Exam 4 Flashcards
A technique for identifying underpriced or overpriced stocks based on ratios of the stock price to accounting fundamentals, like book value per share or EPS
Stock valuation using multiples
Stock Valuation using multiples:
Set a ____. If the ratio of price to fundamental is below average, the stock is considered relatively ___, and if above average, relatively ___.
Benchmark
Cheap
Expensive
Price to book value is the ratio of the market value of the ____ to its latest quarterly ____
Common stock
Book value
A low P/B is an indicator of a possibly ____ stock, while a high P/B might indicate that the stock price is well ___ the cost of replacing the company’s assets, and hence _____.
Undervalued
Above
Overvalued
In an efficient market, the P/B ratio will exceed 1 if the company is able to earn a ____ that exceeds the cost of _____.
Return on equity
Equity capital
Return on equity is ___ divided by ___, or the net income “return” as a percentage of book value
Net income divided by beginning book value
If net income return exceeds r, then the company is able to earn a higher return on its investments than the stockholder could earn elsewhere on comparable risk investments. Thus, the company is generating economic value, sometimes called “____”, on its available assets, and its stock will be priced ____ of book value
Residual income
In excess
If book value accurately measures replacement cost, there must be some _______ (government regulations, high fixed costs, economies of scale) for the long-term average P/B ratio to ___ one. Otherwise, if a company was able to earn an ROE above the cost of equity, you would expect increased ____ in the business, that would drive down ROE in the future
Barriers to entry
Exceed
Competition
Can the P/B be less than one in an efficient market?
Yes
If an industry is in decline, and there is little or no new investment into the industry, ____ often do not accurately reflect _____
Book values
True asset values
When book value does not accurately measure replacement cost, then the long-run or “_____” P/B is not equal to one. Book value differs from replacement cost because of _____ and _____
Equilibrium
Hidden assets and inflation
internally-developed patents and trademarks, past research and development expenditures, past advertising and other marketing expenditures, past start-up costs for employee training, customer relationships, and developed managerial expertise
Hidden assets
P/B’s should logically be ____ after a period of sustained inflation than after a period of stable or falling prices
Higher
Companies with long-lived “real” assets, particularly land and buildings, are most subject to this ___ bias
Inflation
Hidden assets of an acquired company are captured in ____, whereas hidden assets of a comparison firm without acquisitions are left out of ____
Goodwill
Book value
Merger-related comparability problem can be avoided by using ____ as an alternative to P/B
Price/Tangible Book Value
Tangible book value excludes ___ and other ____ assets from book value, so is unaffected by merger purchase accounting
Goodwill
Intangible
Historically, stocks with relatively ___ P/B ratios have earned higher future returns than stocks with relatively ___ P/B ratios
Low
High
Stocks with ___ book-to-market value, tend to outperform stocks with ___ book-to-market ratios
High
Low
Different measures of EPS in the P/E ratio (4):
- Most recent 12 months trailing EPS
- EPS forecast for the current fiscal year
- EPS forecast for a future fiscal year
- GAAP earnings versus ‘operating’ earnings
All else equal, it is better to have a ____ EPS and hence a ___ P/E, than to have ___ EPS and hence a ____ P/E
Positive and positive
Negative and negative
If EPS is negative for two different stocks, the ____ is not a meaningful tool for comparison between them
P/E ratio
The P/E ratio measures the cost of buying a stock as a multiple of the ____ or ___ per share
Earnings or profits
a stock with a P/E of 15 costs $___ to buy for every $__ of per share profits
$15
$1
In a simple analysis, a stock with a low P/E relative to others in the industry, sector, or overall stock market is considered ____
Underpriced
All else equal, in an efficient market, the forward P/E will be higher (3):
- The lower is r, the equity discount rate or cost of equity capital
- The higher the ROE, the return on equity - “good” growth from higher ROE
- The lower the payout ratio if ROE > r, the higher the payout ratio if ROE < r
The lower the perceived risk of a sock or stock index, the ___ the P/E
Higher
For individual stocks, beta from the CAPM measures the systematic risk of a stock relative to the overall market. The lower the systematic (beta) risk of a stock, the ___ the cost of equity capital r, and thus the ___ the P/E
Lower
Higher
Holding the payout ratio constant, firms with higher ROE will have ___ growth rates, and thus will have ___ P/Es than low ROE firms
Higher
Higher
The ____ the ROE, the greater is the opportunity for profitable reinvestment
Higher
For firms with high ROE, lower payout ratios are associated with ____ P/Es, because if the firm can earn a higher ROE than the cost of capital, more reinvestment into the business adds ___
Higher
Value
For firms with ROE below the cost of capital, a ____ payout is a good thing, increasing the ___
Higher
P/E
If ROE is less than r, stockholders would rather
Invest extra cash themselves than have the firm invest on their behalf
In order for the P/E to be a good investment indicator, the analyst must control for ____, ___, and ____.
