Equity

Question 1

Size (Capitalization)

Answer 1

Value of a company
= share price X # of outstanding common shares

Question 2

Style

Answer 2

Value: Market price is LOWER than fundamental valuation
Growth: higher

Question 3

Volatility

Answer 3

Defensive: less susceptible to economic cycles/conditions (ie pharma, food, power, water, gas)
Dynamic: more susceptible

Question 4

Domestic vs. Intl

Answer 4

Developed mrkts typically have higher valuation (PE Ratio) and income

Developing markets typically have higher growth prospects and risk

Question 5

Ordinary Shares vs ADRs

Answer 5

Ordinary shares are held in local currency. holders have voting rights and are last in liquidation (opposed to preferred shares)
ADRs: a negotiable certificate/note issued by a US bank representing ownership in foreign stock that’s traded on a US exchange. Denominated in USD.

Question 6

Dividend Discount Model

Answer 6

on formula sheet

value of stock = dividend per share / (discount rate - growth rate)

discounts future cash flows (dividends) to PV

Question 7

Free Cash Flow

Answer 7

= operating cash - capital expenditures

FCF = EBIT (1-tax rate) + Depreciation and
Amortization – Change in Working Capital –
Capital Expenditure

measurement of company’s ability to enhance shareholder experience

not on formula sheet

Question 8

Weighted Average Cost of Capital (WACC)

Answer 8

not on formula sheet

WACC = (mrkt value of equity / [MV of equity + MV of debt]) X cost of equity + (mrkt value of equity / [MV of equity + MV of debt]) X cost of debt X (1 - corporate tax rate)

Question 9

Fundamental Analysis

Answer 9

Fundamental analysis models a company’s
value by assessing its current and future
profitability.
* The purpose of fundamental analysis is to
identify mispriced stocks relative to some
measure of “true” value derived from financial
data

Question 10

Book Value

Answer 10

Book values are based on historical cost, not actual market values.
* It is possible, but uncommon, for market value to be less than
book value.
* “Floor” or minimum value is the liquidation value per share.
* Tobin’s q is the ratio of market price to replacement cost.
* High book value (high BtoM) indicates a stock may be
undervalued
* Low book value (low BtoM) indicates a stock may be
overvalued

Questions can be worded as book to market, or market to book so watch out

Question 11

Intrinsic v. Market Value

Answer 11

The intrinsic value (IV) is the “true” value,
according to a model.

The market value (MV) is the consensus value
of all market participants

Question 12

P/E and Growth Rate Relation

Answer 12

The growth rate is roughly equal to the P/E ratio.
“If the P/E ratio of Coca Cola is 15, you’d expect the
company to be growing at about 15% per year, etc. But if
the P/E ratio is less than the growth rate, you may have
found yourself a bargain.”

Question 13

Current Ratio

Answer 13

current assets/current liabilities

Question 14

Quick Ratio

Answer 14

[cash + cash equiv. + short-term investments + receivables] /
current liabilities

Children Stab Things Repeatedly
Consequences Later = Quick Recovery

Question 15

Price-Weighted Average

Answer 15

= [final price - initial price] / initial price

Question 16

Cap Weighted Index

Answer 16

“Market value weighted index”
ex. S&P 500, Russell 2000, MSCI EAFE

this index weights individual
companies or stocks based on their market
capitalization thus larger stocks receive more
proportional representation in the index; the
value of a cap-weighted index may be
computed by summing the value of all market
capitalizations and dividing by the number of
stocks in the index

Question 17

pros/cons of cap weighted index

Answer 17

Advantages
* The total return of the index roughly mirrors the change in the total market value of all stocks.
* Rebalancing this type of index is simple.
* Since the index automatically adjusts to changes in stock prices, it
is easy to create a tax efficient mutual fund or ETF to track this type of index.
Disadvantages
* If stock prices reflect emotions over the short term, then the index will systematically own too much of overpriced stocks and too little of bargain priced stocks.
* The index is heavily influenced by the few companies with the
largest market capitalizations. For instance, the top 20 stocks in the S&P 500 index can account for one-third of the total index

