Question 1

Describe characterisitcs of types of equity securities

Accepted Answer

Common shareholders have a residual claim on firm assets and govern the corporation through voting rights. Common shares have variable dividends which the firm is under no legal obligation to pay. Callable common shares allow the firm the right to repurchase the shares at a pre-specified price. Putable common shares give the shareholder the right to sell the shares back to the firm at the pre-specified price. Preferred stock typically does not mature, does not have voting rights, and has dividends that are fixed in the amount but are not a contractual obligation of the firm. Cumulative preferred shares require any dividends that were missed in the past (dividends in arrears) to be paid before common shareholders receive any dividends. Participating preferred shares recieve extra dividends if firm profits exceed a pre-specified level and a value greater than the par value if the firm is liquidated. Convertible preferred stock can be converted to common stock at a pre-specified conversion ratio.

Question 2

Describe the differences in voting rights and other ownership characteristics among different equity classes

Accepted Answer

Some companies' equity shares are divided into different classes, such as Class A and Class B shares. Different classes of common equity may have different voting rights and priority of liquidation.

Question 3

Distinguish between public and private equity securities

Accepted Answer

Compared to publicly traded firms, private equity firms have lower reporting costs, greater ability to focus on long-term prospects, and potentially greater return for investors once the firm goes public. However, private equity investments are illiquid, firm financial disclousre may be limited, and corporate governance may be weaker.

Question 4

Describe methods for investing in non-domestic equity securities

Accepted Answer

Investors who buy foreign stock directly on a foreign stock exchange receive a return denominated in a foreign currency, must abide by the foreign stock exchange's regulations and procedures, and may be faced with less liquidity and less transparency than is available in the investor's domestic markets. Investors can often avoid these disadvantages by purchasing depository receipts for the foreign stock that trade on their domestic exchange. Global depository receipts are issued outside the US and outside the issuer's home country. American depository receipts are denominated in US dollars and are traded on US exchanges. Global registered shares of a firm that trade in different currencies on stock exchanges throughout the world Baskets of listed depository receipts are exchange-traded funds that invest in depository receipts

Question 5

Compare the risk and return characteristics of types of equity securities

Accepted Answer

Equity investor return consist of dividends, capital gains or losses from changes in share prices, and any foreign exchange gains or losses on shares traded in a foreign currency. Compounding of reinvested dividends has been an important part of an equity investor's long-term return. Preferred stock is less risky than common stock because preferred stock pays a known, fixed dividend to investors: preferred stockholders must receive dividends before common stock dividends can be paid; and preferred stockholders have a claim equal to par value if the firm is liquidated. Putable shares are the least risky and callable shares are the most risky. Cumulative preferred shares are less risky than non-cumulative preferred shares, as any dividends missed must be paid before a common stock dividend can be paid.

Question 6

Explain the role of equity securities in the financing of a company's assets

Accepted Answer

Equity securities provide funds to the firm to buy productive assets, to buy other companies or to offer to employees as compensation. Equity securities provide liquidity that may be important when the firm must raise additional funds.

Question 7

Distinguish between the market value and book value of equity securities

Accepted Answer

The book value of equity is the difference between the financial statement value of the firm's assets and liabilities. Positive retained earnings increase the book value of equity. Book values reflect the firm's past operating and financing choices. The market value of equity is the share price multiplied by the number of shares outstanding. Market value reflects investor's expectations about the timing, amount, and risk of the firm's future cash flows.

Question 8

Compare a company's cost of equity, its (accounting) return on equity, and investors' required rates of return.

Accepted Answer

The accounting ROE is caculated as: ROE = firm's net income / average BV of common equity ROE measures whether management is generating a return on common equity but is affected by the firm's accounting methods. The firm's cost of equity is the minimum rate of return that investors in the firm's equity require. Investors required rates of return are reflected in the market prices of the firm's shares.

