502-5 Security Analysis

Question 1

Describe the following methods of calculating an average share price: price-weighted average

Answer 1

The price-weighted (simple) average is calculated by adding the share prices and dividing by the total number of prices.

Question 2

Describe the following methods of calculating an average share price: capitalization-weighted average

Answer 2

The capitalization-weighted average involves (1) weighting each price by the number of shares outstanding to get a total capitalization value for each stock, (2) adding the total values of the stocks, and (3) dividing by the total number of shares. Most indices are capitalization-weighted, and these are the indices that are used in modern portfolio theory

Question 3

Describe the following methods of calculating an average share price: equally weighted average

Answer 3

The percentage change in the price of each security is computed, and then they are added together. This total is then divided by the total number of securities. Every stock has the same weighting in the index, regardless of the overall market capitalization.

Question 4

Briefly explain how a price index works.

Answer 4

A price index allows for an easy comparison of prices over time. An initial price is used as the base year price, and all previous or subsequent years’ prices are compared to it by dividing the other year’s price by the base year’s price. For example, if the base year’s price is $1.00 and the subsequent year’s price is $1.15, the index is 1.15 (1.15 ÷ 1.00). This means that the current price is 15% greater than the base year’s price.

Question 5

Describe the following methods of calculating average returns: arithmetic average return

Answer 5

An arithmetic average return is calculated by adding up the various returns and dividing the total by the number of returns.

Question 6

Describe the following methods of calculating average returns: weighted-average return

Answer 6

A weighted-average return is calculated by (1) multiplying the return of each investment by its respective market value weight in the portfolio and then (2) adding together the weighted returns.

Question 7

Describe the following methods of calculating average returns: geometric average return

Answer 7

The geometric average return is calculated by

(1) successively multiplying 1 plus each return by each other,
(2) taking the “Nth” root of the product (where “n” equals the number of returns), and
(3) subtracting 1 and multiplying by 100.
(4) Or it can be calculated by starting with $1 and seeing what it grows to based upon the given returns, and then solve for the return by doing a basic TVM calculation by inputting the (PV), FV, N, and then solving for I.

Question 8

What is the holding period return?

Answer 8

The HPR is the sum of an investment’s income and change in price over a specified period, divided by the purchase price.

Question 9

Under what circumstances can the HPR (Holding Period Return) be misleading?

Answer 9

The HPR has a major weakness in that it fails to consider when cash flows have occurred. If the holding period of an investment is greater than one year, the HPR overstates the true, annualized return. Conversely, if the time period of an investment is less than one year, the HPR understates the true, annual rate of return and the return must be annualized.

Question 10

Define the internal rate of return.

Answer 10

The IRR is the interest rate that equates the present value of an investment’s cash flows with the cost of the investment

Question 11

What are two problems associated with the use of the internal rate of return method?

Answer 11

First, the IRR method assumes that all cash flows received by an investor from an investment will be reinvested at the same IRR. This is unrealistic since interest rates vary and an investor seldom reinvests all such cash flows in the same investment product— and even if he or she does, there is no assurance that future returns on the reinvested dollars will equal the IRR rate.

Second, when more than one purchase is made in a time period, the IRR results may prove confusing. The timing of the subsequent dollar inflows may increase the weight of the returns from one period over those of another. The result could be an IRR that does not truly reflect the return on the investment itself. Instead, it reflects the return of the investor, due to the investor’s decisions about when to invest his or her available dollars. An investment (e.g., a mutual fund) may have a return of 10% for an entire year, whereas a particular investor in the fund may have a loss of 10% for the year, due to the investor’s decision to invest just before the fund’s price fell.

Question 12

An alternative to the dollar-weighted rate of return is the time-weighted rate of return.

What is a time-weighted return?

Answer 12

A time-weighted return involves calculating the return for each period (HPR) and taking a geometric average. It is a compound rate that ignores the influence of the amount and timing of funds invested in each period.

Question 13

What argument can be made for the use of a time-weighted return rather than a dollar-weighted return in evaluating the performance of a portfolio manager?

Answer 13

Because a manager cannot control the size and timing of money flowing in and out of an account, the use of a dollar-weighted return is inappropriate for evaluating portfolio performance.

Question 14

Calculate the average annual compound rate of return (IRR) earned on a six- year investment in a stock using a dollar-cost-averaging plan. Assume that $5,000 is invested initially, that $500 more is invested at the end of each year, and that the market value of the stock at the end of six years is $14,000.

Answer 14

This problem requires the calculator to be set to “end.”

Average annual compound rate of return = 12.12%

Question 15

Calculate the average annual compound rate of return (IRR) earned on a one- year investment in a mutual fund using a dollar-cost-averaging plan. Assume that $50 is invested at the beginning of each month and that the value of the mutual fund account at the end of the year is $635.

Answer 15

This problem requires the calculator to be set to “begin.”

I = 10.43%

Question 16

How much money should a client invest today to achieve a return of 11% on an investment in a mutual fund if the client needs to accumulate a total retirement fund of $600,000 in 11 years? Assume that the client will also invest $24,000 at the end of each year in addition to the lump-sum investment made now.

