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In: Finance

Question 2. (15 marks) Intergalactic Software Company went public three months ago. You are a sophisticated...

Question 2.

Intergalactic Software Company went public three months ago. You are a sophisticated investor who devotes time to fundamental analysis as a way of identifying mispriced stocks.

1)Which of the following characteristics would you focus on in deciding whether to follow this stock?

  • Market capitalization
  • The average number of shares traded per day
  • The bid-ask spread for the stock
  • Whether the underwriter that brought the firm public is a top tier investment banking firm
  • Whether the firm’s audit company is a Big Four firm
  • Whether there are analysts from major brokerage firms following the company
  • Whether the stock is held mostly by retail or by institutional investors

2) When you looked at the projection for Intergalactic Software Company’s revenue in the future, you found that most of analysts assume the revenue growth rate is mean-reverting over time. What is the rationale to assume that revenue growth rate is mean-reverting over time?

Solutions

Expert Solution

1. Listed following all of the characteristics are quite important while selecting or to start following stock in terms of fundamental or technical analysis point of views,

  • Market capitalization

Market Capitalization gives idea of total amount till now invested in the stock. If the stock belongs to Small/Mid/Karge cap category or not. It gives investors confidence when investing in large-cap stocks as compared to small-cap stocks.

  • The average number of shares traded per day

It gives the idea whether the stock is actively trading or not in the market. It also gives idea about interest about the stock among investors/traders.

  • The bid-ask spread for the stock

Bid-ask spread gives an idea about liquidity about the stock. High bid-ask spread indicates that stock is illiquid or the presence of only buyers/sellers at a time. Which is always not a good signal about a scrip/stock

  • Whether the underwriter that brought the firm public is a top tier investment banking firm

Underwriting by top investment companies gives confidence about fundamentals of stock and confidence on management also.

  • Whether the firm’s audit company is a Big Four firm

Audit done by Big four gives clarity and the presence of clear financial data of the firm.

  • Whether there are analysts from major brokerage firms following the company

If analysts from major brokerage firms following the company mean the stock is fundamentally good or major announcement /policy changes may come related to the firm / sector.

  • Whether the stock is held mostly by retail or by institutional investors

The presence of institutional investors gives confidence to retail investors. As institutional investor may have more access to accurate and timely data about market/firm.

2) revenue growth rate is mean-reverting: A revesion back to mean over a long term period is always expected. Means that growth rate the firm shows in past will be repeated in future under normal economic condition.


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