Question 18

Fundamentally Weighted Index

Answer 18

a type of equity market index where selection
and weighting criteria are based on factors
such as revenue, dividends, or book value
(i.e., measurements of fundamental analysis)

Question 19

pros/cons of fundamentally weighted index

Answer 19

Advantages
* Since the index is not influenced by price, it is not
influenced by short term emotions. Unlike market cap
weighted indexes, pricing errors are random.
* Since fundamental rankings between companies are
based upon sales, book value and other measures of
economic size that change relatively slowly, the index
can be managed through ETFs or mutual funds on a
relatively tax efficient basis.
Disadvantages
The index does not use relative or absolute value to
determine company weights in the index

Question 20

pros/cons of equally weighted index

Answer 20

Advantages
* The index is highly diversified with all stocks in the universe equally weighted.
* As opposed to market cap weighting, the index does not overweight overpriced stocks and underweight underpriced stocks. Pricing errors are
random.
* Easy to construct relatively tax efficient ETFs and mutual funds.
* Usually adds 1 – 2 percent in annual return over long periods after expenses vs. market cap weighted indexes.
Disadvantages
* No distinction is made between the relative or absolute valuation of stocks
within the universe.
* Difficult to keep the stocks in the index equally weighted due to constant price fluctuations.
* Difficult for this type of index to manage substantial amounts of money due
to the need to invest equal amounts in both the largest and smallest stocks.

Question 21

Recent Increase in Correlations

Answer 21

Since the 1990’s there has been an increase in
correlation in equity prices of many international
developed markets.
* There is a fair amount of speculation as to why this has
occurred and if correlations will remain at this level or
possibly move even higher.

• Possible reasons for increased correlations:
  – Globalization (advances in technology, communication, etc.)
  – Increased volatility and crises lead to higher correlations
  – Increase in emerging market capitalization

Question 22

PEG Ratio

Answer 22

Price-Earnings-Growth Rate (PEG Ratio)

PEGR = (P/E) / EGR

This ratio employs the P/E ratio and relates it to a firm’s expected growth rate per year
(EGR). It reflects the firm’s potential value of a share of stock.
Suppose that a firm with a P/E of 8.72 expects an annual growth rate of 8%. Its PEGR
would be
=8.72/8 = 1.09
It is theorized that PEGRs represent the following:
If PEGR = 1 to 2: The firm’s stock is in the normal range of value.
If PEGR < 1: The firm’s stock is undervalued.
If PEGR > 2: The firm’s stock is overvalued.

Question 23

Book-to-Market

Answer 23

• a measure of an asset’s value calculated by
  dividing the asset’s book (accounting) value
  by its market value
• a positive ratio indicates that the market is
  discounting the asset

Question 24

Book Value

Answer 24

Defined
A valuation based on a company’s assets minus its
liabilities.
Formulae
Book Value = assets minus liabilities

Book Value Per Share
= (assets-liabilities) / shares outstanding
= shareholder equity / shares outstanding

Question 25

Price to Book Ratio

Answer 25

P/B ratio = share price/[(assets-liabilities)/shares outstanding]

can also be calculated by dividing the market capitalization by
the book value (assets – liabilities).

Question 26

Price to Sales Ratio

Answer 26

• good for startups who do not have income yet
• lower values may indicate market undervaluation

P/S ratio = stock price/12 month sales per share

Question 27

Return on Assets

Answer 27

Defined
* ROA is a ratio that measures how well company management
is utilizing its assets to generate operating income. It is calculated by dividing earnings before interest and tax payments by total assets.
Example
* ROA = EBIT/assets or
= EBIT/(liabilities + owner equity + retained earnings)
Note: sometimes ROA may be defined as Net earnings
(i.e., after taxes and interest payments)/assets.

