash-flow statement presents all the cash that flowed in and out of
a company over its past reporting period. It indicates whether and why the
company is building up or drawing down its cash.
Table 4.5 details Rex Ltd’s cash-flow statement for the year ending 31 December
2004. It is organised into three sections – operating, investing and financing
activities.
32
Table 4.5: Cash flow statement for the year ending 31 December 2004
R 000
2001
Cash flow statement from operating activities
Cash generated from operations 3 780
Add: Depreciation 2 700
Less: Dividends paid (2 370)
Net increase in working capital (other than cash and marketable (2 160)
securities and notes payable)
Net cash flow from operating activities 1 950
Cash flow from investing activities

Acquisition of fixed assets (8 910)
Net cash flow used in investing activities (8 910)
Cash flow from financing activities

Increase in notes payable 1 080
Increase in debentures 6 480
Decrease in long-term loans (540)
Net cash flow from financing activities 7 020
Increase (decrease) in cash and marketable securities 60
Cash and marketable securities at beginning of the year 2 160
Cash and marketable securities at end of the year 2 220
4.4.1 Operating activities
Cash flow generated from operations is obtained from the income statement –
net income before preferred dividends. Depreciation is added back because it is a
non-cash item deducted from income to obtain net income. The cash outflow for
plant and equipment that gave rise to the depreciation charge occurred when the
plant and equipment was purchased. Depreciation is recognised as an expense on
the income statement over the useful life of the asset.
Rex Ltd had cash outflows in terms of:

o Dividends paid to preference and ordinary shareholders and
o Net increase in working capital (other than cash and marketable securities and
notes payable). Cash flow in respect of notes payable is recorded under
financing activities. Net increase in working capital is calculated as follows:
• Plus: increase in accounts receivable of R945 000;
• Plus: increase in inventories of R2 295 000;
• Less: increase in accounts payable of R810 000;
• Less: increase in accrued taxes of R270 000.
33
4.4.2 Investing activities
In 2004 Rex Ltd invested in new plant and equipment resulting in a cash outflow
of R8 910 000.
4.4.3 Financing activities
Rex Ltd raised financing of R7 560 000 by increasing its short-term debt by
R1 080 000 and long-term debt in the form of debentures by R6 480 000.
It repaid its long-term loan to the tune of R540 000 – a cash outlay.
4.5 Ratio analysis
A ratio seen in isolation has little if any meaning. However its usefulness
increases when it is compared to:
o Other ratios in the same set of financial statements;
o Similar ratios in previous sets of financial statements; and/or
o A standard of performance such as an industry benchmark.
A ratio analysis of Rex Ltd is shown in table 4.6. Comparative figures for 2003
and 2004 as well as the industry average are shown. The column called measure
indicates the notation of the ratio.
Table 4.6: Ratio analysis
2004 2003 Industry Measure
Liquidity ratios
Current ratio 2.4 2.8 2.9 :
Acid-test ratio 1.4 1.8 1.2 :
Asset-management or activity ratios

Inventory turnover ratio 10.0 12.2 9.3 :
Average collection period 43 40 38 days
Average payment period 88 62 90 days
Fixed asset turnover 2.3 2.7 3.1 :
Total asset turnover 1.5 1.7 1.9 :
Financial-leverage ratios
Total debt to total assets 54.1 47.6 40.5 %
Debt to equity 118.0 90.9 110.2 %
Times interest earned 4.0 5.6 5.7 :
Fixed charge coverage 3.1 3.9 4.9 :
Profitability ratios
Gross margin on sales 14.5 14.6 13.6 %
Profit margin on sales 4.3 5.0 4.6 %
Return on assets 6.4 8.4 8.7 %
Return on equity 15.6 18.2 14.9 %
34
4.5.1 Liquidity ratios
Liquidity ratios indicate the ability of the firm to meet its short-term obligations.
Table 4.7 details their calculation and interpretation.
Table 4.7: Liquidity ratios

Ratio Calculation Interpretation
Current current assets Indicates the ability of the
= company to meet its short-term
current liabilities
commitments with short-term
19 770 assets.
=
8 100
= 2.4
Acid-test current assets − inventories Indicates the ability of the

= company to meet its current
current liabilities
liabilities without having to
19 770 − 8 100
= liquidate inventories (the least
8 100 liquid of current assets).
= 1.4
4.5.2 Asset-management or activity ratios
Activity ratios (see table 4.8) deal with the efficient use of resources employed in
the company’s operations.
Table 4.8: Activity ratios

Inventory sales or cost of goods sold Indicates how efficiently a
turnover = company is managing its stock.
average inventories
A high ratio indicates efficient
73818
= stock management. An
(5 805 + 8 100) / 2 unsatisfactory figure or trend
= 10.6 suggests:
o Ineffective inventory control;
o An accumulation of un-
saleable inventory;
o Procurement difficulties that
make it desirable to carry a
larger inventory level to
ensure the continuity of
operations;
o Depressed business
conditions among consumers.
35
Average accounts receivable Indicates the number of days
collection = before settlement of company’s
average sales per day
period credit sales. It shows the
9 450
= efficiency of the company’s
81 000 / 365 credit granting and collection
= 43 days policies.
Average accounts payable Indicates the degree to which

payment = trade creditors represent current
average purchases per day
period obligations due.
1 620
=
6 750 / 365
= 88 days
Fixed asset sales Indicates how efficiently the
=
turnover fixed assets company is using its fixed
assets.
81 000
=
35 100
= 2.3
Total asset sales Indicates the company’s ability

turnover = to generate sales from its total
total assets
asset base.
81 000
=
54 870
= 1.5
4.5.3 Financial-leverage ratios
Financial-leverage ratios measure the capital structure of a company and the

degree to which it is or is not burdened with debt. Rex Ltd is highly leveraged but
this is not out of line with the industry.
Table 4.9 illustrates how financial leverage affects risk and return. Both
companies – leveraged and unleveraged - earn the same EBIT under both
expected and negative scenarios. Under expected market conditions the leverage
company outperforms the unleveraged firm in terms of return on shareholders
equity – 31.5% versus 21.0%. In effect the use of debt has leveraged up the rate
of return on equity.
However under negative market conditions the leveraged company’s return on

equity falls sharply to –7.0% compared to the unleveraged company’s return of
1.8%. This is because the leveraged company must service its debt regardless of
the level of sales and earnings. Thus companies with low debt ratios are less risky
but they also miss the opportunity to leverage up their return on equity.
36
Table 4.9: The risk / return of financial leverage
Unleveraged company
Balance sheet
Fixed assets 500
Current assets 500
Total assets 1 000
Debt 0
Ordinary shareholders equity 1 000
Total liabilities and equity 1 000
Income statement Scenario

Expected Negative
Earnings before interest and tax (EBIT) 300 25

Interest 0 0
Earnings before tax (EBT) 300 25
Tax (30%) 90 8
Net income attributable to ordinary shareholders 210 18
Return on equity 21.0% 1.8%
Leveraged company
Balance sheet
Fixed assets 500
Current assets 500
Total assets 1 000
Debt (interest at 15.0%) 500

Ordinary shareholders equity 500
Total liabilities and equity 1 000
Income statement Scenario

Expected Negative
Earnings before interest and tax (EBIT) 300 25

Interest 75 75
Earnings before tax (EBT) 225 -50
Tax (30%) 68 -15
Net income attributable to ordinary shareholders 158 -35
Return on equity 31.5% -7.0%
Table 4.10 shows the calculation and interpretation of financial-leverage ratios for
Rex Ltd.
37
Table 4.10: Financial-leverage ratios
Total total debt Indicates the percentage of total
debt to = total assets assets financed by creditors. The
total ratio shows the company’s use of
assets =
(13 500 + 8 100 + 8 100) financial leverage to expand
54 870 earnings. A low ratio denotes
= 54.1% relatively little use of external
funding.
Debt to total debt Indicates, as does the total debt

equity = to assets ratio, the protection
equity
afforded creditors in the event of
=
(13 500 + 8 100 + 8 100) liquidation.
25 170
= 118.0%
Times EBIT Indicates by how much EBIT can

interest = fall before the company is unable
interest paid
earned to meet its interest obligations.
7 182
=
1 782
= 4.0
Fixed EB fixed charges and tax Extends the times-interest-earned

charge = ratio to include lease and other
interest paid
coverage fixed charges obligations.
7 182 + 756
= (To calculate earnings before fixed
1 782 + 756 charges the lease payment must
= 3.1 be added back to EBIT)
4.5.4 Profitability ratios

Profitability ratios (table 4.11) indicate the profit-generating ability of a company
showing the combined effect of liquidity, asset management and financial-
leverage on operating results.
38
Table 4.11: Profitability ratios
Gross gross profit (sales − cogs ) Measures gross profit (sales less
profit = cost of goods sold) per rand of
sales
margin
=
(81 000 − 73818) sales. For example in 2004 for
every R1 of sales Rex Ltd
81 000 generated 8.8 cents gross profit.
= 8.8%
Net profit Net income attributable Relates net income attributable to

margin to ordinary shareholders ordinary shareholders to sales. It
= measures net income per rand of
sales
sales. For example in 2001 for
3 510
= every R1 of sales, Rex Ltd
81 000 generated 3.7cents of net income.
= 4.3%
Return Net income attributable Indicates the overall management

on assets to ordinary shareholders efficiency of the company.
(ROA) =
total assets
3 510
=
54 870
= 6.4%
Return Net income attributable The rate of return earned on the

on equity to ordinary shareholders capital provided by ordinary
(ROE) = shareholders. It indicates how
ordinary equity
effectively the company is being
3 510
= managed in the interests of
22 470 shareholders.
= 15.6%
Return on equity is an important indicator of performance. The ratio can be

divided into its component parts to provide insights into the causes of a
company’s ROE.
net income
ROE =
equity
net income sales assets
= × ×
sales assets equity
= profit margin × asset turnover × financial leverage
The breakdown implies that a company can increase its ROE by:
39
Increasing profit margin i.e., becoming more profitable; and/or
Increasing asset turnover i.e., becoming more efficient; and /or
Increasing financial leverage i.e., financing assets with a higher percentage of
debt.
The components of Rex Ltd’s ROE are as follows:
ROE = profit margin × asset turnover × financial leverage

= 4.33 × 1.48 × 2.44
= 15.6
40
1. Define the income statement.
2. Given net income attributable to ordinary shareholders of R2 970 and

number of ordinary shares of 1 000 calculate the company’s earnings
per share.
3. How is the book value per share of a company calculated?
4 What is the difference between a company’s current assets and

current liabilities called?
5. Since a ratio seen in isolation has little if any meaning, how can its
usefulness be increased?
6. Name two liquidity ratios.
7. What is inventory turnover if the cost of goods sold for 2004 is

R69 000 and inventory as at end 2003 is R5 800 and as at end 2004
R8 000?
8 Name three financial-leverage ratios.
9. What is the return on assets if the net income attributable to ordinary

shareholders is R3 000 and total assets is R35 000?
10 How can a company increase its return on equity?
41
1. The income statement contains information on a company’s income

and expenditure over a period of time i.e., the past reporting period of
usually one quarter, 6 months or one year.
2. R2.97 i.e., R2 970 / 1000
3. Book value per share (BVPS) expresses ordinary shareholders equity

on a per share basis i.e., ordinary shareholders equity divided by the
4 The difference between a company’s current assets and current

liabilities is called working capital.
5. A ratio’s usefulness is increased by comparing it to other ratios in the

same set of financial statements; similar ratios in previous sets of
financial statements; and/or a standard of performance such as an
industry benchmark.
6. Two liquidity ratios are the current ratio and acid-test ratio.
7. 10 i.e., R69 000 / ((R5 800 + R8 000) / 2)
8 Three financial-leverage ratios are total debt to total assets, debt to

equity and times interest earned.
9. 8.57% i.e., R3 000 / R35000
10 A company can increase its return on equity by increasing its profit

margin and/or increasing asset turnover and /or increasing financial
leverage.
42
5. Equity valuation

o Outline the approaches to equity valuation;
o Describe equity valuation models;
o Discuss the advantages and disadvantages of equity valuation models.
The objective of this chapter is to discuss the theory and application of valuation
models and to outline their strengths and weaknesses. Firstly the approaches to
equity valuation will be outlined. Thereafter the models will be discussed.
5.1 Approaches to valuation
Equity valuation attempts to estimate the intrinsic value of a share. The intrinsic
value is compared to the prevailing market price of the share to ascertain if the
share is a buy or not i.e., if the estimated intrinsic value is greater than the share
price the share is a buy.
There are two main approaches to the valuation of shares (see table 5.1):
o Discounted cash-flow valuation: the value of a share is the present value of
expected future cash-flows. The cash-flows can be dividends or free cash-
flows;
o Relative valuation: the value of a share is derived from expressing the current
price of a share as a multiple of some quantity seen as relevant to valuation
e.g., earnings or book value.
Table 5.1: Approaches to equity valuation

Discounted cash-flow valuation Relative valuation
Present value of: o Price to earnings
o Dividends o Price to book value
o Free cash-flow to equity
5.2 Discounted cash-flow valuation
5.2.1 Dividend discount models
Dividend discount models (DDMs) calculate the value of a share as the present
value of its future dividends. Since a share has no maturity i.e., it is a perpetual
claim, the value of the share is the present value of dividends through infinity.
The general DDM is as follows:
43
t =∞
DPSt
Vi = ∑ (1 + r ) t
t =1 i
where
Vi = value of share i
DPSt = expected dividends per share
ri = required rate of return on share i
There are two inputs to the model:

o Expected dividends: to obtain expected dividends, assumptions about
expected future growth rate in earnings and dividend payout ratios must be
made.
o Required rate of return: chapter 7 explains how the rate is determined. In this
chapter it is taken as given and denoted by r.
Since the model requires dividends to be forecast over an infinite number of

periods, the model is not of much practical use. However it does serve as a basis
for the other three types of DDM:
o Gordon Growth model;
o Two-stage DDM; and
o Three-stage DDM.
5.2.1.1 Gordon growth model
The Gordon growth model assumes dividends will growth at a constant rate into
the future. Symbolically:
DPS1
Vi =
(r − g )
where
Vi = value of share i
DPS1 = expected dividends per share in one years time
r = shareholder's required rate of retrun
g = constant dividend growth rate
44
Example: using the Gordon growth model to calculate the value of a share
Given:
1. The share is expected to pay a dividend of 97cents per share next year
2. Shareholders required rate of return is 17.5%
3. Dividends are expected to grow at a constant rate of 10.0%
0.97
Value of share =
(0.175 − 0.10)
= R12.93
Example: using the Gordon growth model to calculate the value of a share
Given:
1. The share paid a dividend 97cents per share this year
2. Shareholders required rate of return is 17.5%
3. Dividends are expected to grow at a constant rate of 10.0%
The share paid a dividend of 97 cents in the current year. It is necessary to

calculate the dividend that will be paid next year. The formula is:
DPS1 = DPS 0 (1 + g )
= 0.97 × (1 + 0.10)
DPS0 (1 + g )
Value of share =
(r − g )
97 × (1 + 0.10)
=
(0.175 − 0.10)
= R14.23
The advantage of the Gordon growth model is its simplicity, convenience and
ease of use. Its limitation is that it is extremely sensitive to growth rate input i.e.,
the value of the share approaches infinity as the growth rate and rate of return
converge – see table 5.2.
45
Table 5.2: Value of share as r and g converge
(DPS1=106.70)
(r-g) Value of share
5.0 21.3
0.5 213.4
0.05 2 134.0
0.005 21 340.0
0.0005 213 400.0
0.00005 2 134 000.0
0.000005 21 340 000.0
5.2.1.2 Two-stage model
The two-stage model assumes two stages of dividend growth:

o An initial stage with a high growth rate; and
o A second stage with a long-term, stable, growth rate. The drop to a lower
constant growth rate is immediate.
The formula to calculate the value of a share:
t =n
DPSt Pn DPS n + 1
P0 = ∑ (1 + r ) + where Pn =
t =1
t
(1 + r )n
rn − g n
where :
P0 = price of share in year 0
DPSt = expected dividend per share in year t
Pn = terminal value i .e., price of share at end of year n
r = required rate of return in high−growth stage
g = dividend growth rate in high−growth stage
rn = required rate of return in stable−growth phase i .e., after year n
g n = dividend growth rate in stable−growth phase i.e., after year n
For example assume UV Rays Suncream Ltd. had EPS of R1.00 and DPS of R0.20
last year. UV Rays expects earnings to grow at 22.0% p.a. over the next 3 years.
The dividend payout rate of 20.0% will be maintained. Thereafter growth will
decline to a stable 8% p.a. and the payout ratio will increase to 40.0%. What is
the value of UV Rays’s shares if shareholders require a return of 17.5% in the
high-growth phase and 15.0% during the steady phase?
46
The calculation of EPS and EPS is shown in table 5.3.
Table 5.3: UV Ray Suncream Ltd - calculation of EPS and DPS