Risk
Payout ratio
Return on equity
Growth resulting from a _____ is not as attractive, and can actually be value-destructive, compared with growth resulting from a _____
Low payout ratio
High ROE
Recession -> Temporarily ____ -> ____
Economic boom -> Temporarily _____ ->
Low profits -> High P/E
High profits -> Low P/E
Economic cycles have a big impact on P/E’s for ___ industries, such as autos, appliances, construction, basic materials, etc., because their earnings will _____ with the economy
Cyclical
Rise and fall dramatically
For cyclical industries, like auto, at the peak of the cycle, earnings are ___, and thus P/Es ___, if investors predict a future decline in earnings
Very high
Low
Historically, stocks with relatively ___ P/E ratios have outperformed stocks with relatively ___ P/E ratios
Low
High
P/E is a useful indicator of ___ value
Relative
Stocks with ____ E/Ps tend to outperform stocks with ___ E/Ps
High
Low
All else equal, stocks of companies with high leverage will be ____, and will therefore have a higher cost of equity r and low P/E in an efficient market
Riskier
The extent to which a company’s assets are financed with debt rather than equity
Financial leverage
A stock could appear “cheap” based on its P/E, when in fact it deserves a low price because of its high ___ and hence high ___
High Leverage and cost of equity
To get around the impact of leverage on the P/E ratio, analysts often compute multiples using (2):
- The total market value of equity, plus interest-bearing debt, minus cash and marketable securities in the numerator, defined as enterprise value
- Earnings before interest, taxes, depreciation, and amortization (EBITDA) in the denominator
Enterprise Value/EBITDA = [_____+____-____]/____
[Market Value of Equity + Book Value of Debt - Cash] / EBITDA (Earnings before interest, taxes, depreciation, and amortization)
A company with a low EV/EBITDA ratio is considered ____ in the market
Underpriced
The Enterprise Value/EBITDA essentially disregards ___ and ___ as expenses
Depreciation and Amortization (and taxes)
Price-Earnings to Growth (PEG) ratio is defined as the ratio of the ___ to the expected _____
P/E to the expected growth rate in earnings
The expected growth rate g (in percent) is typically assumed to equal the _______ forecast of Wall Street analysts
Consensus long-term (5 years) earnings growth
A stock with a ___ P/E, relative to the expected future growth of earnings, is more attractive to buy than a stock with a ___ P/E relative to its earnings growth rate
Low
High
The major advantage of the PEG ratio over the P/E is that it incorporates a ______
Forward-looking, long-term growth rate
P/E ratios are both theoretically (through ROE) and empirically positively associated with expected ____. If a stock has a low P/E simply because future growth prospects are poor, it is probably not a ___ stock
Earnings growth
Bargain
The major disadvantage of the PEG ratio is that it depends upon Wall Street’s earnings forecast, which tend to be overly ____ for popular stocks with ____ P/Es
Optimistic
High
Another disadvantage of PEG is that it does not distinguish between growth created by a ______ rate and growth create by a _____
High earnings reinvestment rate
High ROE
If two stocks have the same PEG, the stock with the higher ____ is better, all else equal
Higher dividend yield
A revenue multiple compares the total value of ___ or total value of ____ to the ___ generated
Equity or value of the firm to the revenue generated
Sales = ___
Revenue
Price/Sales = ___ per share/___ per share
Stock price per share/Revenue per share
Enterprise Value/Revenue = ____/____
Enterprise Value/Total Company Revenue
Enterprise Value = ____ + ____ or ____ + ____ - _____
Market Value of Equity + Net Debt
Market Value of Equity + Book Value of Debt - Cash and Marketable Securities
EV/Revenue
Price/Sales
Which should be used and why?
