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CFA L1 > Equity > Flashcards

Equity Flashcards

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1
Q

3 main functions of the financial system

A
  • Allow entities to save and borrow money, raise equity capital, manage risks, trade assets
  • Determine the returns (i.e., interest rates) that equate the total supply of savings with the total demand for borrowing.
  • Allocate capital to its most efficient uses
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2
Q

Money markets

A

Money markets refer to market for debt securities with maturities of 1 year or less

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3
Q

Capital market

A

Capital markets refer to market for debt with longer than 1 yr maturity and equity securities

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4
Q

Pooled investment vehicles

A

Pooled investment vehicles include mutual funds, depositories, and hedge funds. The term refers to structures that combine the funds of many investors in a portfolio of investments. The investor’s ownership interests are referred to as shares, units, depository receipts, or limited partnership interests.

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5
Q

Mutual funds

A

Mutual funds are pooled investment vehicles in which investors can purchase shares, either from the fund itself (an open-ended fund) or in the secondary market (close-ended fund)

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6
Q

Brokers

A

Brokers help clients buy and sell securities by finding counterparties to trade

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7
Q

Block brokers

A

Block brokers help clients execute large trade orders

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8
Q

Dealers

A

Dealers facilitate trading by buying/selling securities with their own money

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9
Q

informationally efficient capital market

A

An informationally efficient capital market is one in which the current price of a security fully, quickly, and rationally reflects all available information about that security. In other words, “you can’t beat the market”

In a perfectly efficient market, investors should use passive investment strategy b/c active investment strategies will underperform due to transaction costs and mgmt fees

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10
Q

market value

A

The market value of an asset is its current price

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11
Q

Intrinsic or fundamental value

A

The intrinsic/fundamental value of an asset is the value that a rational investor w/full knowledge about the asset’s characteristics would willingly pay.

In markets that are highly efficient, investors can typically expect market values to reflect intrinsic values. If markets are not completely efficient, active managers will buy assets for which they think intrinsic values are greater than market values and sell assets for which they think intrinsic values are less than market values.

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12
Q

4 Factors that affect a market’s efficiency

A
  • # of participants: the more you have, the more efficient the market
  • Availability of info: The more info available to investors, the more efficient the market
  • Impediments to trading: Impediments to trading such as high transaction costs or lack of info will allow price inefficiencies to linger and make market inefficient
  • Transaction and info costs: To the extent that the costs of information, analysis, and trading are greater than the potential profit from trading misvalued securities, market prices will be inefficient.
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13
Q

Weak-form market efficiency

A

The weak form of the efficient markets hypothesis (EMH) asserts that stock prices already reflect all the information that can be derived by examining the market trading data, such as history of past prices or trading volume.

In a weak-form efficient market, technical analysis is useless to generate positive risk-adjusted returns

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14
Q

Semi-strong-form market efficiency

A

The semi-strong form of the EMH states that all publicly available info regarding the prospects of a firm must be reflected already in the stock price. Such info incl (in addition to past prices) fundamental data of the firm, balance sheet, earnings, cash flow etc. Obviously semi-strong encompasses the weak-form EMH

In other words, investors can’t really achieve positive risk-adjusted excess returns by using fundamental analysis.

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15
Q

Strong-form market efficiency

A

The strong form of the EMH states that security prices fully reflect all information from both public and private sources. The strong form includes all types of information: past security market information, public, and private (inside) information. This version of EMH encompasses both the weak and semi-strong form EMH

Thus, no investor can consistently achieve risk-adjusted excess returns

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16
Q

If markets are semi-strong form efficient, then investors should invest

A

Passively

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17
Q

loss aversion

A

Loss aversion refers to people’s tendency to prefer avoiding losses to acquiring equivalent gains: it is better to not lose $5 than to find $5.

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18
Q

Investor overconfidence

A

Investor overconfidence is a tendency of investors to overestimate their abilities to analyze security information and identify differences between securities’ market prices and intrinsic values.

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19
Q

Information cascade

A

An information cascade results when investors mimic the decisions of others. The idea is that uninformed or less-informed traders watch the actions of informed traders and follow their investment actions.

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20
Q

Overreaction anomalies

A

The overreaction effect refers to the finding that firms with poor stock returns over the previous 3-5 years have better subsequent returns than firms that had high stock returns over the prior period. This pattern has been attributed to investor overreaction to both unexpected good news and unexpected bad news.

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21
Q

Momentum anomalies

A

Momentum effects have also been found where high short-term returns are followed by continued high returns.

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22
Q

Both the overreaction and momentum effects violate

A

the weak form of market efficiency because they provide evidence of a profitable strategy based only on market data.

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23
Q

statutory voting system

A

Under the statutory voting system, directors are elected one at a time. Therefore, a shareholder may give any one candidate, as a maximum, only a number of votes equal to the number of shares owned. Statutory voting favors majority shareholders.