Year EPS Calculation DPS Calculation
0 1.00 0.20 1.00 x 0.20
1 1.22 1.00 x (1+0.22) 0.24 1.22 x 0.20
2 1.49 1.22 x (1+0.22) 0.30 1.49 x 0.20
3 1.82 1.49 x (1+0.22) 0.36 1.82 x 0.20
4 1.96 1.82 x (1+0.08) 0.78 1.96 x 0.40
The value of the share is:
0.78
P0 =
0.24
+
0.30
+
0.36
+
(0.15 − 0.08)
(1 + 0.175)
1
(1 + 0.175) 2
(1 + 0.175)3 (1 + 0.175)3
= R7.51
The limitations of the two-stage DDM model are that:

o It is difficult to estimate the length of the high-growth phase;
o The immediate fall in growth from initial to second phase is unrealistic;
o Most of the value of the share depends on the terminal value. The terminal
value is extremely sensitive to the steady-stage growth rate estimate. The
terminal value approaches infinity as the growth rate and rate of return
converge.
5.2.1.3 Three-stage model
The three-stage model (see figure 5.1) assumes:

o An initial stable high-growth stage;
o A transitional period of declining growth - the second stage; and
o A final stable-growth stage that lasts forever.
47
Figure 5.1: Expected growth rate and dividend payout in three-stage DDM
Earnings growth rate
high growth
d ec
rea
sin
g gro
wth
ga infinite growth
gn
Dividend payout ratio
high payout
out
p ay
ing
r e as
inc
low payout
High-growth stage Transition stage Infinite-growth stage
The value of the share is the present value of expected dividends during the high-
growth and transitional stages and the terminal value at the beginning of the final
stable-growth stage. Symbolically:
t = n1
EPS0 (1 + g a ) × POa t = n2
EPS n2 (1 + g n ) × POn
t
DPSt
P0 = ∑ + ∑ (1 + r ) +
t =1 (1 + r )
t
t = n1 + 1
t
(rn − g n )(1 + r )
n
where
EPSt = earnings per share in year t
DPSt = dividends per share in year t
g a = growth rate in high−growth stage that lasts n1 periods
g n = growth rate in stable−growth stage
POa = payout ratio in high−growth stage
POn = payout ratio in stable−growth stage
r = rate of return in high−growth stage
rn = rate of return in stable−growth stage
For example assume IM Watching Optical Ltd.’s EPS and DPS last year were
R2.00 and R0.40 respectively. The dividend payout ratio was 20.0%. IM Watching
Optical expects to grow earnings by 30.0% p.a. for the next 5 years. Thereafter
growth will decline and dividend payout ratio increases at 6.0% and 10.0% per
year respectively for the next four years to a stable-growth rate of 6.0% and
48
stable-payout ratio of 60.0%. What is the value per share if shareholders expect
a 16.0% return in the initial and transitional stage and 15.0% in the steady-
growth stage?
Table 5.5 shows the calculation of the share value of IM Watching Optical Ltd. It
is R35.33.
49
Table 5.5: IM Watching Optical Ltd. – value of share
Year Growth EPS Calculation Payout DPS Calculation Rate of PV of Calculation
Rate of EPS ratio of DPS return dividends of present value
0 2.00 20.0 0.40
1 30.0 2.60 2.00x(1+0.30) 20.0 0.52 2.60x0.20 16.0 0.45 0.52
(1 + 0.16)1
2 30.0 3.38 2.60x(1+0.30) 20.0 0.68 3.38x0.20 16.0 0.50 0.68
(1 + 0.16 )2
3 30.0 4.39 3.38x(1+0.30) 20.0 0.88 4.39x0.20 16.0 0.56 0.88
(1 + 0.16)3
4 30.0 5.71 4.39x(1+0.30) 20.0 1.14 5.71x0.20 16.0 0.63 1.14
(1 + 0.16)4
5 30.0 7.43 5.71x(1+0.30) 20.0 1.49 7.43x0.20 16.0 0.71 1.49
(1 + 0.16)5
6 24.0 9.21 7.43x(1+0.24) 30.0 2.76 9.21x0.30 16.0 1.13 2.76
(1 + 0.16)6
7 18.0 10.87 9.21x(1+0.18) 40.0 4.35 10.87x0.40 16.0 1.54 4.35
(1 + 0.16)7
8 12.0 12.17 10.87x(1+0.12) 50.0 6.08 12.17x0.50 16.0 1.86 6.08
(1 + 0.16)8
9 6.0 12.90 12.17x(1+0.06) 60.0 7.74 12.90x0.60 16.0 2.04 7.74
(1 + 0.16)9
10 6.0 13.67 12.90x(1+0.06) 60.0 8.20 13.67x0.60 15.0 25.91 8.20
(0.15 − 0.06)(1 + 0.15)9
Sum of present value of future dividends 35.33
50
Note: this page (page 52) is left blank intentionally for printing purposes
51
5.2.2 Free cash-flow to equity (FCFE) models
The difference between DDMs and FCFE models lies in their definitions of
cash flow. DDMs characterise cash flow to equity as expected dividends.
FCFE models consider cash flow to equity to be the residual cash flow
after:
o Meeting interest and principal payments and
o Providing for capital expenditures to
• Maintain existing assets and
• Invest in new assets for future growth.
FCFE indicates what the company can afford to pay as dividends. Few
companies pay out the entire FCFE as dividends because:
• Companies are reluctant to change dividends and earnings or cash-
flows are generally more variable than dividends;
• Companies may be providing for increases in capital expenditure; and
• If dividends are taxed at a higher rate than capital gains, companies
may choose to retain excess cash and pay out less in dividends.
FCFE is calculated as follows:
FCFE = net income attributable to shareholders

+ depreciation (non-cash charge to income added back)
- capital expenditure
- change in working capital
- principal repayment
+ new debt issues.
The three FCFE valuation models are simple variants of the DDMs:
o The stable-growth FCFE model;
o The two-stage FCFE model; and
o The three-stage FCFE model.
The calculation of a share’s value using FCFE models is identical to that of

DDMs except that FCFE is used as cash flow to equity rather than
dividends.
5.3 Relative valuation
Relative valuation techniques express the price of a share as a ratio

(multiple) of some quantity relevant to a share’s value such as earnings
and book value. They are used as an alternative to discounted cash-flow
analysis when valuing shares.
53
5.3.1 Price/earnings ratio
The price/earnings (P/E) ratio is calculated by dividing a share’s price by

its earnings per share i.e.,
price per share

Pr ice /earnings ( P /E ) ratio =
earnings per share
On the assumption that a company’s P/E ratio fluctuates around its long-
term average value, the share price can be estimated as follows:
Pr ice per share = earnings per share × price /earnings ratio
Example: Share valuation using the price/earnings ratio

Given:
1. The average P/E ratio is 8.0
2. Expected earnings per share is R3.70
Price per share = 3.70 × 8.0

= R29.60
5.3.2 Market (price) to book value
The market to book value (M/B) ratio is calculated by dividing a share’s

price by its book value i.e.,
price per share

Market / book ( M / B ) ratio =
book value per share
On the assumption that a company’s M/B ratio fluctuates around its long-
term average value, the share price can be estimated as follows:
Price per share = book value per share × market / book ratio
Example: Share valuation using the market/book value ratio

Given:
1. The average M/B ratio is 1.3
2. Expected book value per share is R37.20
Price per share = 37.20 × 1.3

= R48.36
54
1. How is the intrinsic value of a share used to determine if the share is a

buy or not?
2. What are the inputs to the dividend discount model?
3. What is the value of a share that is expected to pay a dividend of

R1.00 per share next year if the shareholders’ required rate of return
is 15% and the dividend growth rate is a constant 10%?
4 What are the advantages and disadvantages of the Gordon growth

model?
5. What are the assumptions underlying the two-stage dividend discount

model?
6. What are the assumptions underlying the three-stage dividend

discount model?
7. Differentiate between dividend-discount and free-cash-flow-to-equity

models.
8 Name two relative valuation techniques.
9. What is a share’s P/E ratio if the price per share is R20 and earnings
per share is R2?
10 What is a share’s market / book ratio if the price per share is R20 and
book value per share R22?
55
1. The intrinsic value of the share is compared to its prevailing market

price to ascertain if the share is a buy or not i.e., if the estimated
intrinsic value is greater than the share price, the share is a buy.
2. The inputs to the dividend discount model are expected dividends and
required rate of return.
3. R20 i.e., (1 / (0.15 – 0.10))
4 The advantages of the Gordon growth model are simplicity,

convenience and ease of use. Its disadvantage is that it is extremely
sensitive to growth rate input i.e., the value of the share approaches
infinity as the growth rate and rate of return converge.
5. The two-stage dividend discount model assumes two stages of

dividend growth: an initial stage with a high growth rate; and a
second stage with a long-term, stable, growth rate. The drop to a
lower constant growth rate is immediate.
6. The three-stage dividend discount model assumes three stages of

dividend growth: an initial stable high-growth stage; a transitional
period of declining growth; and a final stable-growth stage that lasts
forever.
7. The difference between dividend-discount and free-cash-flow-to-equity

models lies in their definitions of cash flow. Dividend-discount models
characterise cash flow to equity as expected dividends. Free-cash-
flow-to-equity models consider cash flow to equity to be the residual
cash flow after meeting interest and principal payments and providing
for capital expenditures to maintain existing assets and invest in new
assets for future growth. Free-cash-flow-to-equity models indicate
what the company can afford to pay as dividends.
8 Two relative valuation techniques are the price earnings ratio and the
market price to book value ratio.
9. 10 i.e., R20 / R2
10 0.91 i.e., R20 / R22?
56
6. Company analysis

o Analyse individual companies;
o Discuss the competitive strategy of a company;
o Describe the quality of a company’s management.
Fundamental analysis focuses on determining the intrinsic value of a share

i.e., the present value of all future net cash flows derived from ownership
of the share. The emphasis on future earnings requires the analysis of all
variables that affect the level and growth rate of a company’s earnings
including:
o Quality and depth of management;
o Competitive position of the company;
o Strength of the company’s balance sheet;
o Economic, technical, political and legal environment in which the
company operates; and
o Industry environment and characteristics.
Chapter 3 dealt with the relationship between economic developments

embodied in the business cycle and industry performance. Against this
background the objective of this chapter is to discuss the analysis of
individual companies. Central to this process is the competitive strategy of
the company as well as quality of a company’s management.
6.1 Competitive strategy
Competitive strategy is a company’s search for a competitive position in

an industry to establish a profitable, sustainable position relative to
industry competitors.
The foundations for competitive strategy are:

o The five forces that determine the long-term profitability potential of
an industry – Porter’s five forces model;
o The three strategies for achieving competitive advantage - the
company’s relative competitive position within an industry.
6.1.1 Five forces model
The attractiveness of an industry is determined by the interchange

between five competitive forces. These are listed below and detailed in
figure 6.1:
o Threats of entry limited by barriers;
o Supplier power;
o Buyer power;
o Degree of rivalry among existing competitors; and
o Threat of substitutes.
57
Companies that face intense competition and are threatened by substitute
products and entry of new competitors generally do not earn attractive
returns.
Figure 6.1: Porter’s five-forces model
Supplier power
Supplier concentration Threat of substitutes Degree of rivalry
Importance of volume to suppliers Switching costs Exit barriers
Differentiation of inputs Buyer propensity to substitutes Concentration and balance
Impact of inputs on cost or differentiation Relative price of substitutes Fixed costs / value added
Switching costs Industry growth
Presence of substitute inputs Intermittent overcapacity
Threat of forward integration Product differences
Cost relative to total purchases in industry Switching costs
Brand identity
Diversity of rivals
Corporate stakes
Threats of entry limited by barriers

Absolute cost advantage
Proprietary learning curve
Access to inputs Rivalry
Government policy Buyer power
Economies of scale Bargaining leverage
Capital requirements Buyer volume
Brand identity Buyer information
Switching costs Brand identity
Access to distribution Price sensitivity
Expected retaliation Threat of backward integration
Proprietary product differences Product differentiation
Buyer concentration versus industry
Availability of substitutes
Buyers incentives
6.1.2 Competitive strategies
The overall profitability of a company is determined by its relative position

in an industry. A company with sustainable competitive advantage is likely
to generate superior performance.
Successful and profitable competitive strategies involve one or more of

the following three elements:
o Cost leadership i.e., achieving the lowest cost in the industry. This
strategy often depends on achieving a sufficiently high volume of sales
to exploit available economies of scale;
o Product differentiation aims at achieving higher profit margins by
making customers less sensitive to price. The strategy depends on
having distinct product features that distinguish the company’s product
from the products of its competitors; and
o Specialisation by focussing on a specific market segment. This strategy
is designed to ensure that what the company does in for example
customer service or product design is done exceptionally well. This is
because the company focuses on specific needs to which it is better
tuned than any of its competitors.
Low profitability is often associated with failure to develop in one of these
three directions.
58
6.2 Management – the qualitative element
Management quality is important when estimating the value of a share.

Generally current company results reflect decisions made by earlier
management while future company performance will reflect decisions
made by present management.
Tom Peters in his book In search of excellence identified the following

eight characteristics as being typical of successful business management:
o Intimate knowledge of the needs of the customer and exceptional
attention to these needs. Customer needs are at the forefront of the
company’s activities;
o Exceptional attention to the creative potential of individual employees.
Entrepreneurship is encouraged, autonomy decentralised and
innovation rewarded;
o Corporate values are well-articulated and understood. Corporate values
typically include product quality, low-cost production, innovation;
o The company sticks to the knitting i.e., it does not wander far from its
realm of expertise;
o Administration is lean, organisation structure simple and lines of
responsibility clear;
o Employees are made to feel essential to the success of the company;
o The decision-making process is action orientated;
o Decisive central direction and maximum individual autonomy reinforce
each other.
Danger signals in respect of management quality include:

o Product lines that remain the same year after year;
o Regularly recruiting executives from outside the company. This may
indicate a lack of attention to personnel development;
o Higher compensation for chief executive officer i.e. may be a one-man
show;
o A board of directors with a limited number of non-executive directors;
o Low allocation of funds to research and development. This indicates
that innovation is unlikely to be encouraged;
o Careless treatment of social responsibility matters.
59
1. What variables affect the level and growth rate of a company’s

earnings?
2. Define competitive strategy.
3. What are the foundations for competitive strategy?
4 The attractiveness of an industry is determined by the interchange

between what five competitive forces?
5. Name five components of supplier power.
6. Name seven components of buyer power.
7. What are the generic types of competitive advantage?
8 Name Peters’ eight characteristics typical of successful business

management.
9. Name six red flags in respect of management quality.
10 How is the overall profitability of a company determined?
60
1. Variables that affect the level and growth rate of a company’s earnings include
quality and depth of management; competitive position of the company; strength
of the company’s balance sheet; economic, technical, political and legal
environment in which the company operates; and the characteristics of the
industry in which the company operates.
2. Competitive strategy is a company’s search for a competitive position in an

industry to establish a profitable, sustainable position relative to industry
competitors.
3. The foundations for competitive strategy are: the five forces that determine the
long-term profitability potential of an industry (i.e., threats of entry limited by
barriers; supplier power; buyer power; degree of rivalry among existing
competitors; and threat of substitutes) and the three strategies for achieving
competitive advantage (cost leadership, product differentiation and specialisation).
4 The attractiveness of an industry is determined by the interchange between threats

of entry limited by barriers; supplier power; buyer power; degree of rivalry among
existing competitors; and threat of substitutes.
5. Five components of supplier power are supplier concentration, importance of

volume to suppliers, differentiation of inputs, impact of inputs on costs or
differentiation and switching costs.
6. Seven components of buyer power are bargaining leverage, buyers volume, buyer
information, brand identity, price sensitivity, threat of backward integration and
product differentiation.
7. The generic types of competitive advantage are cost leadership, product

differentiation and specialisation
8 Peters’ eight characteristics typical of successful business management are

knowledge of the needs of the customer and attention to these needs; attention to
the creative potential of individual employees; entrepreneurship; well-articulated
and understood corporate values; the company does not deviate far from its realm
of expertise; lean administration, simple organisation structure and clear lines of
responsibility; employees are made to feel essential to the success of the
company; the decision-making process is action orientated;
decisive central direction and maximum individual autonomy.
9. Six red flags in respect of management quality are product lines that remain the
same year after year; the regular recruitment of executives from outside the
company; higher compensation for chief executive officer; a board of directors with
a limited number of non-executive directors; low allocation of funds to research
and development; and careless treatment of social responsibility matters.
10 The overall profitability of a company is determined by its relative position in an

industry. A company with sustainable competitive advantage is likely to generate
superior performance.
61
7. Portfolio theory

o Define the assumptions on which portfolio theory is based;
o Explain security analysis;
o Discuss portfolio analysis;
o Describe portfolio selection – the problem of selecting an optimum
portfolio for an investor;
o Outline the following portfolio theory models: the Markowitz model,
Sharpe’s index models and the capital asset pricing model (CAPM).
Portfolio management (see figure 7.0) is a three-phase process as follows:

o Security analysis: predicts the risk and return of individual securities;
o Portfolio analysis: produces risk and return predictions about portfolios
– derived from those determined about securities – and establishes the
set of efficient portfolios i.e., the efficient portfolio; and
o Portfolio selection: selects from those portfolios deemed efficient the
single portfolio most suitable for the investor.
This chapter outlines the basic principles of portfolio theory. The contents
are as follows: section 1 specifies the assumptions upon which portfolio
theory is based, sections 2, 3 and 4 discuss security analysis, portfolio
analysis and portfolio selection respectively; and section 5 examines the
major portfolio theory models.
62
7.1 Assumptions
The following assumptions underlie portfolio theory:
o When choosing portfolios, rational investors attempt to maximise utility
and are willing to base their decision solely in terms of risk and return;
o Investors are risk adverse;
o The risk of a portfolio is measured by the variability of its return; and
o For any given level of risk an investor prefers a higher rate of return to
a lower one or for any given level of return an investor prefers less risk
to more risk.
7.2 Security analysis

A portfolio consists of one or more securities. If the actual rate of return
on each security could be accurately predicted, so could the rate of return
of every portfolio. However neither the rate of return of a portfolio nor
each of its component securities can be foreseen with certainty.
The aim of security analysis is to produce the following estimates about

securities that can be used to make predictions about portfolios:
o Expected return;
o Variance and standard deviation i.e., the variability of return or risk.
The variance of a security is a measure of the dispersion of the returns
of the security. The square root of the variance is the standard
deviation and is often used in practice because it measures dispersion
in the same units in which the underlying return is measured. The
greater the variance / standard deviation of a security’s returns, the
larger the risk;
o The covariances and correlation coefficients between securities. It is
not only the security’s own risk that is important but also the
contribution it makes to the variance of the entire portfolio, and this is
primarily a question of its correlation with all other securities in the
portfolio.
7.2.1 Expected return

The future rate of return of a security is not known for certain. Instead
there are several possible rates of return each with a possibility of
materialising. The expected rate of return is the weighted average rate of
return. It is calculated by weighting each possible rate of return with its
probability of occurrence.
For example, assume a share has the following possible rates of return.
The rates as well as the probability of them happening are shown in table
7.1 below;
Table 7.1: Rates and probabilities

Rate of return % Probability
5.0 0.20
10.0 0.30
15.0 0.30
18.0 0.20
Total 1.00
63
Graphically:
Figure 7.1: Probability distribution of rates of return
0.4
0.3
Probability
0.2
0.1
0
5.00 10.00 15.00 18.00
Rates of return %
The formula for calculating the expected return is:
n
E( X ) = ∑P X i i
i =1
where :
E (X ) = the expected return
X i = rate of return X i
Pi = the probability associated with rate of return X i
n = the number of possible rates of return X i
The expected rate of return of the share is12.1% calculated as follows:
Table 7.2: Calculating the expected rate of return

Rate of return % Probability Expected return E(X)
(Xi) (Pi) (PiXi)
5.0 0.20 1.0
10.0 0.30 3.0
15.0 0.30 4.5
18.0 0.20 3.6
Total 1.00 12.1
The expected rate of return is also referred to as the mean of the

probability distribution.
64
7.2.2 Variability of return
The variance and standard deviation (i.e., square root of the variance) are
measures of the dispersion or spread of the probability distribution around
the expected rate of return. The less spread out the distribution is i.e., the
more closely concentrated round the expected value the probability
distribution is, the smaller the variance and standard deviation and the
smaller the risk that the expected rate of return will not materialise.
Thus the variance and standard deviation indicate the variability of return
i.e., the risk that the expected rate of return will not occur.
The formula for calculating the variance is:
∑ P [(X ]
n
− E ( X ))
2
var( X ) = i i
i =1
where
var( X ) = variance
Pi = probability of the ith rate of return occuring
X i = the ith rate of return
E ( X ) = the expected rate of return of the security
A disadvantage of using the variance is that it is expressed in terms of

squared units of the rate of return. Thus the square root of the variance -
the standard deviation - is a more meaningful measure of the dispersion
of the probability distribution. More formally:
std( X ) = var( X )
For example the variance of the share is 20.890 and the standard
deviation is 4.571 i.e., 20.890
Table 7.3: Calculating the variance