Ev/Revenue
Much more sensible because the entire firm, not just the equity, generates sales for the business
Price/Sales and EV/Revenue can be distorted by recent acquisitions. After an acquisition, the _____ immediately adjusts, but trailing-twelve-months revenue will take ___ to fully adjust
Enterprise value
A year
Advantages of EV/Revenue vs. P/E (3):
- Revenue figures are less subject to manipulation than earnings figures (“Operating” earnings differ, R&D, advertising)
- Revenue is more stable over time than earnings (Ex. Cyclical companies like auto industry with high fixed costs and variable earnings)
- Revenue is always non-negative, while earnings can be negative, making P/E uninterpretable
Disadvantage of EV/Revenue vs P/E (1):
It ignores the profit margin that the company is able to earn on its sales
The profit margin is obviously crucial to generating earnings, and ultimately free cash flow, from each dollar of sales
Stocks with relatively ___ market capitalization tend to earn higher future returns than stocks with ___ market capitalization
Small firm effect
Low
High
Two explanations for small firm effect:
Low liquidity and not well known to the investing public (neglected)
_______: Stocks that have earned high returns over the past 3-12 months tend to earn _____ future returns than do past 3-12 month losers
Momentum Effect
Higher
Post-earnings announcement drift: Stocks that have reported _____ earnings tend to outperform stocks reporting ___ earnings, even allowing for a couple of days to process the news
Better-than-expected
Lousy
Explanation to momentum effect and post-earnings announcement drift?
Sales and profit trends tend to last a while, and Wall Street is slow to a just expectations
Investment effect: Stocks that experience a high percentage growth in total assets tend to earn ______
Lower future returns
Investment effect explanation?
By keeping new investment spending relatively low, managers will only choose the most promising new projects. Too-rapid growth overextends the company
Profitability effect: Stocks with high pretax profits as percentage of ____ tend to earn ____ future returns
Book value
Higher
Profitability effect explanation?
Profits are more durable/persistent than investors recognize?
Accruals effect: Stocks with a large (positive) change in _____, scaled by ____, tend to earn lower future returns
Net working capital
Book value
Accruals effect explanation?
A big increase in inventory might indicate that product demand was overestimated. A big increase in accounts receivable might indicate that customers are having trouble paying their bills
Inventory buildup indicates weak sales, AR buildup indicates ‘channel stuffing’
Dilemmas in profiting from anomalies (4):
- Loss of diversification
- Transaction costs
- Statistical artifact
- Recognition leads to more efficient pricing over time
A futures contract is a contract to trade a specific ____ of an asset at a specific ____ at a price that is agreed upon ___
Quantity
Future date
Today
A futures contract obligates the seller to _____ to the buyer on a specified future date in exchange for the agreed-upon ____
Deliver the asset
Futures price
Futures contracts are ____, in that they derive their ___ from their underlying ____
Derivatives
Value
Assets
Futures contracts trade on an ____. As futures prices fluctuate after the contract is entered, profits and losses are settled daily in a procedure called ______.
