Equity Flashcards
Q: What are the three main functions of the financial system?
A: 1. Facilitate saving, borrowing, raising equity capital, managing risks, and trading assets.
2. Determine returns (interest rates) that equate savings supply with borrowing demand.
3. Allocate capital to its most efficient uses.
Q: How does the financial system help entities manage risk?
A: It allows entities to hedge risks related to interest rates, currency fluctuations, and commodity prices through instruments like forwards, futures, options, and insurance contracts.
Q: How do individuals and firms use the financial system for savings and borrowing?
A: - Individuals save for retirement or future needs using stocks, bonds, and certificates of deposit.
Firms save for future expenditures and borrow for capital projects.
Governments issue debt to fund expenditures.
Q: What are the different types of financial markets?
A: - Primary Market: For newly issued securities.
Secondary Market: Where existing securities are traded.
Money Market: For short-term debt securities (≤1 year).
Capital Market: For long-term debt and equity securities.
Spot Market: For immediate asset delivery.
Derivatives Market: For futures, forwards, and options contract
Q: What are the major types of financial securities?
A: - Debt Securities: Bonds, notes, commercial paper.
Equity Securities: Common stock, preferred stock, warrants.
Pooled Investment Vehicles: Mutual funds, ETFs, hedge funds, asset-backed securities.
Q: What are the main types of financial intermediaries?
A: - Brokers & Dealers: Facilitate trading and provide liquidity.
Securitizers: Pool assets and sell interests in them.
Depository Institutions: Banks and credit unions that take deposits and make loans.
Insurance Companies: Manage risk through insurance products.
Q: How does the financial system determine returns?
A: Interest rates are set to balance borrowing and lending. Low rates increase borrowing and decrease saving, while high rates do the opposite. Equilibrium rates vary based on risk, liquidity, and maturity.
Q: What are commodities and real assets, and how are they traded?
A: - Commodities: Traded in spot, forward, and futures markets (e.g., gold, oil, wheat).
Real Assets: Include real estate, equipment, and infrastructure. They can be held directly or through REITs and other investment vehicles.
Front: What is a long position in an asset?
Back: An investor has a long position when they own an asset or have the right or obligation to purchase an asset. Investors who are long benefit when the asset price increases.
Front: How does a short sale work?
Back: In a short sale, an investor borrows an asset, sells it, and later repurchases it to return to the lender. The goal is to profit if the asset price declines.
Front: What is a margin loan and how does leverage affect returns?
Back: A margin loan allows investors to borrow funds to buy securities. Leverage magnifies gains and losses, as returns are calculated based on the equity portion of the investment.
Front: What is the leverage ratio and how is it calculated?
Back: The leverage ratio is the value of the asset divided by the investor’s equity. Example: If the initial margin requirement is 40%, the leverage ratio is
1
/
0.40
=
2.5
1/0.40=2.5.
Front: What costs are associated with short selling?
Back: Short sellers must pay interest on borrowed shares, return dividends (payments-in-lieu), and maintain margin deposits. Institutional investors may receive a short rebate.
Which of the following is most similar to a short position in the underlying asset?
A)
Buying a put.
B)
Writing a put.
C)
Buying a call.
Explanation
Buying a put is most similar to a short position in the underlying asset because the put increases in value if the underlying asset value decreases. The writer of a put and the holder of a call have a long exposure to the underlying asset because their positions increase in value if the underlying asset value increases. (Module 39.2, LOS 39.e)
Q: What is the bid-ask spread, and why is it important?
A: The bid-ask spread is the difference between the bid price (price a dealer will buy a security) and the ask price (price a dealer will sell a security). It represents the dealer’s compensation for providing liquidity.
Q: What is the main difference between market orders and limit orders?
A: Market orders execute immediately at the best available price, while limit orders specify a maximum price to buy or a minimum price to sell, ensuring better price execution but with the risk of not being filled.
Q: What are the primary and secondary markets?
Flashcard 4
A: The primary market is where new securities are issued, such as IPOs. The secondary market is where previously issued securities trade among investors.