Rate of return Probability Pi (Xi-E(X))2
(Xi) (Pi)
5.0 0.20 0.20(5.0-12.1)2 = 10.082
10.0 0.30 0.30(10.0-12.1)2= 1.323
15.0 0.30 0.30(15.0-12.1)2= 2.523
18.0 0.20 0.20(18.0-12.1)2= 6.962
Total 1.00 20.890
7.2.3 The normal probability distribution
The most widely used probability distribution is the normal probability

distribution with its bell-shaped curve (see figure 7.2).
The normal probability distribution has the following characteristics:
65
o The mid-point of the normal curve is the expected value (or mean) of
the distribution;
o The distribution is symmetric around the expected value i.e., 50% of
the values are less than the expected value and 50% greater;
o The probability of obtaining a value within one standard deviation of
the expected value is approximately 68%;
o The probability of obtaining a value within two standard deviations of
the expected value is approximately 95%;
o The probability of obtaining a value within three standard deviation of
the expected value is approximately 99.7%;
Figure 7.2: Normal probability distribution
Volatility
Mean
For example assuming the rate of return of the share is normally

distributed and given that the expected value of the share is 12.1% and
the standard deviation 4.571 the probability is roughly 68% that the
actual rate of return of the share will be between 16.671% and 7.529%
(i.e., between (12.1 + 4.571) and (12.1 – 4.571)). Similarly the
probability is about 95% that the actual rate of return of the share will be
between 21.85% and 2.96% (i.e., 12.1 ± (2 x 4.571)) and approximately
99.7% that the actual rate of return of the share will be between 25.81%
and –1.61% (i.e., 12.1 ± (3 x 4.571).
In general this may not hold because there is no reason to expect the
distribution of a security’s rates of return to be normal. However the
function of the standard deviation is the same in every case – to measure
the likely divergence of the actual rate of return from the expected rate of
return.
7.2.4 Covariances and correlation coefficients

A major attribute of portfolio theory is the requirement that
interrelationships between securities’ rates of return be taken into
66
account. These relationships can be stated in terms of correlation
coefficients and covariances.
The covariance is a measure of the extent to which two variables (i.e.,

securities’ rates of return) move together linearly. If two variables are
independent their covariance is equal to zero. A positive covariance
indicates that the two variables move in the same direction and a negative
covariance that they move in opposite directions.
The covariance is given by:
1 n
cov( X , Y ) = ∑ (X i − E ( X ))(Yi − E (Y ))
n − 1 i =1
For example the calculation of the covariance between the share prices of
Telkom (X) and Altech (Y) from a sample of monthly historic data is
shown in table 7.3.
Table 7.4: Calculation of the covariance between the share prices of Telkom
and Altech
Month Telkom Altech (Xi-E(X)) (Yi-E(Y)) (XiE(X)) x
n Xi Yi (Yi-E(Y))
1 167 60 6.00 4.67 28.00
2 170 64 9.00 8.67 78.00
3 160 57 -1.00 1.67 -1.66
4 152 46 -9.00 -9.33 84.00
5 157 55 -4.00 -0.33 1.33
6 160 50 -1.00 -5.33 5.33
Total 966 332 0.00 0.00 195.00
Expected Note on calculation of the expected value:
value (or 161.0 55.3 Each of the 6 share price occurrences has
mean) the same probability of occurrence. Thus
the expected value is simply the average of
Standard 6.573 6.563 the data series i.e., Telkom 966 / 6 and
deviation
Altech 332 / 6.
Thus
195.00
cov( X , Y ) = = 39.00
5
No significance can be attached to the magnitude of the covariance. A

positive covariance means that on average the rates of return of the two
securities move in the same direction. The correlation coefficient is a more
convenient measure of linear dependence. It measures the strength of the
linear association between two variables. The correlation coefficient is
given by:
67
cov( X , Y )
cor ( X , Y ) =
std( X )std(Y )
where
std = standard deviation
Correlation coefficients range between -1 and 1 with:

o +1 indicating an exact positive linear relationship between the two
variables X and Y i.e., an increasing X is associated with an increasing
Y;
o -1 indicating that although the variables move in perfect unison, they
move in opposite directions i.e., an increasing X is associated with a
decreasing Y; and
o 0 indicating that there is no linear relationship between the two
variables.
For example, the correlation coefficient between Telkom and Altech is:
39.00
cor ( X , Y ) = = 0.904
( 6.573 )( 6.563 )
Since both shares are in the telecommunications sector, it is not
surprising that there is a strong positive linear relationship between the
two shares.
The correlation coefficient measures the extent of the linear association

between two variables. This association does not imply causation - both
variables may be affected by a third variable. For example, there is a
strong correlation between human birth rates and stork population sizes!
7.3 Portfolio analysis

The attractiveness of a portfolio depends upon both its expected return
and its risk.
7.3.1 Expected return

A portfolio’s expected return is the weighted average of the expected
returns of its component securities using the proportions invested as
weights. Symbolically:
n
Ep = ∑X E i i
i =1
where
E p = the portfolio' s expected return
X i = the proportion invested in the ith security
E i = the expected return of the ith security
n = the number of securities in the portfolio
68
For example, the expected rate of return of the portfolio shown in table 2
is 17.98%.
Table 7.5: Calculation of the expected rate of return of a portfolio

Security Proportion Rate of return XiEi
(i) invested (Ei)
(Xi)
Bond 50% 17.5% 8.75%
Shares 30% 20.5% 6.15%
NCD 20% 15.4% 3.08%
Total 17.98%
7.3.2 Variance and standard deviation
The risk of a portfolio is measured by the variability of its expected return.

The variance and standard deviation of the portfolio depend on the
proportion of the portfolio invested in each security as well as the
component securities’ standard deviations and correlation coefficients.
The variance is given by:
n n
varp = ∑∑X X i j cov ij
i =1 j =1
where
varp = the variance of the portfolio
X i = the proportion invested in the ith security
X j = the proportion invested in the jth security
cov ij = the covariance ( i .e., corij std i std j ) between securities i and j
The standard deviation of the portfolio is calculated as follows:
std p = varp
For example (see table 7.6) the portfolio variance is 60.36 and its
standard deviation is 7.76%.
69
Table 7.6: Calculation of the variance of a portfolio
Terms Component securities Total
Bond Shares NCD
Std * 5.0 15.0 10.0
X* 0.5 0.3 0.2 1.0
Bond Shrs NCD Bond Shrs NCD Bond Shrs NCD
corij * 1.00 0.50 0.60 0.50 1.00 0.7 0.60 0.70 1.00
covij (1) 25.00 37.50 30.00 37.50 225.0 105.0 30.00 105.0 100.0
XiXjcovij 6.25 5.63 3.00 5.63 20.25 6.30 3.00 6.30 4.00 60.36
(2)
Terms denoted by * are assumed to be given.
Calculations for the first three terms are shown (where covij = corij stdi stdj)
25.0 = 1.0 x 5.0 x 5.0
37.5 = 0.5 x 5.0 x 15.0
30.0 = 0.6 x 5.0 x 10.0
Calculations for the first three terms are shown:

6.3 = 0.5 x 0.5 x 25.0
5.6 = 0.5 x 0.3 x 37.5
3.0 = 0.5 x 0.2 x 30.0
Thus, assuming a normal distribution, given that the expected return of

the portfolio is 17.98% and the standard deviation 7.76% the probability
is roughly 68% that the actual return of the portfolio will be between
25.74% and 10.22% (i.e.. between (17.98 + 7.76) and (17.98 - 7.76)).
To illustrate how different correlation values effect the variance of a

portfolio, consider the following example. Assume that a portfolio consists
of two securities. The securities have the same expected rates of return of
16%, the same variances of 2% and equal amounts are invested in each.
The expected return of the portfolio will be 16%. The variance of the
portfolio will be (where n = 2):
2 2
varp = X i vari + X j var j + 2 X i X j corij std i std j
varp = ( 0 ,25 )( 0 ,02 ) + ( 0 ,25 )( 0 ,02 ) + 2( 0 ,5 )( 0 ,5 ) corij 0 ,02 0 ,02

varp = 0 ,01 + 0 ,01 corij
If there is no correlation (corij = 0), the variance of the portfolio is 1%, or

less than that of a portfolio invested in only one of the securities. If the
correlation is perfect and positive (corij = 1), the portfolio variance is 2%,
the same as that of a single security. If the correlation is perfect and
negative (corij = -1), the variance of the portfolio is zero.
As investors generally wish to avoid risk (given return) and since the
negative correlation between a security and a portfolio reduces the
variance of a portfolio, such securities would be highly valued. However
70
securities that are highly correlated with a portfolio do not contribute
much to the kind of risk reduction that is the purpose of diversification.
7.3.3 The efficient frontier
A portfolio can consist of one or more securities. For any group of

securities the feasible set of portfolios consists of all single-security
portfolios and all possible combinations of them.
Figure 7.3 indicates the risk and rates of return for 10 portfolios each
consisting of a single different portfolio.
Figure 7.3: Expected return and risk of portfolios
20
18 9
7
16 P
14
3
Expected return
8
12
10 4 10
8 1 2
5
6
4 6
0
0 2 4 6 8 10 12 14 16 18 20
Risk
Clearly portfolio 3 is preferred to portfolio 1 as it offers a higher return for

the same risk. Portfolio 1 is preferred to portfolio 2 as it offers a lower risk
for the same return. It the securities are perfectly correlated, portfolios
made up of combinations of these securities can have smaller variances
for given returns or larger returns for given variances than the single-
security portfolios and would lie in the region above and to the left of the
single-security portfolios. For example portfolio P could represent a
combination of portfolios 3 and 4.
Therefore efficient portfolios will plot along the upper border of the
feasibility set of portfolios. This border is called the efficient frontier and is
represented by curve ABC in figure 7.4.
71
Figure 7.4: The efficient frontier
20
18 C
16
14
B
Expected return
12
10
4
A
2
0
0 2 4 6 8 10 12 14 16 18 20
Risk
Efficient portfolios are fully diversified in that for any given rate of return
no portfolio has less risk and for a given level of risk no other portfolio
provides superior returns.
7.4 Portfolio selection
Portfolio theory is based on the assumption that most investors prefer

high rates of return and dislike risk and the definition of efficient portfolios
follows from this. The efficient set of portfolios is the same for all investors
and rational investors will select portfolios along this efficient frontier.
However investors' preferences for return vis-à-vis risk differ. Investors
who would like to have low levels of risk in their portfolio, pick portfolios
close to point A on the curve. Investors willing to bear more risk will
choose portfolios closer to point B on the curve. Investors willing to
tolerate high levels of risk to earn higher returns may select portfolios
near to point C.
The problem of choosing an optimum portfolio for an individual investor

from those that are efficient is the subject of portfolio selection.
The underlying behaviour that guides the behaviour of investors is the

maximisation of expected utility. Utility is maximised when a given
combination of expected return and risk is preferred to all other
combinations. Since investors wish to increase expected return and avoid
risk it is possible to establish different combinations of expected return
and risk that will be equally valued by an investor. These combinations
will lie on so-called indifference curves – see figure 7.5.
72
Figure 7.5: Indifference curves - risk/return preferences
20
18 C
16 Increasing utility Efficient frontier
14
Expected return
B
12
10 U3
8
U2
6
4 U1
A
2
0
0 2 4 6 8 10 12 14 16 18 20
Risk
Each investor has an infinitely large family of indifference curves. Each

curve represents the set of expected return and risk that are equally
valued. The investor will seek to maximise utility i.e., with reference to
figure 7.5, the investor will prefer indifference curve U3 to U2 and U2 to
U1.
Conceptually the investor is now in a position to select the optimum

portfolio from those making up the efficient set. The optimum portfolio is
the one at point of tangency between the efficient frontier (curve ABC in
figure 7.5) and an indifference curve, The portfolio at point B on the
efficient frontier is optimal as no other portfolio is on as high an
indifference curve.
7.5 Portfolio theory models
7.5.1 Markowitz model
The basic elements of portfolio theory as described in sections 7.1 to 7.4

were developed by Dr Harry Markowitz in 1952. To define Markowitz’s
efficient set of portfolios it is necessary to know the following for each
security:
o Expected return;
o Variance; and
o Covariance with every other security.
If the efficient set were to be selected from a list of 1 000 securities, it

would be necessary to have 1 000 estimates of expected return, 1 000
variances and 99 500 covariances. Because of this practical difficulty the
73
Markowitz portfolio model was mainly of academic interest until William
Sharpe (see 7.5.2) simplified it.
7.5.2 Sharpe’s index models
7.5.2.1 Introduction
Sharpe’s index models are based on the assumption that the returns of all
securities are related only through their individual relationship to one or
other indexes of business activity such as GDP, Dow-Jones Index,
Standard and Poor’s Index, FTSE JSE all-share Index.
The return on a security can be written as follows:
ri = α i + β i I + c i
where
ri = return on securityi
α i = the alpha coefficient of security i
− a constant indicating the return on security i given I
β i = the beta coefficient of security i
− a constant measuring the change in ri given a change in I
I = the rate of return on the market index
c i = residual error term − the return on security i not exp lained by α i or I
The equation breaks down the return on a security into two components:
o The part that is independent of the market (αi and ci); and
o The part that is due to the market (βiI). βi measures the sensitivity of
the security’s return to the return on the market index. For example if
βi equals 2, the return on the security is expected to increase
(decrease) by 2% when the market index increases (decreases) by
1%.
7.5.2.2 Single index model
Sharp’s index models state that the only reason the return of two
securities move together is common co-movement with the market. This
is equivalent to assuming that the residual error term ci for any security i
is unrelated to the residual error term cj for a second security j. Therefore
the covariance between any two securities i and j is equal to βiβjσI2 where
σI2 is the variance of the market index. If the residual risk of the return of
a security (that variation in a security’s return that is unrelated to the
market) is defined as σci2, the expected return and variance of a portfolio
are:
74
n
Rp = ∑ x (α β I )
i =1
i i i
n n
= ∑ x iα i + ∑x β I i i
i =1 i =1
where
Rp = portfolio return
x i = proportion invested in security i
α i = alpha of security i
β i = beta of security i
I = rate of return on the market index
n n
σp = xi β iσ I + σ ci
2 2 2 2
∑
i −1
∑x
i =1
i
where
σ p = portfolio variance
2
σ I = variance of the market index

2
σ ci = residual risk of return of security i

2
The portfolio variance now only depends on:

o the weight of each share in the portfolio (xi);
o The beta of each share (β i);
o The variance of the index (σI2); and
o The variance of the residual error for each share (σci2).
This represents a considerable saving in terms of data input. For example

a 1 000 securities portfolio will require 3 001 inputs – approximately 0.6%
of the inputs required for the Markowitz model.
If the beta of a portfolio is defined as the weighted average of the betas of

each security in the portfolio then the portfolio beta is calculated as
follows:
n
βP = ∑x β i i
i =1
where
β P = portfolio beta
β i = beta of security i
75
Similarly the alpha of a portfolio can be defined as
n
αP = ∑xα i i
i =1
where
α P = portfolio alpha
α i = alpha of security i
The expected return of a portfolio can then be re-written as:
RP = α P + β P I
where
RP = portfolio return
α P = portfolio alpha
β P = portfolio beta
I = rate of return of the market
The risk of a portfolio can also be re-written as:
n
σ P = βP σ I + σ ci
2 2 2 2 2
∑x
i =1
i
If it is assumed that the portfolio consists of equal proportions of each of n

securities then the risk of the portfolio could be written as:
n
1
σ P = βP σ I + σ ci
2 2 2 2
n 2 ∑
i =1
The last term can be expressed as n times the average residual risk of a
security. As the number of securities in the portfolio increases, the
importance of the residual risk – the non-beta risk – diminishes rapidly as
illustrated in table 7.7.
76
Table 7.7: Importance of residual risk
Number of securities Residual risk expressed as a % of the residual risk
of a one-security portfolio
1 100.0
2 50.0
3 33.0
4 25.0
5 20.0
10 10.0
20 5.0
100 1.0
1 000 0.1
The risk that is not eliminated as the number of securities in a portfolio

increases is the risk associated with the portfolio beta. If the residual risk
is assumed to be zero then the risk of a portfolio can be re-stated as
follows:
σ P = βP σ I
2 2 2
σ P = β Pσ I
n
= σI ∑x β i i
i =1
Due to the residual risk (σci2) of a portfolio moving to zero as the number
of securities in a portfolio increases, it is commonly referred to as
diversifiable or unsystematic risk. However the effect of the securities’
betas (βi) on the risk of a portfolio does not decrease as the number of
securities in the portfolio (n) increases. Therefore it is a measure of a
security’s non-diversifiable or systematic risk i.e.,
n n
σP = xi β i σ I σ ci
2 2 2 2
∑ + ∑x i
i =1 i =1
g = systematic risk + unsystematic risk