Exchange
Marking to market
A forward contract is very similar to a futures contract, except it does not _____, and does not have a ____ feature
Trade on an exchange and does not have a marking to market feature
Futures exchanges allow for ____ trades. If I first buy a contract, I can sell the same contract before ____ to avoid taking ____ of the commodity. Ignoring commissions, I will earn a profit if the futures price at the time of reversal is ___ than the original ____ price
Reversing
Expiration
Delivery
Higher
Futures
Buying a futures contract is often referred to as “___” and selling is referred to as “___”
Going long
Going short
Even though I buy a futures contract, there is no initial ____. Similarly, selling a contract provides no upfront ____. However, the futures exchange will require ____ or ____ to be deposited by both the buyer and seller of the contract
Outflow of cash
Revenue
Performance bond
Margin
Possible motivations for trading motivations (3):
- Hedging
- Speculation
- Arbitrage
Individuals or firms that buy or sell a commodity in the course of their business and who could lose money if the price changes against them
Hedgers
Place a bet on the future price movements of a commodity but does not use the commodity in their ongoing business, just simply has an opinion on which way the price of the commodity will go
Speculation
The simultaneous purchase and sale of the same or equivalent security in order to profit from price discrepancies
Arbitrage
Before actually making a futures trade, the investor needs to deposit some money in their account. this money will be used as _____ for their future positions
Margin or performance bonds
Margin or performance bonds are used by the exchange to pay any ____ that the trader incurs to the other side of the ____. The margin deposit of the other party to the trade helps insure that if you start to _____ on a futures position, the other side of the trade will be able to ____
Losses
Contract
Make money
Pay up
Forward contracts are ____ transactions, and do not trade on ___. Margin may or may not be required, and is negotiable between the ____.
Private
An exchange
Two parties
Buyers and sellers of futures contracts must put up _____ with their brokers. Some brokers pay ____ on ___ balances to favored customers
Equal amounts of margin
Interest on margin balances
The amount that must be put up when the trade is placed which is usually __% or less of the ___ value
Initial margin
5% or less of the contract value
The margin for futures contract is higher the more ____ the underlying commodity or asset
Volatile
Marking to market:
If the futures price increases from yesterday, the seller pays the buyer the ___ in the ___ price
If the futures price decreases from yesterday, the buyer pays the seller the ___ in the ___ price
Increase in the futures price
Decrease in the futures price
Brokers and exchanges require that a ____ be maintained at all times after the position is established. If the value of their account falls below this level, the investor will receive a ____ from their broker and must deposit cash to bring them up to the ____ margin
Maintenance margin
Margin call
Initial
At present at the CME, the initial margin is set at ___% of the maintenance margin for speculator/non-members of the exchange. For exchange members, the initial margin is the same as the ____. If the customer is unable or unwilling to deposit enough money to get back to the initial margin, the broker will proceed to close out the position with a ____.
110%
Maintenance margin
Reversing trade
For many commodity futures, the ____ position has a choice as to the timing of delivery within the delivery month, and sometimes can deliver in _____ or ____, with lower prices for _____.
Short
Alternate locations or quality grades
Lower-quality goods
“Cornering the market” and “short squeezes” with physical delivery
Only a small percentage of futures contracts are actually held until ____. This is particularly true for ____ positions in futures with physical delivery. Even ___ make or take delivery infrequently, because it is often more convenient to buy or sell the actual commodity with suppliers or customers, not with another futures trader.
The delivery date
Speculative
Hedgers
To close out a ___ position before the expiration of the contract in a reversing trade or offset, you simply ___ the same number of contracts you had originally ____ to bring the net position to ___.
Long
Sell
Bought
Zero
The difference between the spot or cash price and the futures price is called the ___
Basis
Basis =
Spot price - Futures Price
S - F
Basis risk is the risk that the futures and spot prices will diverge in _____ when closing out a futures position prior to expiration
Unpredictable ways
If making or taking delivery is not desirable, hedgers minimize basis risk by choosing a contract that expires _____ after you plan to close out the position
Relatively soon
Cost-of-carry is the ___ cost of _____ the underlying commodity or asset over the life of the _____
Net
Carrying or owning
Futures contract
Carrying costs include (3):
- The interest cost of financing the purchase of the asset. Even if you have the cash to purchase the asset, there is an opportunity cost of lost interest from not investing the money elsewhere
- Storage and insurance cost, and spoilage costs for perishable commodities
- The cost of carry is reduced by any income that the asset produces. For example, owning a stock index produces dividend income, so owning stocks directly has an advantage over a long position in stock futures
For cost of carry, define F as the current _____, S as the current ___, and rf as the ____ for both borrowing and lending for maturity __. “FV” is ___ as of time T.