Q: How do quote-driven, order-driven, and brokered markets differ?
A: - Quote-driven markets: Dealers provide bid-ask quotes.
Order-driven markets: Buyers and sellers submit orders that are matched based on rules.
Brokered markets: Brokers find counterparties for transactions, often in less liquid assets.
Q: What are stop-loss and stop-buy orders, and how do they work?
A: - Stop-loss order: A sell order triggered when the price drops to a certain level to limit losses.
Stop-buy order: A buy order triggered when the price rises to a certain level, used to limit losses on short positions or confirm price momentum.
Q: What are the key characteristics of a well-functioning financial system?
A: A well-functioning financial system is operationally efficient (low transaction costs), informationally efficient (prices reflect fundamental value), and has complete markets that allow saving, borrowing, hedging, and trading efficiently.
In which of the following types of markets do stocks trade any time the market is open?
A)
Exchange markets.
B)
Call markets.
Incorrect Answer
C)
Continuous markets.
Explanation
Continuous markets are defined as markets where stocks can trade any time the market is open. Some exchange markets are call markets where orders are accumulated and executed at specific times. (Module 39.3, LOS 39.j)
Which of the following would least likely be an objective of market regulation?
A)
Reduce burdensome accounting standards.
Correct Answer
B)
Make it easier for investors to evaluate performance.
Incorrect Answer
C)
Prevent investors from using inside information in securities trading.
Explanation
Market regulation should require financial reporting standards so that information gathering is less expensive and the informational efficiency of the markets is enhanced. (Module 39.3, LOS 39.l)
Q: What is a security market index?
A: A security market index represents the performance of an asset class, market, or market segment. It is created as a portfolio of constituent securities and has a numerical value based on their market prices.
Q: What are key considerations in index construction and management?
A: Index providers must decide:
The target market
Which securities to include
Weighting method
Rebalancing frequency
When to review selection and weighting
Q: What are the different weighting methods for stock indexes?
A: - Price-weighted: Arithmetic average of stock prices (e.g., DJIA).
Equal-weighted: Equal allocation to all securities, requiring frequent rebalancing.
Market-cap weighted: Weights based on market capitalization (e.g., S&P 500).
Float-adjusted market-cap weighted: Weights based on publicly available shares.
Fundamental-weighted: Weights based on financial metrics (e.g., earnings, dividends).
Q: How do market-cap and equal-weighted indexes differ?
A: - Market-cap weighted: Large companies influence index more (momentum bias).
Equal-weighted: Small companies have larger influence; requires rebalancing.
Example: If Stock A (small cap) doubles, it affects the equal-weighted index more than a market-cap weighted index.
Choices that must be made when constructing a security market index least likely include whether to:
A)
use a nominal or interval scale.
B)
measure the performance of an entire market or market segment.
Incorrect Answer
C)
weight the securities equally or by some firm-specific characteristic.
Explanation
To be useful, a security market index must have a numerical value. Selecting the target market and determining the weighting method are among the choices that must be made when constructing a securities index. (Module 40.1, LOS 40.a, 40.c)
LOS 40.f: Rebalancing vs. Reconstitution
.
1️⃣ What is index rebalancing?
Rebalancing adjusts the weights of securities in a portfolio back to target weights after price changes. It is mainly an issue for equal-weighted indexes and is done periodically (usually quarterly).
2️⃣ What is index reconstitution?
Reconstitution involves adding or removing securities from an index to maintain its intended characteristics. Securities are removed if they no longer meet criteria, and new ones are added. This process affects stock prices due to portfolio managers adjusting holdings
3️⃣ What are the primary uses of security market indexes?
Indexes serve as:
A reflection of market sentiment (investor confidence).
A benchmark for active managers to assess performance.
A measure of market return and risk for asset allocation.
A tool for calculating beta and risk-adjusted returns (CAPM).
A model portfolio for passive index funds (ETFs, mutual funds).
What are the main types of equity indexes?
Broad market index: Represents most of a market (e.g., Wilshire 5000).