= undiversifiable risk + diversifiable risk
Investors cannot avoid systematic risk as it affects all financial

indexes/markets e.g., general economic conditions, fiscal and monetary
policy. Unsystematic risk is the variability not explained by general market
movements and is peculiar to the security concerned. It can be avoided
through diversification. This implies that only inefficient portfolios have
unsystematic risk. This is illustrated by figure 7.6.
77
Figure 7.6: Systematic and unsystematic risk
unsystematic (diversifiable) risk decreases as

number of securities increases
systematic (undiversifiable) risk is unchanged

as the number of securities increases
Risk
Total risk
unsystematic risk
systematic risk
Number of securities (i.e., level of diversification)
7.5.2.3 Alphas and betas
If portfolio p in the equation Rp = αp + βp I is taken to be the market

portfolio i.e., all securities are held in the same proportions as they are
represented in the market then the expected return on p (Rp) must be
equal to the expected return of the market index (I). The only values that
ensure Rp = I are alpha (αp) equal to zero and βp equal to one. Therefore
the beta of the market is one and securities are considered to be more or
less risky than the market according to whether their beta is larger or
smaller than one. If the return on a security moves exactly as the market
does, it would have a beta of one. If it were more volatile than the market
its beta would be more than one and less than one if it were less volatile.
However securities seldom behave as indicated by their betas, which is
where alphas come in. They are used to account for changes in securities’
prices not attributable to their betas.
There are two ways of achieving superior portfolio performance:
(i) Forecast the market accurately and adjust the beta of the portfolio
accordingly. For example if a market upswing is expected high beta
securities could be bought and low beta securities sold to raise the
portfolio beta to a level of say 2. If expectations materialise the
portfolio will rise twice as much as the market. If the expectations are
incorrect the portfolio will decline twice as fast as the market.
(ii) Achieve a positive alpha or excess return. If a security has a higher or

lower rate of return than another security with the same beta i.e., it
does better against the market than its beta would have suggested this
could be due to its alpha or various residual non-market influences
78
unique to each stock. If sufficient securities with positive alphas can be
selected, the portfolio will perform better than its beta would have
indicated for a given market movement. For example assume a
security has an alpha of 1% and a beta of 1.50. If the market return is
12.0% the most likely return on the stock is 19.0% i.e., 1+ 12 x1.5.
As more securities are added to a portfolio, the chances of obtaining a

positive alpha and the risk of getting a negative alpha are diversified
away. The portfolio’s volatility will become similar to that of the market.
Conceptually a fully diversified portfolio would have a beta of one and
alpha of zero.
7.5.2.4 Multi-index models
Multi-index models assume that relationships between securities are due

to common associations with more than one index. The additional sources
of covariance between securities resulting from the introduction of
additional indexes can simply be added to the general return equation as
follows:
Ri = α i + β i1 I1 + β i 2 I 2 K β in I n + c i
where
Ri = return on security i
α i = return if all indices were equal to zero i .e., the unique return
I1 = level of index I i
β i1 = responsiveness of Ri to changes in index I1
c i = residual term − the return on security i not exp lained by the equation
Therefore to use multi-index models the following estimates will be

required:
o Expected return for each security;
o Variance of each security’s return;
o Beta of each security’s return in relation to each index;
o Expected return and variance of each index.
For example: in South Africa the gold mining and industrial sectors each
comprise a significant proportion of the total market capitalisation of the
JSE Ltd. The prosperity of gold mining companies depends on a gold price
established by international, political and economic events often divorced
from developments in the South African economy. Therefore it is
reasonable to assume that the returns on mining and industrial shares will
at times be influenced by different underlying factors. Consequently a
two-index model using the mining and industrial indexes (see table 7.8)
has been used to estimate the risk and return of a portfolio comprising the
shares detailed in table 7.9.
79
Table 7.8: Index statistics
Index Return Standard deviation
RI σI
Gold mining (GLDI) 12.00 0.03063

Industrial (INDI) 11.50 0.02096
Table 7.9: Share statistics

Share Proportion Alpha Beta Beta Residual
invested (%) (GLDI) (INDI) risk
xi αi βGLDIi βINDIi σci
Harmony (Har) 20.0 -0.002 1.655 -0.302 0.036

AngloGold (Ang) 30.0 0.000 0.763 0.436 0.029
Barlows (Bar) 50.0 -0.001 0.060 1.197 0.027
The alpha and beta of the portfolio are:
n
α p = ∑ xiα i
i =1
= (0.20 x − 0.002 ) + (0.30 x 0.000 ) + (0.50 x − 0.001)

= 0,0001
n
β GLDIp = ∑x β i GLDIi
i =1
= (0.20 × 1.655) + (0.30 × 0.763) + (0.50 × 0.060 )

= 0.590
n
β INDIp = ∑x β i INDIi
i =1
= (0.20 × −0.302) + (0.30 × 0.436 ) + (0.50 × 1.197)

= 0.669
The portfolio risk and return will be:
n
R p = α p + ∑ β I RI
i =1
= 0.001 + (0.590 × 0.12 ) + (0.669 × 0.115)

= 14.78%
80
n
σ p = β GLDI σ GLDI + β INDI σ INDI + ∑ x i σ ci
2 2 2 2 2 2
i =1
= 0.590
2
× 0.03063
2
+ 0.669
2
× 0.02096
2
+ 0.20
2
× 0.036
2
+ 0.30
2
× 0.029
2
+ 0.50
2
× 0.027
2
= 0.00052312 + .0003097 2
= 0.000833
σ p = 0.000833
= 0.02886
The total risk of the portfolio is 2.886%. Therefore 68% of the time (refer
7.2.3) the portfolio return will be between 17.556% (i.e., 14.67% +
2.886%) and 11.784% (i.e., 14.67% - 2.886%). The systematic risk of
the portfolio is
2.29% i.e., 0.0005231 and the unsystematic risk is 1.76% i.e.,
0.0003097 . The degree of diversification is 62.81% i.e.,
0.0005231/0.0008328, which is to be expected from a portfolio containing
only three securities.
Alternative portfolios can be calculated in different proportions and with

different securities to construct a table such as table 7.9.
Table 7.10: Alternative portfolios

Parameter Portfolio 1 Portfolio 2
Unsystematic risk 1.76% 0.58%

Systematic risk 2.29% 0.92%
Total risk 2.89% 1.09%
Degree of diversification 62.81% 71.43%
Expected return 14.67% 13.27%

Downside potential 11.78% 12.18%
Upside potential 17.56% 14.36%
The choice facing the investor is clearly quantified. Portfolio 1 with an

expected return 1.4% more than portfolio 2 can be chosen. However in
doing so downside risk is increased. The choice will depend on the
investor’s attitude to risk as it relates to return.
81
7.5.3 Capital asset pricing model
7.5.3.1 Introduction
The capital asset pricing model (CAPM) is a refinement of portfolio theory.

It attempts to describe the market relationships if investors behave is the
manner prescribed by portfolio theory. These relationships give an
indication of the relevant measures of risk for portfolios and individual
assets.
7.5.3.2 Assumptions
The simplifying assumptions of the CAPM are:

(i) Investors have homogeneous expectations;
(ii) Investors have identical time horizons;
(iii) Perfect competition exists i.e., there are no transaction costs or
taxes, costless information is available to all investors, investors are
price takers;
(iv) Investors are able to lend or borrow unlimited funds at the risk-free
market interest rate;
(v) Assets are infinitely divisible; and
(vi) All investors attempt to hold Markowitz-efficient portfolios.
7.5.3.3 The capital market line
The CAPM states that by optimally diversifying, all investors will hold the
same portfolio – the market portfolio. The market consists of risky
securities only and is the best diversified portfolio that can be held. It is
the portfolio constructed by holding every security in equal proportion to
its portion of the total market value of all available securities. The market
portfolio is one portfolio on the efficient frontier (point M in figure 7.7).
82
Figure 7.7: The capital market line
N
Leveraged portfolios
Efficient frontier
C
M
Expected return
Lending portfolios
Rf
A
Risk
In addition to risky investments the CAPM recognises another investment

vehicle – a risk-free asset i.e., an asset that can be borrowed or lent
without risk of default e.g., treasury bills. Point Rf in graph 7.7 is the rate
of return on a risk-free asset. The line segment RfM shows the various
portfolios available through combinations of risk-free and risky assets.
Possible portfolio combinations range from a totally invested position in
risk-free assets to one that exactly mirrors the market. Portfolios on the
line segment RfM will be preferred to portfolios on the curve AM as they
offer more return for the same risk.
It is possible to hold efficient portfolios on the line RfM beyond the point of
tangency with curve AMC since borrowing is allowed. Given the simplifying
(unrealistic) assumption that investors can borrow to purchase financial
assets at the same rate that investors receive on a risk-free asset,
efficient portfolios beyond the point of tangency lie on a linear
extrapolation of the line RfM – line segment MN in figure 7.7.
Any point on the line RfMN is achievable by combining the portfolio of

risky assets at M with the risk-less asset or by leveraging the portfolio at
M i.e., by borrowing funds and investing them in portfolio M. Portfolios on
line RfMN are preferred to portfolios on the curves between A and M and M
and C since they offer greater return for a given level of risk or less risk
for a given rate of return. The efficient frontier is now linear and is
referred to as the capital market line. Symbolically:
83
E m − Rf
E p = Rf + ×σp
σm
where
E p = expected return on a portfolio
Rf = risk−free rate
E m = expected return on the market
σ p = standard deviation of returns on the portfolio
σ m = standard deviation of returns on the market
The formula states that the expected return on an efficient portfolio is a

linear function of its risk as measured by the standard deviation. The
slope of the line can be considered the price of risk i.e., the additional
expected return for each additional unit of risk.
For example assume that the risk-free rate of return is 10.0%, the
expected return on the market portfolio is 16.0%, the standard deviation
of the market portfolio’s return is 12% and the standard deviation of the
portfolio is 13%.
0.16 − 0.10
Ep = 0.10 + × 0.13
0.12
The investor will expect to earn a return of 16.5% for bearing risk
equivalent to a standard deviation of 13.0%. The slope of the line is 0.5
i.e., (0.06 / 0.12). Therefore an extra unit of risk is rewarded with an
additional half a unit of return.
The CAPM states that an investor’s choice of an optimum portfolio is

separate from the optimal combination of risky assets. This combination is
identical for all investors. Individual investor’s requirements determine
only the amount of borrowing and lending. This is referred to as the
separation theorem. The theorem allows the development of valuation
under uncertainty that does not depend directly on knowledge of the
degree of risk aversion of investors.
7.5.3.4 The security market line
The capital market line holds only for efficient portfolios. It does not
describe the relationship between the return on inefficient portfolios or
individual securities and their standard deviations.
The CAPM states that the expected return on any portfolio or security is
related to the risk-free rate and return on the market as follows:
84
E p = Rf + β p (E m − Rf )
where
E p = return on the portfolio
Rm = return on the market
β p = beta coefficient of the portfolio
The relationship is similar but not identical to the capital market line. Here
beta rather than standard deviation measures risk. For efficient portfolios
the relationship is the same i.e., βp = σp / σm = 1.
The security market line is represented graphically by figure 7.8.
For example assume the risk-free rate is 10.0%, the expected return on
the market 16.0% and the beta of the portfolio is 0.5, then the expected
return on the portfolio is:
E p = 0.10 + 0.5(0.16 − 0.10)

= 13.0%
The expected return on any portfolio or security can be determined by the

relationship described by the security market line. Since market return
(Rm) and risk-free return (Rf) are not functions of portfolio returns, the
expected return on any portfolio or security can be related to its beta. The
higher the beta of any portfolio or security, the greater must be its
expected return.
Figure 7.8: The security market line
Rm
Expected return
Rpi
Rf
1
Risk
85
As previously stated the risk of any portfolio or security can be divided
into systematic (as measured by beta) and unsystematic risk. According
to the security market line, systematic risk is the only determinant of
expected portfolio returns i.e., unsystematic risk plays no role. Therefore
investors are rewarded for bearing systematic risk i.e., it is not total
variance that affects returns – only that part that cannot be diversified
away. Since investors can eliminate all unsystematic risk through
diversification, there is no reason why they should be rewarded (in the
form of returns) for bearing it.
7.5.3.5 Applications of the CAPM
(i) Cost of equity – the required rate of return on equity
The required rate of return is the minimum rate of return that prospective
investors will accept from an investment to compensate them for deferring
consumption. The rate of return that investors require to make an equity
investment in a firm is generally referred to as the cost of equity. It can
be calculated by using the security market line as follows:
k i = Rf + β i (Rm − Rf )
where
k i = required rate of return on share i
Rm = return on the market
β p = beta of share i
The term (Rm-Rf) is known as the market risk premium. It is generally

based on historic data and indicates the difference between the average
return on shares and average return on risk-free securities over a
measurement period. The term β i(Rm-Rf) is a share’s risk premium and
when added to the risk-free rate gives the required rate of return of a
share.
Example: calculating the required rate of return on a share

Given:
1. The share’s beta is 1.4
2. The risk free-rate is 9.7% (the current treasury bill rate)
3. The return on the market (FTSE JSE All share index) is 17.5%
k i = 0.097 + 1.4( 0.175 − 0.097 )

= 20.6%
86
Given:
1. The share’s beta is 1.4
3. The market risk premium is 7.8%
k i = 0.097 + 1.4( 0.078 )

= 20.6%

Given:
2. The share’s risk premium is 10.9%
k i = 0.097 + 0.109 )
= 20.6%
(ii) Judging the reasonableness of investment objectives
The investment objective of Peoples Pension Fund is “to attain maximum

growth of assets and income consistent with overall quality investments
and preservation of assets in a portfolio consisting primarily of blue-chip
shares and preferred bonds and debentures. The fund requires for the
equity-related portion of the portfolio a return of 25% above the FTSE JSE
all-share index. The trustees are aware that this objective entails more
volatility than the overall market. If unfavorable market conditions are
foreseen, a reduction in volatility is acceptable and desirable. At least 15%
superior performance relative to the all-share index on the downside will
be expected. Thus the expectation for the equity-related portion of the
portfolio in relation to the rate of return of the all-share index is as
follows:
FTSE JSE All-share index Peoples Pension Fund % above index

30.0 37.5 25.0
20.0 25.0 25.0
10.0 12.5 25.0
0.0 2.5
-10.0 -8.5 15.0
-20.0 -17.0 15.0
-30.0 -25.5 15.0
Figure 7.9 illustrates expected returns in terms of the various levels of risk
as expressed by the portfolio’s beta. A portfolio with a beta of 1 would
represent the market (represented by the all-share index). It is assumed
87
that the average rate of return on the all-share index is 10.0%, that bear
markets produce negative market returns of 10.0% and that the average
risk-free rate is 5%. Using the security market line the expected rates of
return of the portfolio with a beta other than 1 can be calculated and
market lines Rf A and Rf B – reflecting respectively long-term expectations
and bear-market vulnerability – can be drawn. For example if the portfolio
beta is 0.5, the portfolio’s expected rate of return will be 7.5% i.e.,
5.0 + 0.5 (10.0 - 5.0).
The fund’s trustees require a return of 12.5% when the market return is
10.0%. To achieve this return the portfolio’s beta will have to be 1.5 – see
figure 7.9 – a position more risky than the market and probably in
violation of the investment objective of “a diversified portfolio of quality
investments with the preservation of capital”.
This incompatibility is further emphasised when expected portfolio results

during a bear market are considered. When the market declines to –
10.0% a loss of 8.5% is required. However a portfolio with a beta of 1.5 is
expected to return –17.5% if the market declines to –10.0%. The
objective of outperforming the market by 25.0% on the upside (12.5%
when market returns are 10.0%) implies an exposure to under-performing
it on the downside by substantially larger proportions (–17.5% when
market returns are –10.0%). To achieve a return of –8.5% when the
market return is -10.0% the beta will have to be reduced from 1.5 to 0.9
i.e., β = ((0.05 + 0.085) / (0.10 + 0.05)).
Figure 7.9: Investment objectives of Peoples Pension Fund
20
A
15.0
15 12.5
10.0
10 7.5 Long-term expectations
Rf
Expected return
5 5.0
-5 -2.5
-10
-10.0
-15 Bear-market vunerability
-20 -17.5
-25
-25.0
-30 B
0 0.5 1 1.5 2
Beta
To shift the portfolio from a beta of 1.5 to 0.9, the portfolio manager must
be able to forecast a bear market well in advance and be willing to incur
88
high transaction costs. Alternatively security selection must be so
proficient that sufficient alpha is achieved to offset the inappropriate beta.
The CAPM can be used to specify precise and remove undefined and
subjective investment objectives. By illustrating how a portfolio may
behave during severe market fluctuations, it indicates what is required in
terms of market timing (adjustment of beta) and the ability to secure
gains (alphas) from the astute selection of undervalued securities.
89
1. What assumptions underlie portfolio theory?
2. What estimates about securities can be used to make predictions

about portfolios?
3. What is the expected return of a security that has possible returns of

10% and 15%? The possible returns have an equal probability of
occurring.
4 What is the significance of a correlation coefficient of 0.9 between

Anglo Platinum and Impala Platinum?
5. Calculate the expected rate of return of the following portfolio:
Security Proportion invested Rate of return

Bonds 50% 8.0%
Shares 50% 20.0%
6. Differentiate between systematic and unsystematic risk.
7. Define multi-index models.
8 Differentiate between the capital and security market lines.
9. According to CAPM, what is the expected return on a portfolio if

The risk-free rate of return is 10%,
The expected return on the market portfolio is 15%,
The standard deviation of the market portfolio’s return is 12% and
The standard deviation of the portfolio’s return is 14%?
10 According to CAPM, what is the expected return on a portfolio if

The risk-free rate of return is 10.0%,
The expected return on the market portfolio is 15.5%,
The standard deviation of the market portfolio’s return is 11.2% and
The beta coefficient of the portfolio is 1.2?
90
1. The assumptions underlying portfolio theory are rational investors

choosing portfolios attempt to maximise utility and are willing to base
their decision solely in terms of risk and return; investors are risk
adverse; the risk of a portfolio is measured by the variability of its
return; and for any given level of risk an investor prefers a higher rate
of return to a lower one and for any given level of return an investor
prefers less risk to more risk.
2. The estimates about securities used to make predictions about

portfolios are expected return; the variability of return (risk); and the
covariances and correlation coefficients between securities.
3. 12.5% i.e., (10.0% X 0.50%) + (15.0% X 0.50%)
4 There is a positive linear relationship between Anglo Platinum and

Impala Platinum i.e., an increasing Anglo Platinum share price is
associated with an increasing Impala Platinum share price. However
the relationship is not exact i.e., 100% but 90%. This association does
not imply causation - both variables may be affected by a third
variable.
5. 14.0% i.e., (8.0% X 0.50%) + (20.0% X 0.50%)
6. Systematic risk as it affects all financial indexes/markets e.g., general

economic conditions, fiscal and monetary policy and as such cannot be
avoided by investors. Unsystematic risk is the variability not explained
by general market movements and is peculiar to the security
concerned. It can be avoided through diversification i.e., unsystematic
risk decreases as the number of securities in the portfolio increases.
This implies that only inefficient portfolios have unsystematic risk.
7. Multi-index models are models that assume that relationships between

securities are due to common associations with more than one index.
8 The capital market line holds only for efficient portfolios. The
relationship described by the security market line can be used to
determine the expected return on any portfolio or security. Beta
measures risk in respect of the security market line while standard
deviation measures risk in respect of the capital market line.
9. 16.60% i.e., 0.10+ 1.2 X (0.155 – 0.10)
10 14.29% i.e., 0.10 + (0.15 – 0.10) / 0.14 X 0.12
91
8. Technical analysis

o Define technical analysis;
o Contrast technical and fundamental analysis;
o Discuss the assumptions underlying technical analysis;
o Understand a typical stock-market chart and how it can be used to
determine share price trends.
“Today’s technical analyst is as much a social philosopher and observer of

world events as his fundamentalist colleague. The distinguishing feature of
the technical analyst continues to be his belief that the market tells its
own story, but he has found new and different ways of defining precisely
what story it is that the market is telling. The chartist sought to define
price trends, which were assumed to be intact until evidence of a change
emerged; today’s technical analyst is more of a contrary thinker who goes
behind the price trends and seeks to define investor sentiment, partly in
price behaviour but perhaps more in readings from the market
environment itself”
Peter Bernstein, 1978
Technical analysis is the study of past stock market price-trend behaviour

to estimate future price trends in an attempt to profit from periodic
changes in these trends. Technical analysis is an extensive subject and
the purpose of this chapter is merely to introduce it by highlighting its
underlying assumptions and briefly describing a typical stock-market chart
and how it is used by technical analysts to determine share price trends.
8.1 Technical and fundamental analysis
Technical and fundamental analysis are often seen as contrary but

generally they complement one another. Fundamental analysis can be
used to determine what shares to buy and sell while technical analysis can
be applied to ascertain when the purchases / sales should take place.
8.2 Assumptions
The following assumptions underlie technical analysis:
(i) Supply and demand determine share prices;

