Exam Flashcards
What is the difference between intrinsic value and stock price?
Intrinsic (accounting) value is an estimate of the actual true value of a company. Market or stock value is the value of a company as reflected by the Company’s stock price - it’s what they’re actually worth.
What is a Capital Market?
A capital market is a market for buying and selling equity and debt instruments. They essentially give savings to people who need cash, promising to give it back through interest and extra dividends in the future.
What are the primary and secondary markets?
The primary market is where new securities are bought and sold for the first time, where the secondary market is for existing, used securities, rather than new issues.
What are the advantages and disadvantages of listing on the stock exchange (going public)?
Share issue raises capital, get the right value, and exposure to the capital market. The disadvantages are the cost and the stock exchange regulations that must be complied with.
What do Stock Price and Volume charts show?
The movements of the two. Stock price movements are driven by information in the market, and investors tend to engage in trading activities after the information is in the market.
What is market efficiency, and what are the foundations of Efficient Market Hypothesis?
An efficient capital market is one where the stock price fully reflects all available information. The foundations of EMH are rationality, independent deviations from rationality, and arbitrage.
What are the three versions of EMH?
Weak form - historical market trending data, such as past prices and volumes are incorporated into share prices
Semi-strong form - all publicly available information is incorporated into share prices
Strong form - all information including public, private and insider are incorporated into share prices
*the top 2 are inefficient because there is a possibility of someone having insider knowledge and profiting
What are the seven analysis of information?
Stock price and volume charts, volume analysis, bid-ask spread and liquidity, 52-week price changes, analysts following, ownership structure, and special events
What is the bid ask spread formula and inputs?
Spread = (2 x (Ask - Bid))/ (Ask + Bid), where
Bid is the highest price investors are willing to pay for a stock
Ask is the lowest price investors are willing to sell a stock
Why do firms disclose bad news?
- avoid reputations cost
- regulatory requirement
- corporate governance
- litigation risk
What is Analyst Following, and what are some benefits?
Analyst following is someone (often who works for an investment bank) who has a key objective to identify mispriced shares. The benefits are improved stock visibility and corporate governance.
What is a firm’s profit potential determined by, and what is the possible information used in a valuation?
A firm’s profit is determined by macroeconomic and other external environmental factors, condition of the industry, and management strategy.
The possible information includes economic growth (TEMPLES), industry analysis (porter’s 5 forces), and company-ape I doc information.
What does TEMPLES stand for?
Technology Economy Market Political Legal Environmental Society
What are Porter’s 5 forces, and how should you begin this analysis in the exam?
- Rivalry among existing firms
- Threat of new entrants
- Threat of substitute products
- Bargaining power of buyers
- Bargaining power of suppliers
Begin with defining the industry, being specific and including geographic location.
What are the two basic competitive strategies?
Cost leadership and differentiation
What is the purpose of Accounting Analysis?
Accounting analysis evaluated the degree to which accounting captures the reality of the business, essentially trying to assess the accounting quality of financial statements.
Accounting distortions must be mitigated, or recognised to ultimately need to be reversed. For example, if you adjust revenues to make them look $1 higher this period, revenue will need to be reduced by $1 in the future.
What are the two components of NPAT?
Cash (transactions-based)
Accruals (adjustments-based)
What is earnings management, and what is the impact?
Earnings management, or income smoothing, is often defined as the planned timing of revenues, expenses, gains and losses to smooth out bumps in earnings. The impact is that it damaged the perceived quality of reporting, and will eventually lead to unnecessary stock price fluctuations.
What are the 3 categories, and 2 examples, of incentives for Earnings Management?
- External forces, for example analyst forecasts or competition
- Internal factors, for example management compensation or unlawful transactions
- Personal factors, such as personal bonuses and ego of executives
What is Conservative versus Liberal Accounting a matter of?
Accounting policy
What is the difference between Aggressive and Big Bath Accounting, and what are they a matter of?
Aggressive accounting wants to increase profit, while Big Bath wants to temporarily decrease profit so it can increase in the future.
This is a matter of short-term accounting application they will reverse.
What are some Institutional Situations where manipulation is more likely?
Firm in the process of raising capital or renegotiation borrowings
Debt covenants likely to be violated
Auditor or management change
Management rewards tied to earnings
Management re-pricing exec stock options
Weak governance structure
Regulatory ratio requirement likely to be violated
Not arm length transaction
Special events such as union negotiations
Firm “in place” as takeover target
Firm engages exotic arrangements
What are some Financial Statement Indicators that manipulation is more likely?
Change in accounting principles/ estimates
Earnings surprise
Drop in profitability after good period
Constant sales or falling sales
Earnings growing faster than sales
Very low earnings
Small or zero profit margin increase
Firm ‘just’ meets analyst expectations
Difference in expenses for tax and financial reporting
Financial reports used for other things like union negotiations
Accounting adjustments in last quarter of FY
What are the three potential sources of accounting data distortions?