Multi-market index: Covers multiple countries (e.g., MSCI World Index).
Multi-market index with fundamental weighting: Adjusts country weightings based on economic factors (e.g., GDP).
Sector index: Tracks industries (e.g., healthcare, financials).
Style index: Tracks investment styles (e.g., small-cap value).
What are key differences between major security market indexes?
Indexes differ in:
Weighting methods (price-weighted, market-cap, equal-weighted).
Number of constituents (Dow 30 vs. Wilshire 5000).
Geographic focus (U.S. vs. global).
Asset type (stocks, bonds, commodities, real estate).
Example:
Dow Jones Industrial Average: 30 large U.S. stocks, price-weighted.
MSCI All Country World Index: Stocks from 47 countries, market-cap weighted.
What are key considerations for fixed-income and alternative indexes?
Fixed-income indexes:
Large security universe, high turnover.
Illiquid markets, pricing challenges.
Examples: Barclays Global Aggregate Bond Index.
Alternative indexes:
Commodities: Based on futures, not spot prices (e.g., S&P GSCI).
Real estate: Tracks REITs or property sales (e.g., FTSE EPRA/NAREIT).
Hedge funds: Self-reported, potential return bias (e.g., HFRX Global Hedge Fund Index).
Q: What is an informationally efficient capital market?
A: A market where security prices fully, quickly, and rationally reflect all available information, making it difficult to consistently achieve abnormal returns.
Q: What are the three forms of market efficiency?
A: 1. Weak-form: Prices reflect past market data; technical analysis is ineffective.
2. Semi-strong form: Prices reflect all publicly available information; fundamental analysis is ineffective.
3. Strong-form: Prices reflect all public and private (inside) information; no one can consistently earn excess returns.
Q: What are key factors that influence market efficiency?
A: 1. Number of market participants (more investors improve efficiency).
2. Availability and fairness of information (greater transparency improves efficiency).
3. Impediments to trading (arbitrage helps correct mispricings).
4. Transaction and information costs (high costs reduce efficiency).
Q: What are examples of market anomalies?
A: - Calendar anomalies (January effect, weekend effect).
Overreaction & momentum effects (extreme past returns predicting reversals or continuations).
Size effect (small-cap stocks outperform large-cap stocks).
Value effect (low P/E or high dividend yield stocks outperform growth stocks).
Earnings announcement drift (stock prices continue reacting after earnings surprises).
Q: How does market efficiency impact investment strategies?
A: - In efficient markets, passive investing (index funds) is preferred.
In inefficient markets, active investing (stock picking, market timing) may generate excess returns.
Even in efficient markets, portfolio managers add value through risk management, asset allocation, and tax efficiency.
Q: What are key investor biases that behavioral finance studies?
A: - Loss aversion (disliking losses more than liking equivalent gains).
Overconfidence (excessive belief in one’s investment skill).
Herd behavior (following others instead of independent analysis).
Mental accounting (treating money differently based on its source or intended use).
Question: What are common shares, and what rights do common shareholders have?
Answer: Common shares represent ownership in a company and come with voting rights. Shareholders have a residual claim on assets after debtholders and preferred stockholders in case of liquidation. They can vote for the board of directors, on mergers, and on auditor selection. Dividends are not guaranteed and are determined by the firm.
Question: What is the difference between statutory and cumulative voting?
Answer: In statutory voting, each share equals one vote per board seat. In cumulative voting, shareholders can allocate their total votes across multiple candidates, allowing minority shareholders to have more influence.
Question: What are the characteristics of preferred shares?
Answer: Preferred shares combine features of debt and equity. They typically pay fixed dividends, have no maturity date, and generally lack voting rights. They may be callable (redeemable by the firm) or putable (sellable back to the issuer).
Question: What is the difference between cumulative and non-cumulative preference shares?
Answer: Cumulative preference shares accumulate unpaid dividends that must be paid before common shareholders receive dividends. Non-cumulative preference shares do not accumulate unpaid dividends, but they still take priority over common shareholders in dividend payments.