(ii) Supply and demand are driven by both rational and irrational investor
behaviour;
(iii) Share prices move in trends – these trends persist for long periods of
time;
(iv) Current trends change in reaction to fluctuations in supply and
demand. Trend changes can be identified in time by the action of the
market.
92
8.2.1 Typical stock market chart
With reference to figure 8.1, the graph begins in a bear market with a
declining trend channel that ends in a trough. This is followed by an
upward trend. Confirmation that the bear trend has reversed is a buy
signal. The share would be held as long as the share price remained in the
rising trend channel. Ideally the share should be sold at the peak of the
cycle but this point cannot usually be identified until the trend changes.
Should the share price ‘s rising trend end in a flat trend channel, it may be
necessary to wait until the price breaks out into either a new upward or
downward trend. If the share price breaks out of the flat trend channel on
the downside, it would be a sell signal.
Figure 8.1:Typical stock market chart
Peak Flat
trend
channel
Sell point
Share price
Declining
trend
channel Rising Declining
trend trend
channel channel
Buy
point
Trough
Buy point
Trough
Time
Source: Reilly pp 875 and Falkena pp 107
93
1. According to Peter Bernstein, what is the ‘distinguishing feature’ of a

technical analyst?
2. Define technical analysis.
3. Differentiate between technical and fundamental analysis. (Hint: see

chapter 4 for the definition of fundamental analysis)
4 What assumptions underlie technical analysis?
Answer the next 6 questions using figure 8.1:
Figure 8.1:Typical stock market chart
Peak Flat
trend
channel
Sell point
Share price
Declining
trend
channel Rising Declining
trend trend
channel channel
Buy
point
Trough
Buy point
Trough
Time
Source: Reilly pp 875 and Falkena pp 107
5. Does the graph begin in a bull or bear market?
6. What would confirm that a bear trend has reversed?
7. After a rising trend channel, when is the best time to sell the share?
8 Why is it not generally possible to sell a share at the peak and buy a
share in a trough?
9. In a flat trend channel would the technical analysts recommend a buy,

sell or hold?
10 If the share price breaks out of a flat trend channel on the downside
would the technical analyst recommend a buy, sell or hold?
94
1. According to Peter Bernstein, the distinguishing feature of a technical

analyst is his belief that the market tells its own story.
2. Technical analysis is the study of past stock market price-trend

behaviour to estimate future price trends in an attempt to profit from
periodic changes in these trends.
3. Fundamental analysis focuses on determining the intrinsic value of a

share i.e., on determining what share to buy. Technical analysis
focuses on determining future price trends in an attempt to profit from
periodic changes in these trends i.e., on determining when to buy or
sell a share.
4 The assumptions underlying technical analysis are supply and demand

determine share prices; supply and demand are driven by both
rational and irrational investor behaviour; share prices move in trends
and these trends persist for long periods of time; current trends
change in reaction to fluctuations in supply and demand and trend
changes can be identified in time by the action of the market.
5. The graph begins in a bear market.
6. A buy signal is confirmation that a bear trend has reversed.
7. Ideally a share should be sold at the peak of cycle i.e., at the end of
the rising trend channel.
8 Because this point i.e., peak or trough cannot usually be identified

until the trend changes.
9. In a flat trend channel the technical analysts would usually

recommend a hold until the price breaks out into a new trend.
10 The technical analyst would recommend a sell.
95
9. Equity derivatives

o Define a futures contract;
o Define an options contract;
o Define a swap;
o Describe how arbitrageurs, hedgers, investors and speculators use
equity derivatives; and
o Outline equity derivatives listed in South Africa.
Equity derivatives are financial instruments that derive their value from
the prices of shares and share indexes. They can be grouped under three
general headings:
o Futures;
o Options; and
o Swaps.
Derivatives market participants can be divided into four groups:

arbitrageurs, hedgers, investors and speculators. With reference to these
groups equity futures, options and swaps will be discussed.
9.1 Futures
A futures contract is an agreement to buy or sell, on an organised

exchange, a standard quantity and quality of an asset at a future date at a
price determined at the time of trading the contract.
9.1.1 Hedging with stock indexes futures
On 15 December 2004 an investor decides to liquidate part of his gold

share portfolio in three months time (on 15 March 2005). The value of the
portfolio is R203 860. The investor expects the FTSE JSE all-gold index to
fall over the next three months. The spot FTSE JSE all-gold index is 1901
while the March all-gold index futures contracts are quoted at 1930/1960.
He decides to sell 10 futures contracts expiring 15 March 2005.
By 15 March 2005 the FTSE JSE all-gold index has fallen by 101 points to
1800 while the market value of the investor's portfolio has declined to
R189 804 - a loss of R14 056 (i.e., 189 804 – 203 860). However,
because the investor sold 10 all-gold index futures contracts, he makes a
profit of R13 000 (i.e., (19 300-18 000) x10) on the futures transaction
(note that on the futures expiry date the futures price becomes equal to
the cash price). Therefore the net loss to the portfolio is R1 056 (i.e.,
13 000-14 056).
96
9.1.2 Arbitraging with share futures
With reference to table 9.1, assume the spot price of Anglogold shares is
R290 per share and the price of the futures contract expiring in 3 months
is R295 per share. The arbitrageur calculates the fair value of the futures
contract as R297 per share (the calculation of fair value is detailed in RPE
module “The derivatives market”). The current 3-month borrowing /
lending rate is 10%.
As the fair value is greater than the market futures price, the arbitrageur:
o Buys the futures contract;
o Shorts the shares and invests the proceeds at 10% per annum.
In 3 months time, the investment would be realised, delivery of the

shares in terms of the futures contract would take place and the short
cash position closed. The arbitrageur would make a risk-less profit of R2
per share.
Table 9.1: Arbitrage example

Given
Current share price 290
Futures price 295
Fair-value futures price 297
Current 3-month interest rate 10.0%
Cash-flow Now 3-month
Long futures contract -295
Short Anglogold share +290

Invest proceeds -290 +297
Take delivery on futures and

close short share position
Net cash-flow 0 2
If on the other hand – see table 9.2 – the market futures price is less than
the fair value price, the arbitrageur would:
o Sell the 3-month R300 futures contract;
o Borrow R290 at 10% p.a.;
o Buy spot Anglogold shares at R290.
97
Table 9.2: Arbitrage example
Given
Current share price 290
Futures price 300
Fair-value futures price 297
Current 3-month interest rate 10.0%
Cash-flow Now 3-month
Short futures contract +300
Borrow +290
Long Anglogold shares -290
Repay loan and interest and -297

deliver shares to the futures
market
Net cash-flow 0 3
In 3 months time the futures contract would be realised at R300 per share
and the shares delivered to the futures market. The loan plus interest
would be repaid. The arbitrageur would realise a R3 per share risk-less
profit.
The example is for illustrative purposes only. It has ignored transaction

costs and the margin between borrowing and lending interest rates. Both
these could make the arbitrage play unprofitable.
9.2 Options
An option contract conveys the right to buy or sell a specific quantity of a

share or share index at a specified price at or before a known date in the
future. As such an option has certain important characteristics:
o It conveys upon the buyer (or holder) a right – not an obligation. Since
the option can be abandoned without further penalty, the maximum
loss the buyer faces is the cost of the option;
o By contrast, if the buyer chooses to exercise his right to buy or sell the
underlying asset or derivative, the seller (or writer) has an obligation
to deliver or take delivery of the underlying asset or derivative.
Therefore the potential loss of the seller is theoretically unlimited.
The simplest derivatives strategies for an investor that is bullish about a

company’s share would be to buy call options or buy futures. In contrast a
bearish investor would buy put options or sell futures. In neither case is it
necessary to buy or sell the underlying share – although this is an
alternative strategy.
98
9.2.1 Speculating with call options
Assume a speculator believes Sallies shares – currently trading at R1.00 -

will stay static over the next couple of months. Therefore she writes 2-
month at-the-money call options on Sallies shares for premium income of
R0.05 per share. At expiry there are three possible outcomes:
(i) Sallies shares stay static at R1.00 as expected. The options will
expire worthless and the speculator will realise R0.05 premium
income per share;
(ii) Sallies shares rise to R1.10 per share and the options expire in the
money. The speculator will buy the shares in the cash market at
R1.10 for delivery to the options market and realise a loss of R0.05
per share.
(iii) Sallies shares fall to R0.90 per share. The options as in outcome (i)
will expire worthless and the speculator will realise R0.05 premium
income per share.
9.2.2 Speculating with put options
Assume a speculator is bullish about Sallies shares – currently trading at

R1.00. She writes 2-month at-the-money put options on Sallies shares for
premium income of R0.03 per share. At expiry there are three possible
outcomes:
(i) Sallies shares stay static at R1.00. The options will expire
worthless and the speculator will realise R0.03 premium income
per share;
(ii) Sallies shares rise to R1.10 per share as expected and the puts
expire out the money. Once again the speculator will realise R0.03
premium income per share;
(iii) Sallies shares fall to R0.90 per share and the option is exercised
against the speculator. The speculator will buy the shares from the
option holder at R1.00 and sell them in the cash market at R0.90.
The speculator will realise a loss of R0.07 (i.e., R0.90 – R1.00 +
R0.03) per share.
9.3 Swaps
The vanilla equity swap (fixed-for-equity equity swap), like any other
basic swap, involves a notional principal, a specified tenor, pre-specified
payment intervals, a fixed rate (swap coupon), and a floating rate pegged
to some well-defined share index. The innovative twist in these swaps is
that the floating rate is linked to the total return (i.e., dividend and capital
appreciation) on a stock index. The stock index can be broadly based such
as the S&P500, the London Financial Times Index, the Nikkei index, the
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FTSE JSE All-Share index or narrowly based such as that for a specific
industry group e.g., the FTSE JSE gold index.
Several variants of the vanilla swap exist. These are described in the table
below.
Variant Description
Floating-for- Equity swap with one side pegged to a floating rate of
equity equity interest and the other to an equity index.
swap
Asset- Equity swaps where the equity return is pegged to the

allocation greater of two stock indexes.
equity swap
Quattro equity Swaps with two equity legs rather than one i.e., one
swap counterparty pays the total return on one stock index and
receives the total return on another stock index.
Blended-index Equity swaps using a blended index i.e., a weighted

equity swap average of two or more indexes, on the equity-pay leg. A
blended-index consisting of many indexes from different
countries is also called a rainbow.
Variable- or Equity swaps, the notional principal of which is reset at

fixed-notional each payment date, implying a constant number of stocks;
equity swaps or fixed, representing a constant cash value invested in
equity regardless of price movements.
The most important uses for equity swaps are: to hedge equity positions,
to gain entry to foreign equity markets and to benefit from market
imperfections via synthetic equity portfolios.
(i) Hedging equity positions
Equity swaps can be used to convert volatile equity returns into stable
fixed-income returns. For example, assume a unit trust holds a diversified
equity portfolio highly correlated with the return on the FTSE JSE All-share
index (ALSI). It wishes to pay the ALSI return and to receive a fixed rate
thereby hedging the pre-existing equity position against downside market
risk over the tenor of the swap. It enters into a swap agreement with its
bank for a tenor of three years on a notional principal of R400million with
quarterly payments. The bank prices the swap at 10,95% p.a. payable
quarterly. The resultant cash-flows are shown on the next page.
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Figure 9.1: Equity swap
10.95%
ALSI return
Equity portfolio Unit trust Bank
ALSI return
It is important to note that because an equity return can be positive or

negative, the cash flow on the equity-linked side of the swap can go in
either direction. If the equity return for the quarter is negative, the bank
pays the unit trust the negative sum as well as the swap coupon on the
fixed leg.
(ii) Gaining entry to foreign equity markets
Equity swaps eliminate the problems associated with different settlement,

accounting and reporting procedures among countries. They allow
international investors to gain access to the high potential growth in
foreign equity markets without the problems associated with a lack of
knowledge about local market conditions, exchange control stipulations
and foreign ownership regulations.
(iii) Benefiting from market imperfections
By circumventing market imperfections it is possible for a synthetic equity

portfolio created via a swap to outperform a real equity portfolio. A
dominant source of savings is the elimination of the transactions costs
associated with acquiring the cash portfolio - the transaction costs of
acquiring a synthetic equity portfolio via an equity swap are significantly
less than the transaction costs of obtaining a real equity portfolio.
Besides initial transaction costs, there are numerous potential savings

based on regulatory or tax arbitrage. For example many countries attach
a withholding tax to dividends paid to foreign investors e.g., United
States, Germany and South Africa. In other countries the underlying
equities included in an index are often illiquid or, through monopoly
control, bid-offer spreads are kept large. Some countries, including South
Africa, impose a turnover tax on transactions in equity. In most countries,
foreign equity is held through custodial banks, as is the case with
American Depository Receipts (ADRs) in the United States. This results in
the payment of custodial fees. There are also transaction costs to
rebalancing a cash equity portfolio when there is a change in the
composition of an index. Substantial benefits could accrue to the extent
that equity swaps eliminate or reduce these costs.
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9.4 South African listed equity derivatives
Listed equity derivatives include:
o Futures contracts and options on futures contracts on equity indexes
listed and traded on the Financial Derivatives Division of the JSE Ltd;
o Futures contracts and options on futures contracts on single shares
(called single stock futures) listed and traded on the Financial
Derivatives Division of the JSE Ltd; and
o Warrants listed and traded on the JSE.
9.4.1 Equity indexes

Safex lists futures contracts and American-style options on futures
contracts on the following FTSE / JSE Africa tradable indexes:
Index Description
FTSE/JSE Top40 Index The top forty companies that are
constituents of the FTSE/JSE All Share Index
ranked by full market capitalisation (before
free float weightings are applied)
FTSE/JSE Gold Mining All companies that are constituents of both
Index the FTSE/JSE All Share Index and the gold
mining sub sector.
FTSE/JSE INDI25 Index The top twenty-five companies that are
constituents of either the basic or general
industrial economic groups ranked by full
market capitalisation (before free float
weightings are applied)
FTSE/JSE FNDI 30 Index The top thirty companies that are
constituents of either the financial or
industrial (basic or general) economic
groups ranked by full market capitalisation
(before free float weightings are applied)
FTSE/JSE RESI 20 Index The top twenty companies that are
constituents of the resources economic
group ranked by full market capitalisation
(before free float weightings are applied)
FTSE/JSE FINI 15 Index The top fifteen companies that are
constituents of the financial economic group
ranked by full market capitalisation (before
free float weightings are applied)
The value of the contract is 10x the Index Level and the minimum price
movement (tick) is 1.
9.4.2 Single stock futures

A single stock future (SSF) is a futures contract on a single share i.e., the
underlying security of the futures contract is an equity listed on an
exchange – the JSE in South Africa’s case. The value of an SSF contract is
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equal to 100 times the share’s futures price. The minimum price
movement is R1 i.e., R0.01 move in the share price.
The Financial Derivatives Division of the JSE Ltd lists American-style

options on SSFs exercisable into SSFs i.e., on exercise of the option
contract, the buyer or seller becomes the buyer or seller of an SSF
contract. On expiry each SSF contract is physically settled i.e., buyer of
the futures contract takes delivery of the actual scrip from the seller.
9.4.3 Warrants
Warrants are derivatives that closely resemble options. They give the
buyer the right but not the obligation to buy (in the case of a call warrant)
and sell (in the case of a put warrant) a specific underlying instrument at
a particular price (the exercise or strike price) on or before the expiry
date.
The following warrants trade on the JSE:
(i) Vanilla call and put warrants are warrants issued on the shares of
a single company listed on the JSE. These warrants can be
American- or European-style options. If exercised they are cash
settled or settled by delivery of the underlying share.
(ii) Index warrants are warrants based on the level of a specific index.
Index warrants are usually cash settled.
(iii) Basket warrants are warrants comprising a basket of shares.
(iv) Discount warrants are warrants that allow holders to buy the
underlying security at a discount to the current market price.
(v) Capital protection warrants are warrants that give holders a
guaranteed return on the underlying security. Not only are holders
guaranteed a specific return but they can also benefit if the
underlying security increases beyond the capital protection level.
(vi) Barrier warrants are the same as vanilla warrants except they
have barrier levels. If the price of the underlying security breaches
the barrier level the barrier warrant lapses i.e., the listing is
terminated and the holder has no more rights.
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1. Name four groups of derivatives market participants.
2. Define a futures contract.
3. Define an option contract.
4 Define a plain vanilla equity swap.
5. If equity prices are expected to fall, speculators will (buy / sell) futures
contracts.
6. If equity prices are expected to rise, speculators will (buy / sell)

futures contracts.
7. If the market price of the futures contract is greater than the fair value
of the futures contract the arbitrageur will (buy / sell) the futures
contract (buy / sell) the shares in the cash market.
8 If the market price of the futures contract is less than the fair value of
the futures contract the arbitrageur will (buy / sell) the futures
contract (buy / sell) the shares in the cash market.
9. An investor that is bullish about a company’s share will buy (call / put)
options.
10 What is a single stock future?
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1. Four groups of derivatives market participants are arbitrageurs,

hedgers, investors and speculators.
2. A futures contract is an agreement to buy or sell, on an organised

exchange, a standard quantity and quality of an asset at a future date
at a price determined at the time of trading the contract
3. An option contract conveys the right to buy or sell a specific quantity

of a share or share index at a specified price at or before a known date
in the future.
4 In the vanilla equity swap one party receives a cash flow equal to the
total return on a notional amount of the stock index and pays a cash
flow equal to interest at the fixed rate on the same notional principal.
5. If equity prices are expected to fall, speculators will (buy / sell) futures
contracts.
6. If equity prices are expected to fall, speculators will sell futures

contracts.
7. If the market price of the futures contract is greater than the fair value
of the futures contract the arbitrageur will sell the futures contract and
buy the shares in the cash market.
8 If the market price of the futures contract is less than the fair value of
the futures contract the arbitrageur will buy the futures contract and
sell the shares in the cash market.
9. An investor that is bullish about a company’s share will buy call

options.
10 A single stock future is a futures contract on a single share.
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10. Private equity