Futures or forward price
Spot price
Risk-free rate
T
Future value
The future value of the storage cost is the cost, billed as of time T, from holding the commodity from now until time T. It includes ____ to store the commodity, and also ____, and any ____ costs
Rent for space
Insurance
Spoilage
The total carrying cost, including both interest and storage, is always ____ for commodities, so the theoretical futures price always exceeds the ___ price
Positive
Spot
Often, the futures price for agricultural commodities is ____ the cost of carry formula predicts. This is because arbitrage does not work very well in _____ markets, particularly because it is usually impossible to short sell an ____ commodity
Less than
Commodity
Agricultural
Financial futures pricing cost of carry formula:
F = S(1+rf)^t - FV(Dividends)
Options are contracts giving the purchaser the right to buy or sell a security, such as a stock, at a ___ price within a specified ____
Fixed
Period of time
Like futures contracts, option contracts are ____, in that they derive their value from their underlying assets
Derivatives
Two major types of options:
Calls and puts
A call option is a contract that gives the buyer the right, but not the ___, to _____ an asset for a fixed price, called the ___ or ___ price, up through a fixed ____ date
Obligation
Purchase
Strike or exercise price
Expiration
Calls:
If the right to exercise is “any time until maturity”
American or American-style option
Calls:
If the right to exercise is only “at the time of maturity”
European or European-style option
The majority of options traded are ____ style options. All options on individual stocks are ____ style
American
American
At initiation of the call contract, the call buyer will pay the seller the ____ price, sometimes called the option ____
Call option
Premium
The seller of a call option is required to deliver the asset in exchange for the ____ price if the call buyer so desires
Strike
Since there is no theoretical upper limit on the price of the asset in the market, the seller of a ‘___’ call (a call sold without accompanying ownership of the asset) is exposed to unlimited potential ____
Naked
Losses
With a call option contract, ____ will need to put up margin with their brokers
Naked call writers
Sellers
A put option is a contract that gives the buyer the right, but not the _____, to ___ an asset for a fixed price, called the ___ or ___ price, up through a fixed expiration date
Obligation
Sell
Strike or exercise price
At initiation of the contract, the buyer will pay the seller the put option ____. The seller of a put is required to ____ of the asset in exchange for paying the ___ price if the put buyer so desires
Premium
Accept delivery
Strike
Puts:
Since the lower limit of the asset price is zero, the seller of a ‘__’ put (a put sold without an accompanying short position in the asset) is exposed to a (large) potential loss equal to the ____ less the ____ received upfront
Naked
Strike price
Put premium
_____ will need to put up margin with their brokers for puts
Naked put writers
Seller
Buying a option is often referred to as having a “___” position, and having sold an option is referred to as having a “____” position. Selling an option is also referred to “____” an option
Long
Short
Writing
At expiration, a call is worthless if _____, but its value increases one-for-one with the stock price if ______. If you own a call option, you receive a positive net cash flow from exercising if the ____ price is greater than the ____ price
St < X
St > X
Stock
Strike
Call Payoff example:
If I am long a call with a strike price of $50, if the stock price is $60 at expiration my payoff is $__, if the stock price is $50 my payoff is $__
$10
$0
Owning a call (or put) requires an upfront investment. Ignoring commissions, you make a profit from owning an option if it finishes _____ and the amount by which it finishes _____ exceeds what you _____
In-the-money
In-the-money
Paid for it
For example, if I am long a call with a strike price of $50 that I purchased for $4, if the stock price is $60 at expiration, my profit is $___ and if it is $50 or below at expiration my profit is $___
$6
-$4
A put is worthless if __ > __, but its value increases by $1 for every $1 decrease in the stock price if ___ < ___.