Question 28

Return on Equity

Answer 28

Defined
ROE is a ratio that measures how well company management is
performing for shareholders (i.e., profitability). It is calculated
by dividing after-tax earnings by shareholder’s equity (i.e.,
book value). It can also be calculated by dividing earnings per share by book value per share.

ROE = net earnings/shareholder’s equity

= net earnings/book value

= earnings per share (aka EPS)/(book value per share)

Formula for P/B, P/E and ROE:
P/B = P/E * ROE

Question 29

Retention Ratio

Example: Company has return on equity of 17%, earnings of $1.75 per share, and pays a dividend of $0.25 per share. The retention rate (i.e., amount used to keep
growing the company – and is not paid out to shareholders) is calculated as follows:

Answer 29

One method for calculating a company’s growth rate is to use something called a
retention rate (or ratio). You multiply the ROE x the retention rate. Retention rate is basically 1 minus the dividend rate paid out.

Example: Company has return on equity of 17%, earnings of $1.75 per share, and pays a dividend of $0.25 per share. The retention rate (i.e., amount used to keep
growing the company – and is not paid out to shareholders) is calculated as follows:
1 – (dividend/earnings)
1 – (0.25/1.75)
1 – .1429
Retention Rate = 85.71%
Growth = ROE x retention rate
= 17% x 85.71%
=14.57% (answer)

Question 30

What is the best valuation metric for small companies including start-ups with no
earnings?

Answer 30

Answer: it depends (of course). So, you’ll want to dissect the information given about the company in question very carefully.

Price to Earnings – no, if the company does not have earnings

Price to Discounted Cash Flow – this metric is used in practice but depends
greatly on the skill of the analyst to predict future cash flows

Price to Book – this could be used, but in some cases will not be very helpful
(e.g., a company in which assets like intellectual property are hard to value)
Price to Sales – this is often one of the better metrics for a start-up, assuming
the company has sales already

ROE and ROA – these metrics will not prove helpful until the company has
income (earnings)

Question 31

A firm has a P/E ratio of 12 and a ROE of 13%. What is the price-to-book value?

Answer 31

1.56

P/B = P/E * ROE

    = 12 * 0.13

    = 1.56

Note that the above formula is derived from the definitional formulas for the ratios: P/B (Price to Book), P/E (Price to Earnings) and ROE (Return on Equity).

Recall, the denominator in ROE is Equity, which is based on book value and NOT a stock’s market price. See CIMA textbook pages 426-433 for more detail about these ratios.

For the specific derivation of the formula:

  P/E * ROE = [(Price/share) / (Earnings/share)] * [(Earnings/share) / (Book Value/share)]

      = [(Price/share) / (Earnings/share)] * [(Earnings/share) / (Book Value/share)]

      = [(Price/share)] * [ 1 / (Book Value/share)]

      = (Price/share) / (Book Value/share)

      = P/B

Reminder: the denominator of Equity in ROE is

= [(Price/share) / (Earnings/share)] * [(Earnings/share) / (Equity/share)]

= [(Price/share) / 1 ] * [ 1 / (Equity/share)]

= [(Price/share) / (Equity/share)]

= P/Eq

= P/B

Question 32

A firm has an ROA of 14%, a debt/equity ratio of 0.8, a tax rate of 35%, and the interest rate on the debt is 10%. The firm’s ROE is ______________.

Answer 32

11.18%

ROE = (1-tax rate) X (ROA+ (ROA - interest)D/E Ratio)
ROE = (1 - 0.35)[14% + (14% - 10%)0.8] = 11.18%.

Question 33

Bulldog Stock enjoyed earnings last year of $21,000,000 while holding $100,000,000 in assets and $10,000,000 in liabilities. Bulldog’s book value and return on equity last year were:

Answer 33

$90,000,000 and 23.3%

Book Value = assets minus liabilities = $100m - $10m = $90m

ROE = earnings / shareholder equity = $21m / $90m = 23.3%

Question 34

Market capitalization can be calculated by…

Answer 34

multiplying the share price by the number of shares outstanding.