• To define private equity;
• To examine the characteristics of private equity;
• To explain the structure of the private equity market and identify and
describe market participants i.e., investors, intermediaries, issuers,
agents and advisors.
Finally, for background purposes, the size and regional breakdown of the
private equity market will be given.
Private equity is an important source of funding for start-up firms,

established private companies, firms in financial distress, and public firms
seeking buyout financing. The objective of this chapter is to describe the
private equity market. Firstly private equity will be defined and the
characteristics thereof examined. Thereafter the structure of the private
equity market will be explained focusing in turn on investors,
intermediaries, issuers, agents and advisors. A brief outline of the
secondary private equity market will follow. Finally the size and regional
breakdown of the market will be given.
In South Africa, black economic empowerment plays a significant role in

the private equity industry. A significant number of private equity firms
are becoming black-empowered or black-owned and many private equity
deals have an aspect of black economic empowerment in them.
10.1 Private equity defined

Private equity is medium to long-term finance provided by investors in
return for an equity stake in potentially high-growth companies. The
companies are generally not quoted on a public stock exchange and need
financing to fund growth, development or business improvement. In
addition to providing capital, the private equity investment encompasses
hands-on application of skills, expertise and strategic vision to the
privately owned companies. The investment is often realised through
flotation on the public markets.
Private equity investments take the form of any security that has an
equity participation feature. The most common forms are ordinary shares,
preference shares and subordinated debt with conversion privileges or
warrants.
10.2 Characteristics of private equity

The key characteristics of private equity are:
o Private equity investments are privately held as opposed to publicly
traded;
o Private equity investment entails active involvement in identifying the
investment, negotiating and structuring the transaction and monitoring
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the company once the investment is made. This often requires serving
as a board member of the company;
o Private equity investments are not intended to be held indefinitely.
Generally alternative exit strategies are evaluated at the time the
initial investment in the company is made. One such strategy would be
to take the company public and sell the shares into the public market;
and
o Private equity investments are high risk and high reward. Private
equity investors seek a high return on their capital when the company
prospers as they risk to lose most, if not all of their investment if the
company fails.
10.3 Structure of the private equity market

The private equity market has three major types of participants –
investors, intermediaries and issuers. Figure 10.1 illustrates how these
participants interact. The left-hand column lists the major investors, the
middle column the major intermediaries, and the right-hand column the
major issuers in the private equity market. Arrows pointing from left to
right indicate the flow of funds and other services. The bottom of the
figure shows a variety of agents and investment advisors that help issuers
or intermediaries raise money or advise investors on the best
intermediaries or issuers in which to invest.
Figure 10.1: The private equity market
Investors Intermediaries Issuers

• Pension funds Independent private equity firms New ventures
Private equity • Seed / early stage
• Endowment
funds and fund
• Start-up
foundations
Private
Private equity Private company
equity fund
• Insurance fund
of funds • Expansion
companies
Private equity • Replacement capital
• Banks fund
• Turnaround
• Non-financial Public company

corporations Captives • Turnaround
• Wealthy families • Buyout

and individuals
Direct investment • Special situations
Investment advisors to Placement agents for Placement agents for

investors funds issuers
10.3.1 Investors
In the late 1970s the private equity market consisted mainly of affluent
individuals, called business angels, who provided capital for early-stage
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and business start-ups. Today institutional investors such as pension
funds and insurance companies are the largest investors.
In general investors invest in private equity because:

o the risk-adjusted returns on private equity are expected to be higher
than that on other investments and
o there are potential diversification benefits.
The principal means of investing in private equity are:

o indirectly in a new private equity fund (see 10.3.2.1);
o indirectly in a private equity funds of funds (see 10.3.2.1);
o directly in a private equity transaction (see 10.3.3); or
o through a secondary purchase of an existing private equity interest
(see 10.4).
10.3.1.1 Pension funds

Pension funds, whether corporate or public pension funds, are attracted
by the market’s high returns and diversification benefits. Consequently
they have large investments in private equity mainly through private
equity funds and fund of funds. However this is expected to change as
many pension plans shift from defined benefit pension plans to defined
contribution pension plans, which generally must invest in assets that are
more liquid than private equity.
From a regulatory perspective, Regulation 28 of the Pension Funds Act

specifies a maximum limit in unlisted shares of 5% of total pension fund
assets.
10.3.1.2 Endowments and foundations

Endowments and foundations can be defined as funds or property donated
to an institution, individual, or group as a source of income. The most
well-know endowments and foundations are university endowments and
foundations.
Endowments and foundations have a very long time horizon when

investing. Because of this they are less sensitive to market volatility. Thus
the long-term and illiquid nature of private equity is attractive to them.
10.3.1.3 Insurance companies

Insurance companies invest in private equity both directly and indirectly
through private equity funds and funds of funds.
In terms of direct investing, insurance companies are less involved than

banks since they provide less expertise in terms of advisory or financial
services.
10.3.1.4 Banks
Banks invest in the private equity market to take advantage of economies
of scope between private equity investing and the provision of other bank
products, especially loans. The economies of scope are explained by the
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bank’s ability to use the same delivery mechanism to provide two or more
separate products and / or services.
Banks are estimated to be the largest direct investors in the private equity
market generally through separately capitalised bank holding company
subsidiaries.
10.3.1.5 Non-financial corporations

Non-financial corporations generally invest in high-risk early-stage
development enterprises that slot in with their competitive and strategic
objectives.
10.3.1.6 Wealthy families and individuals

Wealthy families and individuals, who include the wealthy clients of
commercial and investment banks, still invest in the private equity market
but their relative importance in the market has been reduced by the
growth of investment by institutional investors.
Like other investors, wealthy families and individuals are attracted to

private equity by its high returns.
10.3.2 Intermediaries
There are two types of private equity firms: independent private equity
firms (“independents”) and captive private equity firms (“captives”)
10.3.2.1 Independent private equity firms

Independents raise their funds for investment from external sources such
as institutional investors. The vehicles used by intermediaries to perform
their intermediation role are private equity funds and private equity funds
of funds.
(i) Private equity funds
Since the 1980s private equity funds have emerged as the dominant form
of intermediary for four main reasons:
o Efficiency: Delegating the intensive pre-investment due diligence and
post-investment monitoring required for direct investing is efficient;
o Diversification: A single investor will require a great deal of invested
capital to achieve diversification and exposure similar to that of a
private equity fund;
o Expertise: Gaining the expertise to select, structure and manage
private equity investments requires experiential critical mass that most
investors cannot gain on their own; and
o Assistance to issuers: Specialised intermediaries can better provide
business expertise to the issuers they invest in than most investors.
Independents often manage several private equity funds concurrently,

raising a new fund three to five years after the closing of the fund-raising
process for the previous fund. A private equity fund is usually structured
as a limited-liability partnership with investors as limited partners and the
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independent as general partner. Most private equity funds are closed-end
funds with a finite life of 10 to 12 years. During the life of the fund the
general partner undertakes private equity investments of behalf of the
fund with the obligation to liquidate / exit all investments and return the
proceeds to the investors at the end of the fund’s life.
For its services the general partner receives compensation, generally in

the form of:
o An annual management fee, which is calculated as a percentage of
total fund size;
o Fees for each transaction or deal performed, which is calculated as a
percentage of deal value and
o Carried interest, which is a share in the net gains of the fund and is
calculated as a percentage of net gains, or gains beyond a certain
hurdle rate.
(ii) Private equity fund of funds
A private equity fund of funds is a private equity fund that invests in other
private equity funds. The fund of fund manager co-mingles the
investments of many investors into a single pool, and then uses it to
assemble a portfolio of private equity funds.
Funds of funds are an increasingly popular route for investing because

they offer the advantages of increased diversification and lower entry
amounts compared with private equity funds. The major disadvantage of
investing through funds of funds is the additional layer of fees.
10.3.2.2 Captive private equity firms

Captives, which are usually subsidiaries of large banks or insurance
companies, obtain funds for investment in issuers exclusively or primarily
from their parent organisations i.e., they do not generally solicit funding
externally.
10.3.3 Direct investing

Direct investments are private equity investments made directly by
investors i.e., not through intermediaries such as private equity funds and
funds of funds.
Investing directly in private equity requires:

o Considerable expertise and skills in discovering, analysing, structuring,
managing and exiting from private equity investments; and
o Deal-flow i.e., a broad stream of private equity investment prospects.
Several investors that invest directly also invest in private equity funds
and funds of funds.
10.3.4 Issuers
Issuers in the private equity market differ widely in size, industry, phase
of growth cycle and reasons for raising equity capital. However they have
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one characteristic in common: since private equity is one of the most
expensive forms of finance, it is unlikely that issuers have access to
financing in the debt market (directly or indirectly) or the public equity
market.
For simplicity, issuers have been classified into 3 major groups:

o New ventures;
o Established private companies; and
o Public companies.
10.3.4.1 New ventures

Issuers seeking venture capital are typically young firms that are
projected to show high growth rates. Venture capital includes:
o Seed or early-stage financing, which provides funding to research,
assess or develop a concept. A relatively small amount of capital is
provided to an inventor or entrepreneur to prove the concept and
qualify for start-up financing.
o Start-up financing, which is provided to companies, whether already
set up or in the process of being set up, that have not yet sold their
products commercially and are not yet profitable. Start-up funds are
required for product development and initial marketing.
10.3.4.2 Established private companies

Established private companies use private equity funding to raise finance
for expansion, change their capital structure or to bring about a
turnaround.
Expansion financing provides funding for growth and expansion of a

company, which is breaking even or trading profitably. The funds may be
used for plant expansion, market development, development of a new
product, additional working capital and bridging finance. Bridging finance
is to be repaid from the proceeds of an initial public offering (IPO).
Replacement capital financing provides funding for

o changing ownership e.g., sale of family-owned and closely-held private
companies to the heirs of founding member or new management team
or
o changing capital structure i.e., proportion of debt and equity.
Turnaround financing is provided to private companies in financial or

operational distress with the intention of improving the company’s
performance and restoring its profitability.
10.3.4.3 Public companies

Public companies can also be issuers in the private equity market. They
use private equity funding to effect a turnaround, implement a
management or leveraged buyout, and provide financing in special
situations.
111
Turnaround financing is provided to public companies in financial distress.
Public companies in financial distress are unlikely to be able to issue public
equity except at a large discount and will generally have no access to debt
markets. The intention of turnaround financing is to improve the
company’s performance and restore its profitability.
Buyout financing is used to acquire a significant portion or majority

control of a company. The company is generally a mature public company
with established business plans to finance expansions, consolidations,
spinouts of divisions or subsidiaries. Buyouts of public firms are the most
familiar, most publicised use of private equity.
A leveraged buyout (LBO) is a strategy involving the acquisition of a

major portion or majority control of a company using a significant amount
of debt to meet the cost of acquisition. The equity component of the
acquisition price is typically provided by a pool of private equity capital.
The loan capital is borrowed through a combination of bank facilities and /
or public or privately placed bonds classified as high-yield debt (or junk
bonds). The debt generally appears on the acquired company's balance
sheet and its cash flow will be used to repay the debt.
A management buyout enables a management team to acquire a company

from the existing owners. Management buyouts may be leveraged.
Special situations:
o To finance activities such as planned acquisitions that the companies
want to keep confidential;
o temporary interruption of access to the public equity market due to
investor perceptions e.g., the industry is temporarily out of favour with
public equity markets;
o to save all-in costs when issuing small amounts of equity.
10.3.5 Agents and advisors

There are three groups of agents and advisors:
o Advisors to investors: Investment advisors evaluate and recommend
private equity investments to investors. The investments could take
the form of private equity funds, private equity funds of funds and
direct investments in private equity;
o Agents for private equity funds: Agents assist private equity firms to
raise funds from investors. The success of these fund-raising agents
depends on their reputation among investors for bringing high-quality
offerings. Consequentially they are selective about which funds they
raise funds for; and
o Agents for issuers: Agents help issuers raise equity capital from private
equity funds or directly from investors. These agents identify potential
private equity issuers, compile information about the company,
distribute the information to possible investors and provide negotiation
services to their client issuers.
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10.4 Secondary private equity market
Private equity investments are considered illiquid. There are no stock
exchanges, as there are for publicly-traded securities, on which to buy
and sell interests in private equity funds. However a secondary market for
these interests is developing, which will give investors the chance to sell if
they wish to. A secondary market is a market where investments in
existing private equity funds are made by buying an existing investor’s
share of the fund.
Although secondary markets in the US and Europe are well developed,

South Africa has not yet seen the establishment of an effective and
sustainable secondary market.
10.5 Size and regional analysis of the private equity market

According to International Financial Services, London (IFSL), global equity
investments amounted to USD134.8 billion in 2005 up 22.6% from 2004
(USD 110 billion) (see table 10.1 below).
Table 10.1: Analysis of the global private equity market

Country 2004 2005
% of total % of GDP
(USD bn) (USD bn)
United States 43.8 53.3 39.5 0.4
United Kingdom 22.4 29.6 22.0 1.3
France 6.1 9.1 6.8 0.4
Sweden 1.9 3.7 2.7 1.0
Spain 2.3 3.4 2.5 0.3
Germany 4.4 3.4 2.5 0.1
Netherlands 1.9 2.9 2.2 0.5
Japan 7.1 2.1 1.6 0.0
South Africa 3.8 4.9 3.6 1.9
Others 16.3 22.4 16.6 0.2
Total 110.0 134.8
Source: International Financial Services, London (www.ifsl.org.uk) (international)
South African Venture Capital Association (South Africa)
The U.S. had the largest share of global equity market investments at
39.5%, followed by the U.K. at 22.0%. According to the South African
Venture Capital Association South Africa’s private equity investments were
USD4.9billion in 2005, which amounts to 1.9% of GDP.
113
1. What are the most common forms of private equity securities?
2. Give two reasons why investors invest in private equity.
3. Name four ways of investing in private equity.
4 Why would the long-term and illiquid nature of private equity be

attractive to a university endowment?
5. Why do banks invest in private equity?
6. What vehicles are used by intermediaries to perform their

intermediation role?
7. What compensation does the general partner receive for its services?
8 What does an investor have to have to invest directly in private

equity?
9. What characteristic does all private equity issuers have in common?
10 Public companies can also be issuers in the private equity market.

What do they use private equity funding for?
114
1. Private equity investments take the form of any security that has an
equity participation feature. The most common forms are ordinary
shares, preference shares and subordinated debt with conversion
privileges or warrants.
2. Investors invest in private equity because:

o the risk-adjusted returns on private equity are expected to be
higher than that on other investments and
o there are potential diversification benefits.
3. The principal means of investing in private equity are:

o indirectly in a new private equity fund;
o indirectly in a private equity funds of funds;
o directly in a private equity transaction; and
o through a secondary purchase of an existing private equity
interest.
4 They are attractive to a university endowment because the

endowment has a very long time horizon when investing and is
consequently less sensitive to market volatility.
5. Banks invest in the private equity market to take advantage of

economies of scope between private equity investing and the provision
of other bank products, especially loans.
6. The vehicles used by intermediaries to perform their intermediation

role are private equity funds and private equity funds of funds.
7. The general partner receives compensation in the form of an annual

management fee, fees for each deal performed, and carried interest.
8 Investing directly in private equity requires considerable expertise and

skills in discovering, analysing, structuring, managing and exiting from
private equity investments and deal-flow.
9. Since private equity is one of the most expensive forms of finance, it is

unlikely that issuers have access to financing in the debt market
(directly or indirectly) or the public equity market.
10 Public companies use private equity funding to achieve a turnaround,

implement a management or leveraged buyout, or provide financing in
special situations such as a temporary interruption of access to the
public equity market due to investor perceptions.
115
11. JSE Ltd

o Define the role of the JSE Ltd;
o Discuss the categories of members and the requirements with which
they must comply;
o Describe the trading functions of the JSE Ltd;
o Discuss the initial and ongoing requirements for listing shares on the
JSE Ltd.
The JSE Ltd (JSE) is an exchange licensed in terms of the Securities

Services Act, 2005 (SSA). It regulates the trading, clearing and
settlement of inter alia equities, warrants and Krugerrand coins. Although
the JSE is the only stock exchange in South Africa, SSA allows for the
existence and operation of more than one exchange. JSE is governed
externally by SSA, which is administered by the Financial Services Board
(FSB). The exchange is governed internally by its own rules and
directives, which must be approved by the FSB.
On 1 July 2005, the JSE demutualised in terms of section 53 of the SSA

ending its 118 year history as a tax-exempt, member owned, voluntary
association to become JSE Limited a public but unlisted company with a
share capital. JSE Ltd listed on the exchange in June 2006.
The structure of this chapter is firstly to define the role of the JSE. Then
the JSE’s membership requirements, trading functions and listing
requirements will be described
The information in this chapter has been sourced predominantly from the
JSE Ltd.
11.1 The role of the JSE
While the JSE was established in 1887 to enable new mines and their
financiers to raise funds for the development of the mining industry, the
majority of the companies currently listed are non-mining organisations.
The primary functions of the exchange are:

o To generate risk capital i.e., provide a means for companies to issue
new shares in order to raise primary capital; and
o To provide an orderly market for trading in shares that have already
been issued.
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11.2 JSE Membership
11.2.1 Categories of members