St > X
St < X
If you own a put option, you receive a positive net cash flow from exercising if the stock price is ___ the strike price
Less than
For example, if I am long a put with a strike price of $50, if the stock price is $40 at expiration my payoff is $___ and if it is $50 or above at expiration my payoff is $___
If my put cost $6 upfront, my profit is $___ in the former case and $___ in the latter
$10
$0
$4
$-6
Places a floor on the value of the position as of the expiration date
Protective put strategy
At-the-money means
Current stock price equals the strike price
In-the-money means
If you exercised now, you would get a positive payoff
In-the-money
Calls - ___ > ___
Puts - ___ < ___
Calls - Stock Price > Strike Price
Puts - Stock Price < Strike Price
Out-of-the-money means
A negative cash flow from exercising now
Out-of-the-money
Calls - ___ < ___
Puts - ___ > ___
Calls - Stock Price < Strike Price
Puts - Stock Price > Strike Price
Option price = ___ + ___
Intrinsic value + time value
Intrinsic value is the amount the option would be worth if you were forced to decide whether to exe cerise or not ___, assuming the option is American style
Now
For a call, intrinsic value = ____
For a put, intrinsic value = ____
Max{0, S - X}
Max{0, X - S}
Time value is the difference between the ____ of an option and its _____
Market price and its intrinsic value
In an efficient market, time value is always ____ or equal to ____ for American-style options
Greater than or equal to zero
Protective put: Owning asset combined with long put option: guarantees minimum proceeds equal to the put’s ____
Exercise price
Suppose the stock I own now trades at $55 and I buy a put with a strike of $50 for $4. If the stock drops to $40 at expiration, I will exercise, receiving $__. My loss is $__, a smaller loss than $__ if I had not purchased the put. If the stock rises to $70 at expiration, I will not exercise. My profit is $__, a smaller profit than $__ if I had not purchased the put
Receiving: $50
Loss: $5 + $4 = $9
Smaller than: $55-$40 = $15 (without the put)
Profit: $15 - $4 = $11
Smaller than: $70 - $55 = $15 (without the put)
Writing call on asset together with owning asset (long asset plus short call)
Covered call
Suppose the stock I own now trades at $55 and I write a call with a strike of $60 for $4. If the stock drops to $40 at expiration, the call buyer will not exercise. My loss is $__, a smaller loss than $__ if I had not written the call. If the stock rises to $70 at expiration, the call buyer will exercise. My profit is $__, a smaller profit than $__ if I had not written the call
Loss: $15 - $4 = $11
Smaller than: $55 - $40 = $15 (without writing the call)
Profit: $5 + $4 = $9
Smaller than: $70 - $55 = $15 (without writing the call)
Sell put, and lend the present value of the strike price, ensuring you have enough cash if the put is exercised against you at the maturity date
Covered put writing
Covered put writing can be superior to covered call writing if put options are relatively ____ in the market versus calls, and/or the dividends paid on the stock through expiration turn out to be ___ than expected
Overpriced
Less
Combination of call and put, each with same exercise price and expiration date
Straddle
Buy call and buy put
Long straddle
Write call and write put
Short straddle
A long straddle is a bet that the stock will end up _____ the strike price, in either direction. So, it is a bet that volatility will be ____ than expected in the market
Far away from
Higher
A short straddle is a bet that the stock will end up _____ the strike price. So, it is a bet that volatility will be ____ than expected in the market
Near
Lower
Vertical spread is the combination of two or more call options/put options on same asset with differing _____ but the same _____
Exercise prices
Expiration date
Buy call with low strike and write call with high strike
Bullish call spread
Buy call with high strike and write call with low strike
Bearish call spread
Buy put with low strike and write put with high strike
Bullish put spread
Buy put with high strike and write put with low strike
Bearish put spread
Collared stock position is a stock and options strategy that brackets value of portfolio between two bounds. You own the stock, buy a ___ with a strike ____ current stock price, and sell a ___ with a strike ____ current stock price
Put
Below
Call
Above
A ‘zero-cost’ collar is a collar where the ____ price equals the ___ price
Call price equals put price
Put-call parity is the relationship between the price of a _____ and the price of a ____ with the same ___ price and ______
European call and European put
Strike
Expiration date
From put-call parity formula, owning a call is like owning the ____ until the expiration date without receiving the ____, protected by owning a ___, and partially financed by borrowing the present value of the ____ price.
Stock
Dividend income
Put
Strike
Put-call parity formula: Owning a put is like ____ the stock until the expiration date without having to pay the ____ on a ____, protected by owning a ____, and lending the present value of the ___ price
Shorting
Dividends
Short sale
Call
Strike
