10 Client Profiles and Investment Risk Flashcards
Purchasing broad-based index puts can protect against which of the following risks?
A. Non-systematic
B. Over-diversification
C. Diversification
D. Systematic
D. Systematic
Rationale:
If you think the overall market could drop, bet that way by buying puts on a broad market index.
A fundamental analyst would be concerned with all of the following except:
A. Workingcapital
B. Income statements
C. Current ratio
D. Open short positions
D. Open short positions
Rationale:
Open short positions would be of interest to a technical analyst. Open short positions = market data, as opposed to information about the company itself.
When a company declares a cash dividend, which of the following items is affected?
A. Pre-tax income
B. Debt ratio
C. Current liabilities
D. Current assets
C. Current liabilities
Rationale:
The dividend to be paid represents a liability until it’s paid.
XXR common stock has a dividend payout ratio of 40%, EPS of $3.00 and a PE ratio of 12. What is the market price of XXR common stock?
A. $12
B. $15
C. $20
D. $36
D. $36
Rationale:
PE or “P/E” ratio is just the market PRICE compared to the EARNINGS per share. If the earnings are S3.00, a PE of 12 means the stock costs 12 times the earnings, or $36.
RRT Corp. had Net Income of $10,000,000 last year. After the company pays $1,000,000 in preferred dividends, an owner of one of the company’s 1,000,000 common shares would notice an EPS of:
A. $3.33
B. $5
C. $10
D. $9
D. $9
Rationale:
After paying the preferred dividend the earnings pie is worth $9,000,000. There are 1,000,000 slices of the pie, so each one is worth $9. EPS. No big deal.
If a company issues long-term convertible debentures, all of the following are affected except:
A. Accounts payable
B. Total assets
C. Current assets
D. Working capital
A. Accounts payable
Rationale:
Issuing securities raises cash, which is a current asset, which makes it part of total assets. Working capital equals current assets minus current liabilities. The only item we haven’t mentioned is “accounts payable,” which means it’s the answer.
If a chartist notices a head and shoulders top formation, he might conclude that:
A. It’s a good time to buy stock
B. The downtrend is about to reverse
C. It may be time to sell stock short
D. The uptrend will continue another 90 days
C. It may be time to sell stock short
Rationale:
A head-and-shoulders pattern signals that a trend is about to reverse. If it’s on the top, we used to be in an uptrend. Now it’s time to sell.
A company’s net profit margin is:
A. Net income divided by interest expense
B. Higher than its gross margin
C. Always the same as its gross margin
D. Net income divided by revenues
D. Net income divided by revenues
Rationale:
What is the profit compared to the sales? For each dollar we took in (revenue), how many cents did we keep (profit)? Net margin is always less than gross margin, because there are many, many subtractions to make between gross margin and the “bottom line.
A company’s gross margin would include revenue and:
A. Bond interest
B. Cost of goods sold
C. Federal taxes
D. Paid-in surplus
B. Cost of goods sold
Rationale:
Revenue minus COGS (cost of goods sold) equals gross profit. For the margin (%) of gross profit just take what’s left at this point and compare it to (divide it by) revenues. Its a lemonade stand, and you just sold a glass of lemonade for $1. The cost of the lemons, water, sugar, ice, and the paper cup totaled 60 cents. You have a gross profit of 40 cents, which is a gross margin of 40% of revenue. What’s the net margin? We’d have to deduct the cost of the lemonade stand itself, the classified ads in the local paper, the signs nailed to all the trees up and down the block, interest on the bank note, and taxes before we got there.
The theoretical liquidation value of a share of common stock is known as the:
A. Par value
B. Market value
C. Liquidation ratio
D. Book value
D. Book value
Rationale:
If we took all the assets and liquidated them, paid off the creditors and the preferred stock holders, how much would be left for each share of common stock. That’s the book value. Value investors like to buy stocks close to their book value, since at that point, most of the bad news has been priced into the stock.