The JSE authorises the following members:
o a trading services provider (TSP) is a member who is authorised to
perform trading services. Trading services is the execution of
transactions in equity securities by a member for the member’s own
account; and with or on behalf of a client;
o a custody services provider (CSP) is a member who is authorised to
perform custody services. Custody services are services provided by a
custody services provider on behalf of its clients or another member
and that member’s clients, in relation to the exercising of control over
uncertificated equity securities and funds intended for the purchase of
equity securities held by a member on behalf of controlled clients; and
o an investment services provider (ISP) is a member who is authorised
to perform investment services. A member may apply to perform
investment services only if it has also applied to perform trading
services. Investment services are services provided by an investment
services provider to its clients, and includes:
• exercising discretion in the management of JSE authorised
investments on behalf of clients;
• providing investment advice to a client in respect of JSE
authorised investments; and
• safeguarding JSE authorised investments, other than
uncertificated equity securities and funds intended for the
purchase of equity securities.
11.2.2 Requirements
Members of the exchange must observe the following general

requirements:
o be incorporated and registered as a domestic company under the
Companies Act;
o only appoint executive and non-executive directors who comply with
the fit and proper requirements;
o ensure that a shareholder who is a natural person and who directly or
indirectly holds in excess of 10% of the issued shares of the applicant
or member complies with the fit and proper requirements;
o appoint a compliance officer who complies with the fit and proper
requirements;
o appoint a settlement officer and an alternate settlement officer who
comply with the fit and proper requirements;
o appoint a CSDP, unless it only performs, or intends to perform,
custody services and it does not require a CSDP in order to perform
such services; and
o meet the specific conditions of membership such as:
employ adequate resources, procedures and systems necessary
for the effective performance of regulated services that the
member provides and for ensuring compliance with SSA Act and
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the rules and directives that are relevant to the performance of
such regulated services;
ensure that its employees are suitable, adequately trained and
properly supervised;
ensure that it maintains adequate financial resources to meet its
business commitments and to withstand the risks to which its
business is subject.
11.3 Trading
The JSE’s automated trading system is called JSE TradElect™ (TradElect).
TradElect is operated under license from the London Stock Exchange. The
JSE operates an order-driven, central order book trading system with
opening, intra-day and closing auctions. TradElect provides for the
hierarchical organization of the market into segments, sectors and
securities (see figure 11.1).
Figure 11.1: JSE equities market structure
JSE Top JSE Medium Liquid JSE Less Liquid Specialist Products NSX
Companies ZA02 ZA03 ZA04 ZA11
ZA01 Less liquid equities
Liquid and Medium and related Warrant Instruments NSX instruments.
TOP40 equities and liquid equities and Functional sectors
instruments. Investment products
related instruments. related instruments may obey different
Functional sectors Other products
Functional sectors which are not part of trading schedules
obey the same Functional sectors
obey the same the TOP40. and trade period
trading schedules obey the same
trading schedules Functional sectors rules.
and trade period trading schedules
and similar trade obey the same Intra-day liquidity
rules. and trade period
period rules. trading schedules auctions will be used
Intra-day liquidity rules.
and similar trade auctions are used to to facilitate trade.
period rules. facilitate trade.
AltX
A market segment identifies a set of securities traded according to a

common micro structural model (e.g. opening auction, continuous trading
and closing auction). An example of a segment is ZA01 – JSE Top 40
Companies. A market segment is characterised by a number of specific
rules, which govern the trading activities that may take place within that
segment. Similar tradable instruments and participants are assigned to a
particular segment. A market segment is divided into market sectors.
A market sector defines the group of instruments within a segment that

follow the same trading schedule i.e., it identifies a set of securities
characterized by a common sequence of market phases and market
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periods. This enables different rules to come into operation at different
times of the day. An example of a market sector is J1H1, which includes
high-priced (greater than R30) United Kingdom dual-listed South African
equities in market segment ZA01 - JSE Top 40 Companies.
The security is the instrument with which the trading book is associated
(e.g. ordinary shares of Anglo American “AGL”)
The official trading hours of the JSE are 09h00 to 17h00. The trading day
is divided into phases for securities in ZA01, ZA02, ZA03 & ZA11 (see
figure 11.2) and ZA04 (see figure 11.3) to facilitate liquidity, price
formation and market integrity through volatility interruptions. Orders are
entered and ranked in price time priority. Market participants have the
ability to submit “parked orders”. This allows for the entry and removal of
orders to be based upon a specific period based transition.
Figure 11.2: JSE trading phases for securities in ZA01, ZA02, ZA03 & ZA11
08h30 08h35-09h00 09h00-16h50 16h50-17h00 17h00-18h00
Continuous Trading
VWAP
Open
Opening Closing Post-trade

Auction Liquidity Intra-day Volatility Auction run-off
Auction Auction
12h00-12h15
Figure 11.3: JSE trading phases for securities in ZA04
08h30 08h35-09h10 09h10-16h49 16h49-18h00
Continuous Trading
Open
Opening End of Continuous

Auction Trading
There are six main trading phases and one administration phase. These
are described in table 11.1.
Table 11.1: Trading and administration phases

Phase Details
Open (08h30) This period allows for the automatic deletion of all
orders that expired overnight. No participant activity is
allowed. Once the order deletions have been processed,
it enables traders to view their valid orders on the order
book.
Opening each auction begins will a call period. The market
Auction (08:35) participants are able to enter new orders and modify or
119
delete existing orders. Throughout this period, an
indicative uncrossing price is published as and when the
bids and offers are updated.
There are certain times when unusual events occur in
auction calls and to minimise their impact and lead to
optimal price formation and auction execution the
events need to be brought to the attention of the
market. This is achieved through auction call extensions.
There are two types of extensions:
• Price Monitoring Extension - if the likely execution
price at the end of the normal auction call, lies
outside defined tolerances from the last traded
price, then the auction call could be extended for a
certain period of time to increase the likelihood that
the price movement might be reduced. If no
execution can take place during price determination,
it is not possible to enter a price monitoring
extension.
• Market Order Extension - if market orders within the
order book are not executable or only partially
executable (i.e. there is a market order surplus) at
the end of the call period, the call period could be
extended for a certain time in order to increase the
execution probability of market orders in auctions. It
is then followed by a Price Determination Period -
the auction price is the price with the maximum
executable volume. If this is not unique, the
minimum surplus, the market pressure and, if
necessary, the reference price are additionally taken
into account in establishing the auction price.
Continuous All un-executed orders from the Opening Auction are
Trading forwarded to continuous trading unless otherwise
(09:00) restricted by the market participant through use of an
expiry time field. During Continuous Trading, each new
incoming order is checked for matching against orders
already on the book. If a match is found, orders in the
order book are matched according to price-time priority.
Following an order match, details of the trade (but not
the details of the participants involved) will be published
to the market. Continuous Trading can be interrupted by
Volatility Auctions, dynamically triggered by excessive
trade by trade price movements
Intra-day A 15 minute period during the day scheduled to focus
auction (12:00 liquidity on the less-liquid instruments.
– 12:15)
End of End of Continuous trading is a period much the same as
continuous the closing auction during which the closing prices for
trading (16:49) warrants and investment products are determined. The
difference lies in the price determination methodology
which is based on the best bid or offer. During this
period persistent orders can be deleted, and new orders
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to be injected on the next trading day can be entered.
Only the Client Reference field for existing orders can be
modified.
The closing price for all instruments in ZA04 e.g.

warrants and investment products is calculated using
the mid of the best bid and offer. The mid price is equal
to the sum of the best bid price and the best offer price
divided by two, rounded up to be consistent with the
relevant price format.
The closing The Closing Auction is very similar to the Opening
auction call Auction and is used to determine the closing price for
period (16:50) the day. One difference lies in the number of auction
call extensions that are possible; there can be up to
three extensions following the call period to ensure
optimum price discovery.
If no price can be determined during a Closing Auction

(i.e. no volume can execute), then the volume-weighted
average price (VWAP) is used as the closing price. If no
VWAP could be determined during the VWAP period,
then the last automated trade (LAT) price is used as the
closing price.
Post trade run- Runoff is an order book administration or management
off (17:00) period in which market participants can perform
housekeeping activities. During this period persistent
orders can be deleted, and new orders to be injected on
the next trading day can be entered. Only the Client
Reference field of existing orders can be modified.
All persistent orders on the book that have not been

deleted, expired or fully matched will be carried forward
to participate in the next day's Opening Auction.
Manual Reported Trades (those negotiated off market

and reported to the Exchange in accordance with the
JSE rules and directives) can be entered till the end of
the post trade run-off period (18:00).
11.3.1 Characteristics of the Order Book

o Buy and sell orders are placed into a central order book
o Full depth of the order book is visible i.e. every buy and sell order is
displayed
o During continuous trading, orders are matched continuously on a
price-time priority basis
o Matching (uncrossing) of the order book occurs at the end of auction
periods
o Pre and post trade anonymity
o Standard settlement terms only (T+5) i.e. no same day settlement
and other special terms.
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o 2 main order types – Limit (LO) and Market Orders (MO)
o They can be subject to:
Execution based validity (execute and eliminate/ Fill or kill)
Time based validity - Good till Time (GTT) and Good till cancelled
(GTC)
Period based validity – Good for Day (GFD), At the Open (ATO),
At the Close (ATC), Good for Auction (GFA), Good for Intra-day
Auction (GFX)
o No Market Orders (MO) without execution based validity or period
based validity is accepted during the Continuous Trading phase.
11.3.2 Broker Deal Accounting System

The JSE operates a back-office system that members are obliged to use.
This is called the Broker Deal Accounting System (BDA) and is used to
confirm and clear trades, settle trades between members and their clients,
perform back office accounting and draw up financial statements.
11.4 Listings
11.4.1 Listing requirements
A company that wishes to have its shares traded on a stock exchange
must apply for a listing on that exchange. A listing on the exchange will
greatly improve the tradability of a company’s shares, which would in turn
enable it to raise capital from the public for expansion or acquisitions.
An exchange has certain legal responsibilities towards the public at large

for example ensuring an orderly market, distributing information,
guaranteeing the transactions on the exchange, facilitating clearing and
settlement of transactions and protecting the interests of investors.
Consequently the exchange will lay down certain requirements that a

company must comply with before it will be allowed to list. These
requirements are designed to aid the exchange in meeting the above
objectives. Rules relating to new applications for listing, the marketing of
shares and obligations of the company issuing the shares form the main
body of these requirements.
The listings requirements of the JSE are built around some general
principles, which will determine the interpretation of specific requirements
should the need arise. They are as follows:
o The Committee of the JSE must be satisfied that the applicant is
suitable and that it is appropriate for those securities to be listed:
o All material activities of the issuing company should timeously be
disclosed to shareholders and the public.
o Shareholders must receive full information and the opportunity to vote
upon substantial changes in the issuer’s business operations and
matters affecting the company’s constitution or shareholders’ rights.
o Persons disseminating information into the market place must observe
the highest standards of care.
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o Holders of the same class of securities of an issuer must enjoy fair and
equal treatment in respect of their securities; and
o The listings requirements and the continuing obligations should
promote investor confidence in standards of disclosure in the conduct
of issuers’ affairs and in the market as a whole.
An application for listing must be made by a sponsor and submitted to the

Committee of the JSE. They are normally corporate brokers, investment
banks and other professional advisers. They must however be approved
by the JSE and included in the Committee’s Register of Sponsors before
they will be allowed to act as sponsor. Sponsors not only assist the
applicant with the application, but also advise on a continuous basis on
the application of the listing requirements, including the continuing
obligations.
11.4.2 Choice of board or market

The JSE operated 4 boards or markets:
o The Main Board;
o The Venture Capital Market (VCM);
o The Development Capital Market (DCM); and
o AltX is an alternative exchange running parallel to the Main Board. The
primary purpose of the exchange is to facilitate capital raising for the
business expansion and development of small to medium and growing
companies.
VCM and DCM boards were previously alternative markets to the Main
Board. This has changed. Although VCM and DCM listings will continue to
exist, AltX is the only current alternative to the Main Board for new
listings.
A company wishing to list on one of theses boards must comply with the
JSE listings requirements. These include not only initial requirements, but
also continuing obligations designed to ensure a fair, transparent and
orderly market. Failure to comply with the listings requirements may lead
to certain penalties including possible suspension or termination of the
listing.
Requirements relating to the specific boards are:
Listing Main VCM DCM AltX

Requirements Board
Share Capital R25 million R500 000 R1 million R2 million
Profit history 3 Years None 2 years None
R8 million Not R500 000 Not
Pre-tax Profit
applicable applicable
Shareholder spread
i.e., the percentage
20% 10% 10% 10%
of shares held by
the public
Sponsor/Designated Sponsor Sponsor Sponsor Designated
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Advisor Adviser
Publication of
financial results in Compulsory Compulsory Compulsory Voluntary
the press
All
directors to
Education Not Not Not attend
Requirements applicable applicable applicable Directors
Induction
Programme
The agreement with the LSE contemplates the creation of an international

board whose listing requirements will comply with the listings
requirements of the United Kingdom (UK). South African companies
complying therewith may be admitted to trading on the JSE and the LSE,
provided they comply with the UK admission requirements. Securities
allowed to trade in this manner will be regarded as having a primary
listing on both exchanges.
11.4.3 Listing requirements applicable to all boards
11.4.3.1 The applicant

o He applicant must be incorporated or otherwise legally validly
established.
o The applicant must be operating in conformity with its memorandum
and articles of association and all laws its country of incorporation or
establishment.
o Directors and senior management must have appropriate expertise and
experience of the applicant and its business.
o Directors must declare themselves free of any conflicts of interest
between directors’ duties and their private interests.
11.4.3.2 Financial Information

o Financial statements must conform to the law as well as the South
African Statements of Generally Accepted Accounting Practice (GAAP)
and International Financial Reporting Standards (IFRS) and must be
audited.
o If a listed company has subsidiaries, the statements must be in
consolidated form.
o Profit forecasts, if any, must be accompanied by a report by the
auditors and sponsor.
o A working capital statement stating that adequate working capital
exists or containing proposals to obtain the necessary working capital
must be provided. This does not apply to financial institutions suitably
regulated by another authority with regard to solvency and capital
adequacy requirements.
11.4.3.3 The securities

o The issue of securities must adhere to the law, memorandum and
articles of association and authorisations and documentation required.
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o Securities already listed elsewhere, must comply with the law of that
country and the rules of that exchange.
o Securities must be fully paid up and freely transferable.
o Low or high voting securities i.e. securities with reduced or enhanced
voting rights are not allowed.
o Convertible securities will only be allowed if there are enough
authorised but unissued shares to cater for the conversion.
11.4.3.4 Public shareholders

Shareholders that are directors of the company or its subsidiaries or
associates of them, a pension fund for those directors, persons entitled to
nominate directors or persons or persons holding more than 10% of the
shares of a company shall not be regarded as part of the public
shareholding. This does not however apply to fund managers, depositary
receipt holders or nominees.
11.4.4 Continuing obligations of listed companies

Compliance with continuous obligations ensures that the securities market
is conducted in an orderly fashion and that all market participants have
simultaneous access to information.
A listed company must, subject to the approval of the JSE, release without
delay any circumstances, events or new developments that may affect the
financial position of the company to prevent the creation of a false market
in the securities. This information as well as any other price sensitive
information may not be released to a third party until such time as the
information has been released through SENS. (Stock Exchange News
Service) Cautionary announcements must be approved by the JSE before
they are released through SENS. Other information like dividend
declarations and interim financial reports must also be released through
SENS.
A listed company is obliged to supply its shareholders as well as the JSE

with the notice of its annual general meeting and the audited financial
statements.
Alterations to the capital structure, changes of rights attaching to

securities, the basis of allotment, aspects affecting conversion rights and
the results of new issues must be announced without delay through SENS.
A listed company must ensure fair and equal treatment among

shareholders. Shares with voting rights differing from other securities in a
particular class will not be allowed.
Issues for cash must first be offered by way of a rights offer to existing
shareholders proportionately to their current shareholding. This is known
as a pre-emptive right. This right may however be waived by an ordinary
resolution of shareholders.
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The spread of shareholders required by the listing requirements relating to
each board or market, must be maintained. If not, the company’s listing
may be suspended.
Listed companies must provide all the facilities and information to enable
shareholders to exercise their rights e.g. attending meetings and
exercising their votes.
The JSE must be advised of any change to the board. This information
must also be released through SENS. The JSE must be notified of all
transactions in the securities of the company by any director or on behalf
of a director or any associate of that director. The JSE will then release
the information through SENS.
The JSE must be informed should the appointment of the auditors of a

listed company be terminated or they resign. A letter from the auditors
must accompany this notice stating the reasons for the termination or
resignation.
11.4.5 Corporate Governance

In terms of corporate governance the listing requirements specify the
following:
there must be a policy detailing the procedures for appointments to the
board. Such appointments must be formal and transparent, and a
matter for the board as a whole
there must be a policy evidencing a clear division of responsibilities at
board level to ensure a balance of power and authority, such that that
no one individual has unfettered powers of decision-making;
the chief executive officer must not also hold the position of
chairperson (this requirement does not apply to companies listed on
AltX );
an audit committee and remuneration committee should be appointed
in compliance with the King II report on Corporate Governance. If
required, given the nature of the company’s business and composition
of its board, a risk committee and nomination committee may be
appointed. The composition of such committees, a brief description of
their mandates, the number of meetings held and other relevant
information must be disclosed in the annual report (this requirement
does not apply to companies listed on AltX );
a brief CV of each director standing for election or re-election at the
annual general meeting should accompany the notice of annual general
meeting contained in the annual report; and
the capacity of each director must be categorised as executive, non-
executive or independent:
executive directors that are involved in the day to day

directors management and running of the business and are in full
time salaried employment of the company and/or any
of its subsidiaries;
non- directors that are not involved in the day to day
executive management of the business and are not full-time
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directors salaried employee of the company and/or any of its
subsidiaries
independent non executive directors who:
directors • are not representatives of any shareholder who has
the ability to control or materially influence
management and/or the board;
• have not been employed by the company or the
group of which it currently forms part in any
executive capacity for the preceding three financial
years;
• are not members of the immediate family of an
individual who is, or has been in any of the past
three financial years, employed by the company or
the group in an executive capacity;
• are not professional advisors to the company or the
group, other than in the capacity as a director;
• are not material suppliers to, or customers of the
company or group;
• have no material contractual relationship with the
company or group; and
• are free from any business or other relationship
which could be seen to materially interfere with the
individual’s capacity to act in an independent
manner;
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1. What are the primary functions of the JSE?
2. Name the categories of member of the JSE?
3. What special conditions must members comply with?
4 What is the JSE’s automated trading system called?
5. What are the main trading functions of the JSE’s trading system?
6. Name the general principles around which the listing requirements of

the JSE are built.
7. Name the boards operated by the JSE.
8 What are the subscribed capital requirements for the boards operated
by the JSE?
9. What is AltX?
10 What is the primary purpose of AltX?
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1. The primary functions of the JSE are to generate risk capital and
provide an orderly market for trading in shares that have already been
issued.
2. The categories of member of the JSE are trading services provider,

custody services provider and investment services provider.
3. The special conditions that members must comply with are employing
adequate resources, procedures and systems; ensuring that its
employees are suitable, adequately trained and properly and ensuring
that it maintains adequate financial resources.
4 The JSE’s automated trading system is called TradElect.
5. The main trading functions of the JSE’s trading system are the entry of
orders into the order book and the display of the books either as
agents or market makers ; the market opening period and auction call
period; automated trading period; intra-day call period or volatility
auction period in certain cases; the closing auction call period; and
after-hours trading.
6. The general principles are that the Committee of the JSE must be
satisfied that the applicant is suitable and that it is appropriate for
those securities to be listed: all material activities of the issuing
company should timeously be disclosed to shareholders and the
public; shareholders must receive full information and the opportunity
to vote upon substantial changes in the issuer’s business operations
and matters affecting the company’s constitution or shareholders’
rights; persons disseminating information into the market place must
observe the highest standards of care; holders of the same class of
securities of an issuer must enjoy fair and equal treatment in respect
of their securities; and the listings requirements and the continuing
obligations should promote investor confidence in standards of
disclosure in the conduct of issuers’ affairs and in the market as a
whole.
7. The boards are the main board; the venture capital market; the
development capital market and AltX .
8 Board Subscribed capital