Answer 16

This problem requires the calculator to be set to “end.”

PV = $41,413.62

Question 17

If a client invests $60,000 now in a mutual fund and plans to add $8,000 to the fund at the end of each year for the next 22 years, how much will the client have accumulated at the end of that time if the fund has a total return of 13% per year?

Answer 17

FV = $1,726,757.89

Question 18

A client wants to accumulate $500,000 during the next 15 years. She has $75,000 to invest now in mutual funds, and she wants to know how much she needs to add to the funds at the end of each quarter if the funds earn 12% per year.

Answer 18

PMT = $356.51

Question 19

What is the IRR that has been earned from an investment in a coin collection that was purchased six years ago for $1,200, was expanded at the end of the third year at a cost of $400, and has just sold for $2,500?

Answer 19

This is an unequal cash flow problem, and thus it requires the use of the cash flow keys. There is one period per year.

IRR = 8.75%

Question 20

Assume the following cash flows are expected for an investment, and assume that the client’s required annual rate of return for an investment at this level of risk is 11%. What is the PV of this investment?

Y1: $50 (INFLOW)
Y2: $60 (INFLOW)
Y3: $100 (OUTFLOW)
Y4:0
Y5: $600 (INFLOW)

Answer 20

After inputting the preceding values, hit “SHIFT, NPV” to solve for PV. PV = $376.69

Question 21

Assume that a two-year investment in a mutual fund paid $25 at the end of each quarter for the first four quarters and that it paid $30 at the end of each quarter for the second year. Assume that the initial investment was $7,000 and that the account value at the time of the final quarterly distribution was $10,500. Finally, assume that quarterly distributions are not reinvested back into the mutual fund. What is the IRR earned on this fund?

Answer 21

After inputting the preceding values, hit “SHIFT, IRR/YR” to solve for compound return (IRR).
IRR = 22.11%

Question 22

Calculate the arithmetic and geometric average returns for the following:
8%, 15.25%

Answer 22

arithmetic average:
8 + 15.25/ 2 = 11.625

geometric average:

1.00 × 1.08 × 1.1525 = 1.2447. Set calculator for 1 P/YR, then (1) PV, 1.2447 FV, 2 N, I = 11.57%

Question 23

An investor bought a stock for $28 and sold it for $48 after four years.

What is the stock’s holding period return?

Answer 23

48-28/28 = .7143 OR 71.43%

Question 24

An investor bought a stock for $28 and sold it for $48 after four years.

What is the stock’s average annual compound rate of return?

Answer 24

I = 14.43%

Question 25

Assume that an investor purchased a stock for $30, sold it for $45 after six years, and collected an annual dividend of $1.75 during the six-year period.

What was the HPR on the investment?

Answer 25

45 + (1.75 X6) -30/ 30 = .85 OR 85%

Question 26

Assume that an investor purchased a stock for $30, sold it for $45 after six years, and collected an annual dividend of $1.75 during the six-year period.

What was the compound annual return on the investment?

Answer 26

I = 12%

Question 27

Assume a client invested in A mutual fund in the amounts and at the prices shown in the following table.

Initial investment: $10,000 at $10 per share
End of year 1: $15,000 at $15 per share
End of year 2 value per share: $12

What is the IRR (dollar-weighted return) the fund?
What is the time-weighted return for the fund?

Answer 27

The dollar-weighted return (IRR) for Fund A is –2.88%.

1.00 × 0.50 × 2.40 = 1.20, then (1) PV, 1.20 FV, 2 N, I = 9.54%

Question 28

Your client invested $12,000 in the Achievement Mutual Fund five years ago. All dividends and distributions from the fund were reinvested in the fund. If this fund were liquidated today for $19,000, what would be the compound rate of return on this investment?

Answer 28

Compound rate of return = 9.63%

Question 29

Your client has used a dollar-cost-averaging plan to invest in a mutual fund. Purchases of $2,000 have been made at the beginning of each year for five years. Now (at the end of the fifth year) the fund is worth $13,000.
What is the compound return (IRR) for this investment?

Set the calculator to “begin.”

Answer 29

IRR = 8.88%

Question 30

Your client is considering purchasing a real estate rental property. Her required rate of return for this investment is 10.5% per year. She wants to know how much the property should cost in order for her to earn an average annual compound return of 10.5%. She expects that the property will have the following net cash flows.

Y1: 10,000
Y2: 11,000
Y3: 12,000
Y4: 13,000
Y5: 15,000+200,000

Answer 30

“SHIFT, NPV” to solve for present value.

The client should pay $166,177 for the property.

Question 31

Your client is considering purchasing a real estate rental property. She wants to know what her compound rate of return is if she purchases the property for $166,177

Y1: 10,000
Y2: 11,000
Y3: 12,000
Y4: 13,000
Y5: 15,000+200,000

Answer 31

10.5%

Question 32

Your client is considering purchasing a real estate rental property. She will purchase the real estate for $166,177

Y1: 10,000
Y2: 11,000
Y3: 12,000
Y4: 13,000
Y5: 14,000+200,000

What is the NPR?