Question 35

Calculate the current and quick ratios, respectively, for IVY League stock.

Cash $10,000,000

Receivables $42,000,000

Inventories $35,000,000

Capital long-term investments $75,000,000

Property and equipment $225,000,000

Short-term accounts payable $27,000,000

Long-term debt $150,000,000

Answer 35

3.22, 1.93

Current Ratio = current assets divided by current liabilities.

Current Assets for this company = cash, receivables, inventories = $87m

Current Liabilities = short-term accounts payable = $27m

$87m / $27m = 3.22

Quick Ratio = (cash and equivalents + ST investments + receivables) / current liabilities

Quick Ratio assets for this company = cash, receivables = $52m

Current Liabilities = short-term accounts payable = $27m

$52m / $27m = 1.93

Question 36

What is the CAPE ratio of the following stock?

Stock price $45.10/share

Forward looking PE ratio = 22.2

Current PE ratio = 31.6

Current earnings per share = $2.08

Inflation adjusted 10-year historical earnings per share = $1.12

Answer 36

40.27

Shiller PE Ratio

also known as the “cyclically adjusted (CAPE) PE”
smoothes out fluctuations in earnings due to the business cycle
uses earnings per share figures adjusted for inflation and averaged over 10 years as the denominator
CAPE Ratio formula:

share price / 10-year earnings average adjusted for inflation

$45.10 / $1.12 = 40.27

Question 37

What is the PEG ratio of the following stock and determine whether it is over or undervalued?

Stock price = $60.00/share

Current PE ratio = 32

Current earnings per share: $1.87

Projected earnings per share: $1.96

Answer 37

6.65, overvalued

PEGR = P/E divided by expected growth rate

Solve for growth rate: ($1.96 - $1.87) / $1.87 = 4.81%

32 / 4.81 = 6.65

This ratio employs the P/E ratio and relates it to a firm’s expected growth rate per year (EGR). It reflects the firm’s potential value of a share of stock.

It is theorized that PEGRs represent the following:

If PEGR = 1 to 2: The firm’s stock is in the normal range of value.

If PEGR < 1: The firm’s stock is undervalued.

If PEGR > 2: The firm’s stock is overvalued.

Question 38

Use the retention rate to determine growth rate for the following company.

ROA = 2.12

ROE = 3.57

EPS = $0.87

PE Ratio = 17.25

Dividends = $0.12

Answer 38

3.08%

Solve for retention rate: 1 – (dividend/earnings)

1 – (0.12 / 0.87) = 86.21%

Growth = ROE x retention rate

= 3.57 x 86.21% = 3.08%

Using Retention Ratio to solve for growth rate

One method for calculating a company’s growth rate is to use something called a retention rate (or ratio). You multiply the ROE x the retention rate. Retention rate is basically 1 minus the dividend rate paid out.

Another example: Company has return on equity of 17%, earnings of $1.75 per share, and pays a dividend of $0.25 per share. The retention rate (i.e., amount used to keep growing the company – and is not paid out to shareholders) is calculated as follows:

1 – (dividend/earnings)

1 – (0.25/1.75)

1 – .1429

Retention Rate = 85.71%

Growth = ROE x retention rate

= 17% x 85.71%

=14.57% (answer)

Question 39

Example: Company has return on equity of 17%, earnings of $1.75 per share, and
pays a dividend of $0.25 per share. The retention rate (i.e., amount used to keep
growing the company – and is not paid out to shareholders) is calculated as follows:

Answer 39

1 – (dividend/earnings)
1 – (0.25/1.75)
1 – .1429
Retention Rate = 85.71%
Growth = ROE x retention rate
= 17% x 85.71%
=14.57% (answer)