Question 9

Explain the uses of industry analysis and the relation of industry analysis to company analysis

Accepted Answer

Industry analysis is necessary for understanding a company's business environment before engaging in analysis of the company. The industry environment can provide information about the firm's potential growth, competition, risks, appropriate debt levels, and credit risk. Industry valuation can be used in an active management strategy to determine which industries to overweight or underweight in a portfolio. Industry representation is often a component in a performance attribution analysis of a portfolio's return

Question 10

Compare methods by which companies can be grouped, current industry classification systems, and classify a company, given a description of its activities and the classification system

Accepted Answer

Firms can be grouped into industries according to their products and services or business cycle sensistivity, or through statistical methods that group firms with high historical correlation in returns. Industry classification systems from commercial providers include Global industry classification standard (standard & poor's and MSCI Barra Russel Global Sectors Industry Classification Benchmark (Dow Jones and FTSE) Industry classfiication systems developed by government agencies include the International Standard Industrial Classification (ISIC) North American Industry Classification System (NAICS) Systems designed for the European Union and Australi/New Zealand

Question 11

Explain the factors that affect the sensitivity of a company to the business cycle and the uses and limitations of industry and company and company descriptors such as "growth", "defensive", and "cyclical".

Accepted Answer

A cyclical firm has earnings that are highly dependent on the business cycle. A non-cyclical firm has earnings that are less dependent on the business cycle. Industries can be affected classified as cyclical or non-cyclical. Non-cyclical industries or firms can be blassified as defensive (demand for the product tends not to fluctuate with the business cycle) or growth (demand is so strong that it is largely unaffected by the business cycle). Limitations of descriptors such as growth, defensive, and cyclical include the facts that cyclical industries often include growth firms; even non-cyclical industries can be affected by severe recessions; defensive industries are not always safe investments; business cycle timing differs across countries and regions; and the classifications of firms is somewhat arbitrary.

Question 12

Explain the relation of "peer group", as used in equity valuation, to a company's indsutry classification.

Accepted Answer

A peer group should consist of companies iwth similar business activities, demand drivers, cost structure drivers, and avilability of capital. To form a peer group, the analyst will often start by identifying companies in teh same industry, but the analyst should use other information to verify that the firms in an industry are comparable.

Question 13

Describe the elements that need to be covered in a thorough industry analysis

Accepted Answer

A thorough industry analysis should: evaluate the relationships between macroeconomic variables and industry trends estimate industry variables using different approaches and scenarios check estimates against those from other analysts compare the valuation for different industries compare the valuation for industries across time to determin risk and rotation strategies analyze industry prospects based on strategic groups classify industries by their life-cycle stage position the industry on the experience curve consdier demographic, macroeconomic, governmental, social, and technological influences examine the forces that determine industry competition

Question 14

Describe the principles of strategic analysis of an industry

Accepted Answer

Strategic analysis of an industry involves analzing the competitive forces that determine the possibility of economic profits Porter's five forces that determine industry competition are: 1. Rivalry amoung existing competitors 2. Threat of new entrants 3. Threat of substitute products 4. Bargaining power of buyers 5. Bargaining power of suppliers

Question 15

Explain the effects of barriers to entry, industry concentration, industry capacity, and market share stability on pricing power and return on capital.

Accepted Answer

High barriers to entry prevent new competitors from taking away market share, but they do not guarantee pricing power or high return on capital, espcially if the products are undifferentiated or barriers to exit resultin overcapacity. Barriers to entry may change over time. While market fragmentation usually resutls in strong competition and low return on capital, high industry concentration may not guarantee pricing power. If industry products are undifferentiated, consumers will switch to the cheapest producer. Overcapacity may result in price wars. Capacity is fixed in the short run and variable in the long run. Undercapacity typically results in pricing power. Producers may onverinvest in new capacity, especially in cyclical industries or if the capacity is physical and specialized. Non-physical capacity comes into production and can be reallocated more quickly than physical capacity. Highly variable market shares indicate a highly competitive industry. Stable market shares suggest less intense competition. High switching costs contribute to market share stabitliy.

Question 16

Compare characteristics of representative industries from various economic sectors

Accepted Answer

The elements of an industry strategic analysis are the major firms barriers to entry industry competition demographic influences governmetn influence social influence technological influence and whether the industry is growth, defensive or cyclical

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Equity Analysis and Valuation Flashcards

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