Main board R25million
Venture capital market R500 000
Development Capital Market R1million
AltX R2million
9. AltX is an alternative exchange established by the JSE running parallel

to the JSE’s main board.
10 The primary purpose of the exchange is to facilitate capital raising for
129
the business expansion and development of small to medium and
growing companies.
130
12. Strate (share transactions totally electronic)

o Describe the roleplayers in equities clearing and settlement in South
Africa;
o Outline the equities clearance and settlement process.
Strate Ltd provides clearing, settlement and electronic safekeeping for all
listed company equities and warrants in South Africa. Strate Ltd is owned
by the JSE, five domestic banks and one international bank. From May
2002 the JSE Ltd outsourced settlement of all on-market trades, including
all listed equities and warrants to Strate Ltd. In 2003 Strate merged with
UNEXcor and Central Depository Ltd (CDL). CDL provided settlement and
depositary services for all government debt and UNEXcor was the clearing
house for the Bond Exchange of South Africa. As a result of the merger
the bonds and money market instruments also settle via Strate.
The objective of this chapter is to describe Strate and other roleplayers in

equities clearing and settlement in South Africa.
The information in this chapter has been sourced predominantly from the
Strate’s web site (www.strate.co.za).
12.1 The roleplayers
Strate is the authorised Central Securities Depository (CSD) for equities,

warrants and bonds in South Africa. It operates an electronic settlement
system that achieves secure and efficient electronic settlement of share
transactions on the JSE and for off-market trades. It also maintains an
electronic register for all Strate-approved securities.
Shares in companies listed on the JSE can now only be bought and sold if
they have been dematerialised on the Strate system. Dematerialisation is
the process by which paper share certificates are replaced with electronic
records of share ownership. To dematerialise their shares investors hand
their share certificates to either their stockbroker or Central Securities
Depository Participant (CSDP). CSDPs are the only market players who
can liaise directly with Strate. To qualify for CSDP status entry criteria set
out by Strate and approved by the Financial Services Board must be
fulfilled. There are currently (March 2008) six CSDPs: ABSA Bank, First
National Bank, Nedbank, Standard Bank, Société Générale and
Computershare.
Under the Strate system there are two types of clients: controlled and
non-controlled:
o Controlled broker clients elect to keep their shares and cash in the
custody of their broker and, therefore, indirectly in the custody of the
broker’s chosen CSDP. Because CSDPs are the only market players
131
who liaise directly with Strate, all brokers must have accounts with
CSDPs and communicate electronically with them using an
international network called SWIFT (Society for Worldwide Inter-bank
Financial Telecommunications).
o Controlled clients deal directly and exclusively with their broker and
their share statements comes from their broker.
o Non-controlled broker clients appoint their own CSDP to act on their
behalf. The investors surrender their certificates and open accounts
with their selected CSDP while dealing with their brokers only when
they want to trade. They would have to provide their broker with the
details of their share accounts at the CSDP when trading. Non-
controlled clients receive share statements directly from their CSDP.
12.2 Clearing and settlement
Equities clearing and settlement in South Africa is shown in figure 11.1.
Figure 12.1: Clearing and settlement
Client A Client B
(Buyer)
Buy Order TradElect Sell Order
(Seller)
Settlement Confirmation / Affirmation
Settlement Confirmation / Affirmation

Contract Note Buy Order Matched Sell Order Contract Note
Trade
Broker A Allocations Allocations Broker B

BDA
Trade
Settlement Settlement
Order Status Order Monitoring
Intimations System
Allegement
Allegement
CSDP Status Intimations SAFIRES
Commitment
Status Intimations CSDP
Commitment
Payment Payment Confirmation
Funding of Order
Payment of
Amount Amount
SAMOS
Source: www.strate.co.za
SAFIRES – South African Financial Instruments Real-time Settlement
In the equities settlement environment, there are three levels of netting:

o The first takes place at Broker level within the BDA (Broker Deal
Accounting) system, where the transactions of all the Controlled
Clients and Proprietary Accounts of the Broker are netted. This net
balance of securities and funds is processed by the Broker’s CSDP as if
it was one Non-controlled Client transaction.
o The second takes place at CSDP level within SAFIRES (the system run
by Strate Ltd) and involves securities only. The net long or short
132
position of each CSDP is established and only the net short positions
are reserved for transfer by Strate.
o The third level of netting takes place also within SAFIRES, with funds.
For all net batches “ready for settlement” when the SARB Real Time
Gross Settlement system (SAMOS) opens, the net pay/receive
positions are aggregated and only the net cash positions are settled
between the commercial banks on a multi-lateral net basis
The method of settlement is that:

o The net securities balance due from the delivering CSDPs is reserved
by Strate;
o The funds are transferred from paying banks to receiving banks. Cash
is settled through the National Payment System (NPS) through the
real-time South African Multiple Option system (SAMOS) operated by
the South African Reserve Bank using Central Bank funds;
o The reservation on the securities is lifted and the securities transferred
from the net deliverers to the net receivers thereby achieving SFI DvP
(simultaneous, final and irrevocable, delivery versus payment in
Central Bank funds);
o The CSDPs update the sub-registers and nominee registers and the
brokers update their nominee registers as well.
All JSE trades are conducted on the basis of T+5 settlement. Once the net
batches have settled between the CSDPs on an SFI DvP basis, transfer of
beneficial ownership of securities at client level takes place. This occurs
electronically either within the sub-register maintained by the CSDP or
within the nominee register maintained by the CSDP or the Broker.
133
1. What is a CSD?
2. What is a CSDP?
3. Who are the CSDPs?
4 What is dematerialisation?
5. Define a controlled broker client.
6. Define a controlled client.
7. Define a non-controlled broker client.
8 Outline the three levels of netting that occur in the equity settlement
environment.
9. Outline the method of equity settlement.
10 On what settlement basis are all JSE trades conducted?
134
1. A CSD is a central securities depository. Strate is the authorised CSD

for equities in South Africa. It operates an electronic settlement
system that achieves secure and efficient electronic settlement of
share transactions on the JSE and for off-market trades.
2. A CSDP is a Central Securities Depository Participant. To dematerialise

their shares investors hand their share certificates to their CSDP,
which are the only market players who can liaise directly with Strate.
3. The CSDPs are ABSA Bank, First National Bank, Nedbank, Standard
Bank, Société Générale and Computershare.
4 Dematerialisation is the process by which paper share certificates are

replaced with electronic records of share ownership.
5. Controlled broker clients are clients that elect to keep their shares and
cash in the custody of their broker and, therefore, indirectly in the
custody of the broker’s chosen CSDP.
6. Controlled clients are clients that deal directly and exclusively with
their broker and their share statements comes from their broker
7. Non-controlled broker clients are clients that appoint their own CSDP
to act on their behalf.
8 The three levels of netting are at broker level within the BDA system;
at CSDP level within SAFIRES with securities only and within SAFIRES
with funds.
9. The method of equity settlement is the net securities balance due from
the delivering CSDPs is reserved by STRATE; the funds are transferred
from paying banks to receiving banks; the reservation on the
securities is lifted and the securities transferred from the net
deliverers to the net receivers; and the CSDPs update the sub-
registers and nominee registers and the brokers update their nominee
registers..
10 All JSE trades are conducted on the basis of T+5 settlement.
135
13. Glossary
agent one who acts on behalf of another (i.e., the principal)

alpha (α) the rate of return produced on average by a security or
portfolio independent of the return on the market.
Arbitrage: simultaneously buying and selling a security at different
prices in different markets to make risk-less profits. There
are no arbitrage opportunities in perfectly efficient markets.
Transaction costs often preclude arbitrage opportunities.
At-the-money If an option’s exercise price is approximately equal to the
current market price of the underlying.
Beta (β) Measures the sensitivity to general market movements of
rates of return on a security or portfolio.
Broker An agent that acts as intermediary between buyers and
sellers in trading securities, commodities or other property.
Brokers charge commission for their services.
Clearing house A division or subsidiary of an exchange that verifies trades,
guarantees the trade against default risk, and transfers
margin amounts. Legally a market participant makes a
futures or traded-options transaction with the clearing
house.
Clearing system: A system set up to expedite the transfer of ownership of
securities
Clearing: The settlement of a transaction often involving the exchange
of payments and / or documentation.
Closed-end fund A fund with a fixed number of shares
Convertible security A security that gives its owner the right to exchange the
security for common shares in a company at a preset
conversion ratio. The security is typically preference shares,
warrants or debt.
Dealer A firm (or individual) that buys and sells securities as a
principal rather than as an agent. The dealer’s profit or loss
is the difference between the price paid and the price
received for the same security. The dealer must disclose to
the customer that it has acted as principal. The same firm
may function, at different times, either as either broker or
dealer.
Debentures – Debentures that can be repaid on a periodic basis at the
callable discretion of the issuer.
Debentures – Debentures that carry the right to exchange all or part
convertible thereof for other securities, usually shares, at previously
specified terms.
Debentures – Debentures of a subsidiary or associated company
guaranteed guaranteed by the holding or controlling company.
Debentures – Debentures on which the payment of interest is contingent
income on the earnings of the company.
Debentures – Debentures that pay their holders interest as well as a
participation or stipulated share of the profits of the company.
profit-sharing
Debentures – Debentures that can be redeemed prior to maturity or at
136
redeemable specific intervals.
Debentures – Debentures secured by the immovable property of a
secured company.
Debentures – Debentures on which the rates are tied to the rates on other
variable-rate capital or money market instruments.
Delivery versus Under this settlement rule, the delivery of and payment for
payment bonds are simultaneous.
Dematerialisation The process by which paper share certificates are replaced
with electronic records of ownership.
Diversification The spreading of investments over more than one security
to reduce the uncertainty of future returns caused by
unsystematic risk.
Economies of scope Economies of scope exist when the average cost falls as
more products are produced jointly. In other words, banks
providing multiple products and services produce them at a
lower cost than banks providing specialised products and
services. Therefore there is competitive advantage by selling
a broader rather than narrower range of products.
Economies of scope are explained by the bank’s ability to

use the same delivery mechanism to provide two or more
separate products and / or services.
Exchange The organised market in which the purchases or sales of
securities such as shares, futures and options take place.
Financial leverage The use of debt financing.
Free float The amount of shares of a company freely available to
investors. It excludes those shares where shareholding is
restricted to specific individuals or groups of individuals. The
use of free float weightings when calculating indexes gives a
more representative view of what is available in the market.
Hedge A position taken to offset the risk associated with some
other position. Most often, the initial position is a cash
position and the hedge position involves a risk-management
instrument such as a forward, futures, option or swap.
Institutional Comprises the non-depository financial institutions,
investors sometimes referred to as the financial “contractual savings
and investment” institutions such as pension and
endowment funds, insurance companies, collective
investment schemes.
Legs The two sides of a swap.
Leverage The magnification of gains and losses by only paying for a
part of the underlying value of the instrument or asset; the
smaller the amount of funds invested, the greater the
leverage.
Long To own a financial instrument.
Maturity See tenor.
Maturity date The date on which an instrument terminates, if any.
Notional principal The amount of principal on which the interest is calculated in
terms of an interest-rate swap. In the case of interest-rate
swaps the principal is purely notional in that no exchange of
principal takes place.
137
Notionals Commodities, equities or principals that exist primarily for
purposes of calculating service payments.
Preference shares – Preference shares that carry a right to have all or part
convertible thereof exchanged for other securities, usually shares, on
previously specified terms.
Preference shares – Preference shares that, in addition their dividend rate, share
participating in the profits of the company according to a predetermined
formula.
Preference shares – Preference shares redeemable at the option of the company
redeemable at a specific price on a specified date or over a stated period.
Primary market The market in which securities are first issued.
Secondary market The market in which previously issued securities are traded.
Security A generic term encompassing all forms of financial
instruments such as shares, bonds, NCDs, debentures and
mortgages.
Settlement: The delivery of payment for a security
Short Selling a financial instrument without owning it.
Speculating Buying or selling financial instruments in the hope of
profiting from subsequent price movements.
Strip A series of futures with consecutive expirations.
Subordinated debt A loan that has a lower priority than a senior loan should the
asset or company be liquidated. It is also known as junior
debt.
Swap coupon The interest payment on the fixed-rate side of a swap
Systematic risk The volatility of rates of return on securities or portfolios
associated with changes in rates of return of the market as a
whole.
Tenor The time remaining to maturity of a financial instrument.
Termination date See maturity date.
Transaction costs The costs associated with engaging in a financial transaction.
underwriting The process of placing a newly issued security, such as
shares or bonds, with investors. An underwriter of such a
transaction is usually a bank or a syndicate of banks.
Underwriters assume the risk of placing the securities i.e.,
should they not be able to find enough investors, then they
hold the unplaced securities themselves.
Unsystematic risk The variability of rates of return on securities or portfolios
not explained by general market movements. It is avoidable
through diversification.
Volatility The degree to which the price of a financial instrument tends
to fluctuate over time.
Warrant A security that gives the holder the right to purchase shares
in a company at a pre-determined price. A warrant is a long
term option, usually valid for several years or indefinitely.
Typically, warrants are issued concurrently with preference
shares, subordinated debt or bonds to increase the appeal of
the shares or bonds to potential investors.
138
14. Bibliography
Absa Bank, 1997, The Business cycle, Economic spotlight number 21.
Bodie, Z. and Merton, Robert C., 1998, Finance, preliminary edition,

London:Prentice-Hall.
Brigham, Eugene F, and Houston, Joel F., 1998, Fundamentals of Financial

Management, 8th edition, New York:Dryden.
Dear, Keith, SurfStat australia, July 1998,

www.surfstat.newcastle.edu.au/surfstat/main/surfstat-main.html
Falkena, H.B., Kok, W.J. and Meijer, J.H (editors), 1995, The South African
Financial System, Halfway House:Southern Books.
Fenn, George W, Liang, Nellie and Prowse, Stephen, 1995, The Economics of
Private Equity, Washington: Board of Governors of the Federal Reserve System..
Goodspeed, I., 1990. Theory of Portfolio Management, ABSA Bank research report
no 90/06.
Goodspeed, I., December 1997, Currency options in SA Treasurer.
Goodspeed, I., March 1998, The foundations of financial risk management in SA

Treasurer.
Goodspeed, I., September 1997, The basics of foreign exchange management:

spot and forwards in SA Treasurer.
Gwartney, James D and Stroup, Richard L. and Sobel, Russell S., 2000, Economics
Private and Public Choice, 9th edition, New York:Dryden.
KPMG and South African Venture Capital Association, 2006, Venture Capital and
Private Equity Industry Performance Survey of South Africa covering the 2005
calendar year.
Livingston, M., 1993, Money and capital markets, Miami:Kolb.
Lorie, J.H. and M.T. Hamilton, 1973. The Stock Exchange, London: Yale University
Press.
Mohr, P.J., van der Merwe, C., Bothe, Z.C. & Inggs, J. 1988. The practical guide to
South African economic indicators. Johannesburg:Lexicon Publishers.
Newton, H.J., J.H. Carroll, N. Wang and D. Whiting, Statistics 30X Class Notes, Fall
1996. www.stat.tamu.edu/stat30x/trydouble2.html.
Niemira, Michael P. & Klein, Philip A. 1994. Forecasting financial and economic
cycles. New York:John Wiley & Sons Inc.
139
Reilly, Frank K. and Brown, Keith C, 2000, Investment Analysis and Portfolio
Management, 6th edition, New York:Dryden.
Sharpe, W.F., 1970. Portfolio theory and capital markets, New York: McGraw-Hill.
The Economist, 1997,Guide to economic indicators, New York:John Wiley
United Building Society Ltd. 1989. Recent financial innovations abroad and their
impact on the South African financial system, in Financial risk management in
South Africa, edited by H.B. Falkena, W.J. Kok & J.H. Meijer. London: The
Macmillan Press Ltd.
140
Document control
Update Description Reference

Feb-2007 o Update statistics Ingrid
o Add chapter on Private Equity Goodspeed
Mar-2007 o Update statistics Ingrid
o Minor changes to chapters 7 Goodspeed
and 12
o Major changes to chapter 11
(JSE Ltd) regarding rules,
boards, TradElect
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The Equity Market

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The Equity Market

Framework of the financial markets

Derivatives Derivatives Derivatives

Bond and long-term Interest-bearing markets

South Africa JSE Ltd www.jse.co.za

Chapter learning objectives:

Equity, also known as shares or stock, represents ownership in a business or

The most important types of limited companies are:

Important features of limited companies are:

Table 1.1: Gross fixed capital formation (in R million)

Residential buildings 26 344 23 821 10.6

Total 182 187 157 507 15.7

Source: South African Reserve Bank Quarterly Bulletin March 2008

One of the major decisions facing companies is whether to finance investment

1.2.2 Ordinary shares (common stock)

The most important characteristics of ordinary shares are:

Returns to ordinary shareholders consist of:

1.2.3 Preference shares

Preference shares carry preferential rights over ordinary shares in terms of

There are a number of types of preference shares:

1.2.4 Debt, preference shares and ordinary shares compared

Table 1.2: Differences between debt, ordinary and preference shares

Seniority of A contractual claim A residual claim i.e., A residual claim.

Voice in Have no right to Have the right to Have a limited voice

1. How do limited companies differ from sole traders and partnerships?

2. What are the most important types of limited companies?

3. What are the most important features of limited companies?

4 What is the maximum amount a shareholder can lose if a company is

5. Name the main sources of long-term funds available to firms.

6. Define long- and short-term debt.

7. Define ordinary shares.

8 What are the most important characteristics of ordinary shares?

9. If a company has issued 10 000 preference shares at a par value of

10 Name the types of preference shares.

1. Limited companies differ from sole traders and partnerships in that

2. The most important types of limited companies are public limited

4 The maximum amount a shareholder can lose if a company is wound

5. The main sources of long-term funds available to firms are debt,

7. Ordinary shares are a source of equity funding i.e., a source of funds

8 The most important characteristics of ordinary shares are that they

9. R10 000 i.e., 10 000 x R10 x 10%

10 Types of preference shares are cumulative, non-cumulative,

Chapter learning objectives:

The stock market is the institutional framework through which:

2.1 Characteristics of a good market

2.2 Primary markets

New issues (seasoned or IPOs) are usually underwritten by investment bankers

2.3 Secondary markets

2.3.1 Trading systems

2.3.2 Trading methodology

2.3.3 National stock exchanges

Table 2.1: Characteristics of stock exchanges

Turnover (%) 88.4 125.8 48.9 124.8 134.3

2.3.4 Regional stock exchanges

The over-the-counter market is not a formal exchange with membership

Although NASDAQ began as a system to store and display quotations on over-

2.3.5.2 Third market

2.3.5.3 Fourth market

2.4 Stock market indexes

They are used:

2.4.1 Constructing stock market indexes

(i) The sample of shares used must be representative of the whole

There are three predominant weighting schemes used in constructing indexes:

2.4.1.1 Price-weighted series