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24
Q

Cumulative voting

A

Under cumulative voting system, total number of votes each shareholder may cast = (# of shares owned) x (# of directors to be elected). With cumulative voting, a shareholder may give all the votes he/she holds to a single candidate. Cumulative voting favors minority shareholders.

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25
Q

Cumulative preferred shares

A

Cumulative preferred shares are usually promised fixed dividends. The dividends of cumulative preferred shares accumulate over time when they are not paid

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26
Q

Non-cumulative preferred shares

A

For non-cumulative preferred shares, the dividends don’t accumulate over time when they haven’t been paid out

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27
Q

Convertible preferred shares

A

Convertible preferred shares can be exchanged for common stock at a set conversion ratio

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28
Q

Compared to public equity, private equity has the following characteristics:

A
  • Less liquidity because no public market for the shares exists.
  • Share price is negotiated between the firm and its investors, not determined in a market.
  • More limited firm financial disclosure because there is no government or exchange requirement to do so.
  • Lower reporting costs because of less onerous reporting requirements.
  • Potentially weaker corporate governance because of reduced reporting requirements and less public scrutiny.
  • Greater ability to focus on long-term prospects because there is no public pressure for short-term results.
  • Potentially greater return for investors once the firm goes public.
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29
Q

Depository receipts (DRs)

A

Depository receipts represent ownership in a foreign firm and are traded in the markets of other countries in local market currencies. A bank deposits shares of the foreign firm and then issues receipts representing ownership of a specific # of foreign shares

30
Q

If a firm is involved with the issue, the depository receipt is a

A

sponsored DR. Otherwise, it’s an unsponsored DR

A sponsored DR provides investors voting rights and is usually subject to greater disclosure requirements

31
Q

Global Depository receipts (GDRs)

A

GDRs are issued outside the US and the issuer’s home country. Even though they’re not listed on US exchanges, they’re usually denominated in USD and can be sold to institutional investors.

GDRs aren’t subject to the capital flow restrictions imposed by governments and therefore offer the firm/investor greater opportunities for foreign investments

32
Q

American Depository receipts (ADRs)

A

ADRs are denominated in USD and trade in the US.

33
Q

Equity capital is used for:

A
  • purchase of long-term assets, equipment, R&D

- expansion into new businesses or geographic areas

34
Q

Book value of equity is

A

firm’s asset on balance sheet - firm’s liabilities on balance sheet

35
Q

Market value of equity is

A

(Net income - preferred dividends)/(Avg Book value of common equity )

36
Q

A firm’s cost of equity is

A

expected equilibrium total return (including dividends) on its shares in the market.

37
Q

participating preferred share

A

Investors in participating preference shares receive extra dividends if firm profits exceed a predetermined level and may receive a value greater than the par value of the preferred stock if the firm is liquidated.

38
Q

To calculate price return of an index

A

R = (1 + RS1)(1 + RS2)(1 + RS3)(1 + RS4)…(1 + RSk) − 1

R = portfolio return during measurement period
k = total # subperiods
RSk = portfolio return during the subperiod k
39
Q

A security market index is used to represent

A

the performance of an asset class, security market, or segment of a market.

40
Q

An index return is

A

the %age of change in the index’s value over a period of time.

41
Q

Price-weighted index

A

Price-weighted index = (sum of stock prices)/(# of stocks in index adjusted for splits)

42
Q

Market-capitalization weighting

A

current index value = [(current total market value of index stocks)/(base year total market value of index stocks)] x base year index value

43
Q

An equal-weighted index

A

places an equal weight on the returns of all index stocks, regardless of their prices or market values. (E.g. a $2 change in the price of a $20 stock is the same as a $30 change in the price of s $300 stock regardless the size of company)

Put it another way, an equal weighted price indicator series assumes that an equal dollar investment is made in each stock in the index.

The return of an equal-weighted index over a given period is often calculated as a simple average of the returns of the index stocks

44
Q

The difference between price return and total return index is that

A

cash distributions (i.e. dividends) are included in a total return index. In other words, total return would be different than price return if dividends were paid out. If no dividends paid out, then they’re the same

45
Q

A sector is

A

a group of similar industries

46
Q

Systems that are grouped by products and services usually use a firm’s

A

principal business activity to classify firms

47
Q

Sensitivity to business cycles

A

Firms can also be classified by their sensitivity to business cycles. Options are either cyclical or non-cyclical

48
Q

Cyclical firm

A

A cyclical company is a business whose success is determined by the economy. Economic activity follows a cycle of fluctuations, known as the business cycle, and the share price of a cyclical company is closely linked to this.

49
Q

A non-cyclical (or defensive) firm

A

Non-cyclical stocks, or defensive stocks, comprise businesses that operate in industries that do well during economic downturns. This is because these businesses have essential goods such as utilities.