- random estimation errors
- rigidity in accounting rules
- systematic accounting choices
What are the steps in performing an accounting analysis?
- Identify principal accounting policies
- Assess accounting flexibility
- Evaluate accounting strategy
- Evaluate the quality of disclosure
- Identify potential red flags
- Undo accounting distortions
What is some ways CEO’s are incentivised?
A CEO gets a base salary regardless of performance, and so having a low base salary but linking bonuses to performance ties performance with financial reward (Twitter CEP). However, if a CEO wants to be reinstated and kept on by the Board, they need to prove they are doing good things. Also, reputation is often big for CEO
What is Earnings Persistence?
The ability of current earnings to predict future earnings.
What are the Balance Sheet Approach, and Cash Flow Approach formulas to measure the quality of Accruals?
Balance Sheet: accrual ratio = ((NOAend - NOAbeg)/ ((NOAend + NOAbeg)/2))
CF Statement: accruals ratio = ((NI - CFO - CFI)/ ((NOAend + NOAbeg)/2))
What are the four steps of business analysis?
- Business strategy analysis includes identifying key success and risk factors etc., to set up the rest of the analysis
- Accounting analysis which undoes accounting distortions by recasting accounting numbers
- Financial analysis, which aims to use financial data to analyse the performance of a firm
- Prospective analysis uses all the above to make predictions of future performance
What is the lemons problem?
The lemons problem states that if investors rely solely on management info on investment proposals, they cannot distinguish between good and bad ideas as management will frame them all as good. They therefore treat them all as ‘average’, and good ideas aren’t put forward as they are under appreciated.
What is the difference between fundamental and technician analysis, and the underlying assumptions?
Fundamental analysis uses info in financial statements and other sources to assess expected future performance, and likely value.
Technician analysis uses patterns of share price changes, trading volumes, etc. to make recommendation to buy or sell a share.
What are the two competitive advantage strategies, and what is a companies major investment under both?
- Cost leadership, where companies invest in logistics to ensure maximum efficiency
- Product differentiation, where companies invest in R&D, technology, marketing, etc.
What are the two cash flow formulas?
FCFF - (CF(1 + g))/ (rWACC - g)
FCFE - (CF(1 +g))/ (rE - g)
How do you calculate cost of debt?
Total interest expense / total debt
How are preference dividends and other dividends classified?
Preference dividends are expenses because a company has to pay, while dividends are equity because the company chooses how many of their profits get paid to shareholders (if any)
What are the accounts which affect working capital from operations?
Accounts receivable, inventory, cash/ cash equivalents, accounts payable, other current liabilities
What are the four possible measures of growth rates?
- Sustainable growth rate
- Historical growth rate
- Industry average growth rate
- Growth rate implied by current share price, or dividend growth rate
What is working capital?
Operating liquidity available to a business
What is the WACC formula?
WACC = (D/V)rd(1-t) + (E/V)re
What is the cost of equity formula?
re = rf + Beta(rm- rf)
What is the implied cost of equity model?
re = ((D0(1+g)/ P0) + g
What is the dividend discount model growth formula?
Vt = (DIV(1+g)/ (re-g)
Why is FCFF better?
Asset betas are more constant than equity betas, you don’t have to forecast for each period, and you need to substrate the value of debt and value of assets
What is the Residual Income Model (Residual Operating Income Model)?
Ve0 = NOA0 +(ReOI/(1+rc)^t) + ((TVt - NOAt)/(1+rc)^t) - NFOt
What is the link between proprietary costs and disclosure of information?
When considering how much information to disclose, management face the trade off between quality disclosures which reduce information asymmetry, and the potential proprietary costs of competitors knowing too much information.
What is the traditional formula for a Company’s leverage?
ROE = ROA x Financial Leverage
What are the steps in calculating share price?
Table using FCF to find PV (using cost of equity as growth rate)
Determine TV by FCF(1+g) over r less g
PV of TV,
plus total PV of finite cost to get total value of equity
Outstanding number of shares
Share price
What are two limitations of the dividend discount model?
- can’t use it for companies that have not paid dividend
- it is hard to predict future payments if there is no pattern to previous payments
Analyse the CAPM model using market return-based measure of beta for less liquid stocks.
Stocks less liquid or less frequently taxed will not follow the pattern of market return beta is calculate off, meaning Beta estimation will not represent true risk for the business. We could use industry beta for example to help prevent this
What is the CAPM model?
Expected return = beta(portfolio return - risk free rate), or
Cost of equity = rf +beta(market risk premium)
What is the DuPont Traditional ROE formula?
Profit margin x Asset turnover x Leverage,
Where PM is NI/ sales and L is Av TA / Av SE
What is the formula for net income?
NOPAT - after tax interest expense
What is closing equity made up of?
Closing equity = opening equity + profit - dividends + equity injection - buybacks