Answer 32

The NPV is the difference between the present value of the future cash flows, as computed in part a., above, and the purchase price, which in this case is $166,177.

Question 33

Explain how the information in the following ratio would be significant to an investor or analyst.

activity ratios

Answer 33

Activity ratios measure how efficiently a firm manages its inventory, accounts receivable, and fixed assets. This would include the speed with which inventory is sold, how quickly accounts receivable are turned into cash, and how many dollars of sales are generated by fixed assets. The key activity ratios are the inventory turnover and the average collection period of accounts receivable.

Question 34

Explain how the information in the following ratio would be significant to an investor or analyst.

profitability ratios

Answer 34

Profitability ratios are among the most important ratios to stock investors. They measure how much income is earned relative to some base, such as assets, sales, or equity. The key profitability ratios are the gross profit, operating profit and net profit margin, return on assets, and return on common equity.

Question 35

Explain how the information in the following ratio would be significant to an investor or analyst.

leverage or capitalization ratios

Answer 35

Leverage or capitalization ratios measure the extent to which a firm uses debt financing to magnify its return to equity shareholders. They also measure the ability of a firm to service its debt requirements. The key leverage or capitalization ratios are the debt-to-total-capital ratio, the debt-to-equity ratio, the debt-to- total-assets ratio, and the times-interest-earned ratio.

Question 36

Why is the return on common equity important?

Answer 36

Return on common equity is the key measure of how well a firm’s management employs the money entrusted to it by the firm’s owners—the holders of its common stock.

Question 37

What problems are associated with ratio analysis?

Answer 37

First of all, one ratio by itself means little. Several ratios taken together may give a clear picture of a firm’s strengths and weaknesses, but rarely will all the ratios indicate the same tendency. Although ratios facilitate comparisons, individuals using ratios for this purpose must be sure that the same ratio definitions are being used in all cases. In addition, comparing a firm’s ratio to an industry average poses potential problems because of the difficulty of classifying a firm into a single industry. Differences in accounting practices also affect ratio analysis.

Question 38

Why is cash flow important to an analyst?

Answer 38

Net income includes many required accounting entries that may materially affect net income but not materially affect a firm’s operations. These include noncash expenses such as depreciation and amortization, loss reserves, and valuation deductions. Sales of appreciated assets and business units can also materially affect net income. Cash flow analysis eliminates the impact of noncash income and expenses and onetime special charges or credits and allows an analyst to view the earnings of a firm on the same basis as would a business owner who lives and dies on cash flow, not on accounting income.

Question 39

How is free cash flow computed?

Answer 39

Free cash flow adds to net income noncash expenses such as depreciation and amortization and deducts cash paid for debt service (principal) and capital expenditures. The remainder is the free cash flow available to pay dividends, make additional capital expenditures or purchase additional business operations, retire debt, or repurchase shares of the firm.

Question 40

Explain how cash flow analysis is used in valuation analysis.

Answer 40

A price-to-cash-flow multiple is used in a manner that is similar to the way the price-to-earnings multiple is used to calculate the intrinsic value of a company. Cash flow is also used by some analysts in a manner that is similar to the way the dividend discount model is used to compute a company’s value.

Question 41

Explain how the following technical analysis techniques work.

Dow theory

Answer 41

The object of the Dow theory is to determine changes in the primary movement of the market. (A primary move is considered to be a broad market movement that lasts several years, as opposed to intermediate or secondary moves (within primary moves) that represent interruptions lasting several weeks or months and day-to-day moves that occur randomly.) Once a trend is established, it is assumed to exist until a reversal is proved. The Dow theory asserts that measures of stock prices tend to move together. A bull market is indicated when both the Dow Jones Industrial Average and the Dow Jones Transportation Average rise. The trend will continue as long as the averages confirm each other (move in the same direction). A bear market is indicated when both of these indicators decline.

Question 42

Explain how the following technical analysis techniques work.

Barron’s Confidence Index

Answer 42

When investors fear a market decline, they sell low-quality bonds and buy high-quality bonds. The yield differential between high- and low-quality issues thus increases. When the differential increases, the Confidence Index declines and security prices may fall. A bull market is indicated when yields narrow between high- quality and low-quality bonds, and the Confidence Index rises.

Question 43

How can financial leverage affect a firm’s return on equity

Answer 43

By using financial leverage, a firm may be able to increase the owners’ rate of return on their investments, which is called return on equity. It is calculated by dividing net earnings by common equity. Depending on the proportion of total capital that is borrowed, the interest rate paid to creditors, and the marginal corporate income tax rate, the increase or decrease in ROE can be substantial.

Question 44

Company EHO has assets of $500 million and $125 million in liabilities. For the past year the company earned $150 million, and paid out $20 million in dividends. What is its ROE and dividend growth rate?

Answer 44

$500,000,000 – $125,000,000 = $375,000,000 in equity $150,000,000 profit/$375,000,000 equity = .40 (40%) ROE Dividend growth rate is: g = ROE x RR
Retention rate is $130,000,000/$150,000,000 = .8667 (86.67%)
g = .40 × .8667 = .3467 (34.67%)