50
Q

Growth industries

A

Growth industries are another category of non-cyclicals and are typically characterized by above-normal expansion in sales and profits independent of the business cycle.

51
Q

Peer group

A

A peer group is a set of similar companies an analyst will use for valuation comparisons. More specifically, a peer group will consist of companies with similar business activities, demand drivers, cost structure drivers, and availability of capital.

To form a peer group, an analyst will often start by identifying companies in the same industry classification

52
Q

Strategic analysis

A

Strategic analysis examines how an industry’s competitive environment influences a firm’s strategy:

  1. Rivalry among existing competitors: Rivalry increases when many firms of relatively equal size compete within an industry. Slow growth leads to competition as firms fight for market share, and high fixed costs lead to price decreases as firms try to operate at full capacity. Industries with products that are undifferentiated or have barriers (are costly) to exit tend to have high levels of competition.
  2. Threat of entry: Industries that have significant barriers to entry will find it easier to maintain premium pricing. It is costly to enter the steel or oil production industries. Those industries have large barriers to entry and thus less competition from newcomers.
  3. Threat of substitutes: Substitute products limit the profit potential of an industry because they limit the prices firms can charge by increasing the elasticity of demand. The more differentiated the products are within an industry, the less price competition there will be.
  4.  Power of buyers: Buyers’ ability to bargain for lower prices or higher quality influences industry profitability.
  5. Power of suppliers: Suppliers’ ability to raise prices or limit supply influences industry profitability. Suppliers are more powerful if there are just a few of them and their products are scarce.
53
Q

Declaration date

A

The date the board of directors approve the payment of dividend

54
Q

Ex-dividend date

A

The first day on which a share purchaser will not receive the next dividend. In other words, if you buy the share on or after ex-dividend date, you won’t receive the dividend

55
Q

Record date

A

The date on which the company checks its records to identify shareholders of the company

56
Q

Payment date

A

The date dividends are paid out

57
Q

discount cash flow models (or present value models)

A

a stock’s value is estimated as the PV of dividends (dividend discount models) or the PV of cash available to shareholders after the firm meets its necessary capital expenditures and working capital expenses (free cash flow to equity models)

58
Q

multiplier models (or market multiple models)

A

There are 2 types of multiplier models that can be used to estimate intrinsic value:

  1. ratio of stock price to fundamentals (i.e. earnings, sales, book value etc.). Usually P/E ratio is used
  2. Ratio of enterprise value to either EBITDA or revenue. Enterprise value is the market value of all firm’s outstanding securities - (cash + short-term investments)
59
Q

asset based models

A

In asset-based models, the intrinsic value of common stock is estimated as total asset value minus liabilities and preferred stock

60
Q

In a price multiple approach, an analyst compares

A

a stock’s price multiple to a benchmark value based on an index, industry group of firms, or a peer group of firms within an industry.

Common price multiples used for valuation include price-to-earnings, price-to-cash flow, price-to-sales, and price-to-book value ratios.

61
Q

Price-earnings (P/E) ratio

A

The P/E ratio is a firm’s stock price divided by earnings per share

62
Q

Price-sales (P/S) ratio

A

The P/S ratio is a firm’s stock price divided by sales per share

63
Q

Price-book value (P/B) ratio

A

The P/B ratio is a firm’s stock price divided by book value of equity per share

64
Q

Price-cash flow (P/CF) ratio

A

The P/CF ratio is a firm’s stock price divided by cash flow per share, where cash flow may be defined as operating cash flow or free cash flow

65
Q

P0/E1

A

(P0/E1) = (D1/E1)/(k-g)

Also known as justified or leading P/E ratio b/c it’s based on earnings of next period

D1/E1 = expected dividend payout ratio
k = required return on stock
g= expected constant growth rate of dividends
66
Q

Enterprise value

A

Enterprise value = market value of common and preferred stock + market value of debt − (cash and short-term investments)

Enterprise value is appropriate when an analyst wants to compare the values of firms that have significant differences in capital structure.

67
Q

An enterprise value multiple is typically calculated as the ratio of

A

enterprise value to EBITDA or some other measure of operating income.

Net income is not typically used because it reflects a firm’s current capital structure and non-cash charges, and because the ratio becomes meaningless when net income is negative.

68
Q

High barriers to entry benefit existing industry firms because

A

they prevent new competitors from competing for market share and reducing the existing firms’ return on capital

69
Q

Low barriers to entry don’t benefit existing industry firms b/c

A

firms would have little pricing power and competition reduces existing firms’ return on capital

70
Q

In an undercapacity of an industry,

A

results in higher pricing power and higher return on capital.

Undercapacity is a situation in which demand > supply

71
Q

In an overcapacity of an industry

A

results in lower pricing power and lower return on capital

CFA L1 (23 decks)

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