Which of the following theories disavows the value of stock selection?
A. Active
B. Fundamentalist
C. Efficient market theory
D. Passives
C. Efficient market theory
Rationale:
An efficient market is one where all stock prices reflect all known information. If you believe that, you see no value in selecting stocks. Each one is priced efficiently—there are no bargains, and even if there were, you wouldn’t be sharp or lucky enough to spot them.
XYZ has EPS of $3.00, pays a dividend yield of 1.9% and has a market price of $30.00. What is the PE?
A. 110
B. 1.90%
C. 10
D. $10
C. 10
Rationale:
The stock price is simply 10 times greater than the earnings. The P is 10 times bigger than the E.
Which of the following usually has the highest beta?
A. Mid-cap stock
B. Small-cap stock
C. Money market funds
D. Blue chip stock
B. Small-cap stock
Rationale:
A small cap stock is associated with a young, unproven company. What’s propping up the stock price? Hope, speculation, hot air.
Which of the following has the lowest volatility?
A. Mid-cap stock
B. Money market mutual fund
C. Small-cap stock
D. Large-cap stock
B. Money market mutual fund
Rationale:
Most money market mutual funds are called “stable value,” because the share price is maintained at S1.
All of the following is found on the balance sheet except:
A. Cash
B. Accounts payable
C. Revenue
D. Accounts receivable
C. Revenue
Rationale:
Revenue is the top line of the income statement. Financial statements of public companies are readily available online and in shareholder reports.
Which of the following would be of least interest to a technical analyst?
A. Daily trading volumes
B. Historical price
C. P/E ratio
D. Advance/decline line
C. P/E ratio
Rationale:
A fundamental analyst pores over financial statements (balance sheet, cash flow, P&L) of a particular company in order to uncover value in the form of current ratios, debt ratios, quick ratios, etc. The technical analyst is looking at charts, volume levels, and price patterns of the stock itself or the indexes, trying to figure out which way the market is headed next.
A customer needs growth but is not comfortable with excessive risk. You would recommend that she buy:
A. Government bond mutual fund
B. Corporate bond mutual fund
C. GNMA
D. Blue chip stocks
D. Blue chip stocks
Rationale:
Buy stock for growth. The other three choices represent income investments.
Your customer requires maximum current income and is not risk-averse. You would recommend that he buy:
A. Junk bonds
B. Government bonds
C. STRIPS
D. Government bond mutual fund
A. Junk bonds
Rationale:
Were you too much of a wimp to choose “junk bonds”? If you want maximum income and are willing to party, buy junk bonds. The other three choices are for ultraconservatives looking to preserve capital.
ABC Corporation has a PE of 10, a market price of $30 and pays $1 in dividends, for a dividend payout ratio of:
A. 10%
B. 2:1
C. 1:2
D. 33.3%
D. 33.3%
Rationale:
Step one, what is the EPS? Has to be $3. The stock price of $30 is 10 times the EPS, so the EPS is $3. What percentage of $3 gets paid out In dividends? One-third, or 33.3%.
A quick ratio would not include:
A. Inventory
B. Cash
C. Marketable securities
D. Accounts receivable
A. Inventory
Rationale:
A little trick is to associate the T in “quick” with the T in “inventory.” Or, know the concept we exclude the inventory in case they can’t sell it. Would they still be able to cover current obligations? If so, I like their financial strength.
A technical analyst would be least concerned with:
A. P/E ratio
B. Open short positions
C. Advance/decline line
D. Volume
A. P/E ratio
Rationale:
It’s important to keep the concerns of fundamental and technical analysts separate. Technical analysts care about the following advance/decline line, volume, head-and-shoulders, support and resistance, charts, open short positions.
A fundamental analyst is least concerned with:
A. Market price
B. Working capital
C. Acid test
D. Earnings trends
A. Market price
Rationale:
Market price in and of itself is meaningless. It has to be compared to the earnings (price-to-earnings) or the book value (price-to-book), or the sales (price to-sales), or to something before it has any meaning.