Question: How do public and private equity securities differ?
Answer: Public equity is traded in open markets with high liquidity and regulatory disclosures. Private equity has less liquidity, fewer disclosure requirements, lower reporting costs, and allows firms to focus on long-term goals.
Question: What are the three main types of private equity investments?
Answer: The three main types are:
Venture Capital – Funding for early-stage firms.
Leveraged Buyouts (LBOs) – Buying firms using debt, often by existing management (MBOs).
Private Investment in Public Equity (PIPEs) – Public firms selling equity privately at a discount for quick capital.
Q: What is direct investing in foreign equity securities?
A: Direct investing involves purchasing foreign company shares in foreign markets. Challenges include foreign currency risk, illiquidity, varying reporting standards, and the need to understand foreign regulations.
Q: What are depository receipts (DRs)?
A: DRs represent ownership in a foreign firm and trade in other countries’ markets in local currencies. They are issued by a bank holding the foreign company’s shares and simplify foreign investment.
Q: What is the difference between sponsored and unsponsored DRs?
A: Sponsored DRs provide voting rights and require greater disclosure, while unsponsored DRs do not grant voting rights to investors, as the depository bank retains them.
Q: What are Global Depository Receipts (GDRs)?
A: GDRs are issued outside the U.S. and the issuer’s home country, often traded in London and Luxembourg. They are usually denominated in U.S. dollars and allow investment without capital flow restrictions.
Q: What are American Depository Receipts (ADRs)?
A: ADRs are U.S.-dollar-denominated securities representing foreign shares that trade in the U.S. They can be Level I, II, III, or Rule 144A, depending on listing and capital-raising ability.
Q: What are Global Registered Shares (GRS) and Baskets of Listed Depository Receipts (BLDRs)?
A: GRS are traded in multiple currencies across global exchanges, while BLDRs are ETFs consisting of multiple DRs, trading like stocks in the market.
Q: What is the purpose of a company research report?
A: A company research report provides an analyst’s valuation and investment recommendations based on projected earnings, cash flows, and financial position.
Q: What are the key components of an initial company research report?
A: Front matter, recommendation rationales, company description, industry overview, financial analysis, valuation, ESG factors, and key risks.
Q: What differentiates an initial research report from a subsequent one?
A: Initial reports are more thorough, while subsequent reports provide updates, variance analyses, changes in valuation, and risk assessments.
Q: What factors define a company’s business model?
.
A: Products/services, customers, sales channels, pricing/payment terms, and supplier relationships
Q: What are the four types of information sources analysts use to determine a company’s business model?
A: 1) Company disclosures, 2) Public third-party sources, 3) Proprietary third-party sources, and 4) Proprietary primary research.
Q: Why is understanding a company’s business model important for analysts?
A: It helps analysts determine key income and balance sheet drivers, competitive positioning, and investment potential.
Would you like me to adjust or simplify any of these?
Q: What are the two primary approaches analysts use to analyze revenue drivers?
A: Analysts use a bottom-up approach, breaking revenue into specific drivers like price, volume, segments, or geography, and a top-down approach, which considers macroeconomic factors like market share or GDP growth.
Q: What determines a company’s ability to set prices without losing sales?
A: Pricing power depends on industry market structure and competitive positioning. Highly competitive markets limit pricing power, while less competitive markets (monopolies, oligopolies) allow companies to set higher prices.
Q: How does operating leverage impact a company’s profitability?
A: Operating leverage occurs when a company has high fixed costs. It amplifies profits when sales increase but also magnifies losses when sales decline. It is measured by degree of operating leverage (DOL):
DOL = %Δ Operating Profit / %Δ Sales
Q: What are key profitability metrics used to evaluate operating performance?
A: - Gross Profit = Revenue – Cost of Sales
EBITDA = Gross Profit – Operating Expenses
EBIT (Operating Profit) = EBITDA – Depreciation & Amortization
Each metric can be divided by revenue to calculate gross margin, EBITDA margin, and EBIT margin.
Q: What does a company’s working capital indicate?
A: Working capital (Current Assets – Current Liabilities) measures liquidity and short-term financial health. A positive working capital suggests the company can finance operations internally, while a negative one indicates reliance on external financing.
Q: How do analysts evaluate a company’s capital structure?
A: Analysts assess a company’s use of debt and equity through leverage ratios, coverage ratios, and the degree of financial leverage (DFL):
DFL = %Δ Net Income / %Δ Operating Income
Higher DFL indicates greater sensitivity of net income to changes in operating income.
Q: What is the purpose of industry and competitive analysis?
A: It helps analyze industry size, profits, market share, and a company’s position within its industry to assess future profitability and competitive standing.
Q: What factors contribute to differences in profitability within an industry?
A: Business model, company size, and competitive strategy, while industry-wide factors set a profitability limit.
Q: What are the five steps of industry and competitive analysis?
A:
Define the industry.
Survey industry size, growth, profitability, and market share trends.
Analyze industry structure using frameworks like Porter’s Five Forces.
Examine external influences (PESTLE).
Assess companies’ competitive strategies.
Q: What are the major industry classification systems?
A:
GICS: Sector → Industry Groups → Industries → Subindustries
ICB: Industries → Supersectors → Sectors → Subsectors
TRBC: Economic Sectors → Business Sectors → Industry Groups → Industries → Activities
Q: What are common ways to classify companies?
A: By:
Product/service
Business cycle sensitivity (cyclical vs. defensive)
Financial measures (market cap, profitability ratios)
Geography
ESG factors
Q: How is industry concentration measured, and what does it indicate?
A: The Herfindahl-Hirschman Index (HHI) sums the squares of firms’ market shares.
HHI < 1,500: Low concentration, high competition, lower pricing power.
HHI 1,500-2,500: Moderate concentration.
HHI > 2,500: High concentration, lower competition, greater pricing power.
Q: What are the five forces in Porter’s industry analysis framework?
A: Rivalry among competitors, threat of new entrants, threat of substitutes, bargaining power of buyers, and bargaining power of suppliers.
Q: What factors increase rivalry among existing competitors?
A: High number of competitors, slow industry growth, high fixed costs, undifferentiated products, and costly exit barriers.
Q: What factors create high barriers to entry in an industry?
A: Large capital requirements, economies of scale, strong brand identity, government regulations, and high switching costs for consumers.
Q: How do substitute products affect industry profitability?
A: Substitutes increase price elasticity of demand, limiting the price firms can charge and reducing overall profitability.
Q: When do buyers and suppliers have high bargaining power?
A: Buyers have power when they can easily switch suppliers or demand lower prices. Suppliers have power when they are few in number or provide scarce, essential inputs.
Q: What are the six factors in the PESTLE framework?
A: Political, Economic, Social, Technological, Legal, and Environmental influences on industry dynamics.
Q: What are the four key forecast objects in financial forecasting?
A: 1. Financial statement lines with clear drivers
2. Financial statement items without clear drivers
3. Summary measures
4. Ad hoc items
Q: Why is it important to avoid overly complex financial forecasting models?
A: Complex models require significant effort to create and maintain, and they are not necessarily more accurate than simpler models.
Q: What are the four forecasting approaches used in financial analysis?
A: 1. Base forecasts on historical results
2. Assume results will converge to a historical base rate
3. Use management guidance
4. Use discretionary forecasting methods
Q: When is it appropriate to use historical results as a forecasting approach?
A: When forecasting noncyclical or mature-stage companies, or when analyzing objects considered immaterial.
Q: What is a key limitation of using management guidance for financial forecasting?
A: Management guidance often includes assumptions that may be biased, and it may not be reliable for cyclical companies.
Q: What factors determine the appropriate forecast horizon?
A: Investor time horizon, industry cyclicality, and company-specific factors such as operational changes.
Which approach is most appropriate for an analyst to use to forecast revenues for a company in a highly cyclical industry?
A)
Historical results.
Incorrect Answer
B)
Analyst’s discretionary forecast.