An example of a narrow-based index would be:
A. DJIA
B. Internet Index
C. S&P 100
D. S&P 500
B. Internet Index
Rationale:
If the index names an industry, it has a narrow focus.
A chartist could use a buy-stop order, which would only be triggered above:
A. Parity
B. The head and shoulders formation
C. Resistance
D. Support
C. Resistance
Rationale:
A typical exam question that combines more than one concept. You have to know what a buy-stop is, and you have to know what resistance is. You have to know a lot of things to pass the Series 7.
An investor betting against those who buy stock in small quantities is using:
A. Seller’s revenge
B. Buyer’s revenge
C. Odd lot theory
D. Extreme arrogance
C. Odd lot theory
Rationale:
Odd-lotters are small investors. Whatever they do–do the opposite.
XYZ Software Corporation is concerned that a smaller competitor may have just developed a faster suite of business software that costs less and runs more reliably. This is an example of which type of risk?
A. Deflationary risk
B. Market risk
C. Inflationary risk
D. Business risk
D. Business risk
Rationale:
The risk of competition, the risk of your products becoming obsolete, the risk of poor management… that’s all business risk. If you’ve ever bought stock in a great business that suddenly went horribly wrong, well, I’ll see you at the next Krispy Kreme annual meeting if you’re still holding.
Which of the following is usually associated with low dividend payout ratios?
A. Blue chip stocks
B. Utilities
C. Government bonds
D. Small cap stocks
D. Small cap stocks
Rationale:
If the company is small, it probably reinvests most of the profits back into the business. When it matures and goes into middle age, it might start feeling more sure of itself and generous enough to pay out dividends.
If a company sells convertible bonds all of the following are affected except:
A. Current assets
B. Net worth
C. Total liabilities
D. Working capital
B. Net worth
Rationale:
Net worth is the difference between assets and liabilities. If you issue, say, $100 million of bonds, you take in $100 million of cash (asset) and put the par value of the bonds down as a long-term liability of $100 million. Net worth is unchanged. But, when you take in cash, that’s a current asset, which is part of working capital. And the par value of the bonds represents, again, a long-term liability. Remember, current assets affect total assets and current liabilities affect total liabilities.
XYZ pays a 4.65% dividend yield, has a P/E of 9 and trades at $36. What is EPS?
A. not determinable
B. $3.33
C. $3.00
D. $4.00
D. $4.00
ABC sold 1,000,000 shares of their $1 par value common stock at $6 in their recent IPO. All of the following were affected except:
A. Working capital
B. Total liabilities
C. Paid-in surplus
D. Current ratio
B. Total liabilities
Rationale:
When a company issues stock, they don take on liabilities. They simply give up a percentage of ownership to the shareholders. The amount above par value that investors pay in the IPO is the “paid-i n surplus.” When they issue stock, the company takes in cash, which is a current asset. Current assets are part of both working capital and the current ratio. In fact, working capital and the current ratio are just two ways of looking at the same thing—how big are the current assets compared to the current liabilities?
A technical analyst is looking for the resistance line on the chart of ABC common stock. The analyst is looking for:
A. The point at which open sell-stop orders have been placed
B. The point at which the stock stops dropping
C. A steadily increasing line
D. The point at which the stock stops rising
D. The point at which the stock stops rising
Rationale:
If you forget a term on the test, don’t be afraid to use intuition. Resistance and “point at which stock stops rising” seem to go pretty well together, right?
If a public corporation’s shareholder equity increases even while total assets are the same, which of the following best explains the phenomenon?
A. Intangible book value per share
B. Increased short-term liabilities
C. Higher paid-in surplus
D. Decreased total liabilities
D. Decreased total liabilities
Rationale:
Keep it simple: Assets - Liabilities = Shareholder Equity (net worth). If Shareholder Equity went up with Assets unchanged, Liabilities had to be decreased.