C)
Historical base rates and convergence.
Explanation
An analyst’s discretionary forecast is most frequently used for companies in cyclical industries as well as companies that have few or no peers, those that do not provide management guidance, and those in the midst of a significant business transition.
The historical results approach is not appropriate for companies in cyclical industries because a future period is probably going to be at a dissimilar point in the business cycle compared to the current or past period, so the results would not be comparable. The historical base rates and convergence approach is not appropriate for companies in highly cyclical industries because the smooth convergence to a long-term base rate would hide the annual volatility. (Module 45.1, LOS 45.a)
Q: What is intrinsic value, and how do analysts use it in valuation?
A: Intrinsic value is the rational value investors would place on an asset if they had full knowledge of its characteristics. Analysts use valuation models to estimate intrinsic values and compare them to market prices to determine if stocks are overvalued, undervalued, or fairly valued.
Q: What are the three major categories of equity valuation models?
A: 1. Discounted Cash Flow Models – Estimate stock value as the present value of future cash flows (e.g., Dividend Discount Model, Free Cash Flow to Equity Model).
2. Multiplier Models – Use ratios like P/E or EV/EBITDA to estimate intrinsic value.
3. Asset-Based Models – Estimate value as total asset value minus liabilities and preferred stock.
Flashcard 3: Types of Dividends and Stock Splits
Q: What are the differences between cash dividends, stock dividends, stock splits, and reverse stock splits?
A: - Cash dividends: Paid in cash to shareholders, either regular or special.
Stock dividends: Paid in additional shares rather than cash, increasing share count but not shareholder wealth.
Stock splits: Increase the number of shares, reducing price per share (e.g., 3-for-1 split).
Reverse stock splits: Reduce the number of shares, increasing price per share
Q: Why might a company repurchase its own shares?
A: Companies repurchase shares to:
Distribute cash to shareholders as an alternative to dividends.
Support or signal undervaluation of stock.
Offset dilution from employee stock options.
Provide tax advantages in some jurisdictions.
Q: What are the key dates in the dividend payment process?
A: 1. Declaration date – Board announces dividend.
2. Ex-dividend date – First day a buyer won’t receive the dividend.
3. Holder-of-record date – Shareholders as of this date receive the dividend.
4. Payment date – Dividend is distributed to shareholders.
Q: What is the rationale behind using present value models to value equity?
A: Present value models assume that the intrinsic value of a stock is the present value of its expected future cash flows, typically dividends or free cash flow to equity (FCFE).
Q: What is Free Cash Flow to Equity (FCFE), and why is it used instead of dividends?
A: FCFE represents the cash available to equity holders after debt obligations and capital expenditures. It is used when firms do not pay dividends but generate cash flow available to shareholders.
Q: What is the rationale for using price multiples in equity valuation?
A: Price multiples are widely used because they are easy to calculate, readily available, and allow for time series and cross-sectional comparisons. They provide a relative valuation by comparing a stock’s price multiple to a benchmark.
Q: How does the price-to-earnings (P/E) ratio relate to fundamentals?
A: The justified P/E ratio is derived from the Gordon growth model and is influenced by the dividend payout ratio, required rate of return, and expected growth rate. Higher payout and growth rates increase P/E, while a higher required return decreases it.
Q: What is enterprise value (EV), and how is it used in valuation?
A: EV represents the total value of a firm, calculated as:
EV = Market value of equity + Market value of debt – Cash & short-term investments
It is commonly compared to EBITDA (EV/EBITDA) to assess firm valuation, especially when capital structures differ.
Q: What is an asset-based valuation model?
A: It estimates a firm’s equity value as the market value of assets minus the market value of liabilities. This method is useful for firms with tangible assets but may underestimate value for firms with significant intangible assets.
Q: What are the key differences between price multiples based on comparables vs. fundamentals?
A: - Comparables: Uses market prices of similar firms to determine if a stock is over/undervalued.
Fundamentals: Uses valuation models (e.g., DDM) to estimate what a multiple should be based on intrinsic factors.
