Investment Formulas to remember

Question 1

What is the formula for the Zero Growth Dividend Model?

Answer 1

Price= Dividend/Req. Rate of Return

Question 2

What is the constant Dividend Growth Model and what does it tell us?

Answer 2

IV (intrinsic Value)= dividend (1 + growth rate of dividend)/required rate of return-constant growth rate

We are trying to determine if a stock is overvalued and undervalued
IV is GREATER than CMP.. buy the stock. Why? B/c its undervalued
IV is LESS than CMP..don’t buy the stock. Why? B/c its overvalued

Question 3

Dividend Discount Model Shortcuts

Answer 3

When 1st growth rate is lower than 2nd growth rate, pick the NEXT LOWEST NUMBER.

You will use the constant number when solving the dividend discount model question, but you will pick answer based on the next lowest number. So for example:

Stock is expected to grow its $2 div by 6% for 3 years. After, dividends will grow at constant of 8%.

3 (1.08)/ .10-.08= 108… pick next lowest number

When the 1st growth rate is higher than 2nd growth rate, pick NEXT HIGHEST NUMBER.

Stock is expected to grow its $2 dividend by 15% for 3 years. After, it will grow at 10%.

Start by finding the constant growth.

2(1+.10)/.12-.10=110.. pick next highest number

Question 4

What are some key facts on the dividend discount model?

Answer 4

**based on assumptions.

If investors RR GOES UP, value of Common Stock goes DOWN
If investors RR GOES DOWN, value of Common Stock goes UP

If mkt LOWERS the RR of a stock, the value of common stock will RISE
If IV is LOWER than mkt value, the investor will earn a LOWER rate of return–> sell stock.

If investors expect that growth in dividends will be higher as a result of favorable development for the firm, the value of common stock will RISE

Question 5

What is the P/E ratio and what does it tell us?

Answer 5

Price to earning ratio-can tell us if a stock is overvalued or undervalued relative to its earnings.

Earnings X PE ratio they give you= PE ratio

Question 6

What is Price/Free Cash Flow formula and what does it tell us?

Answer 6

Price to Free Cash Flow determine whether or not to buy a stock.. it’s similar to Div. Discount Model.

Example: FCF is $3.00. The projected FCF growth rate is 5% and clients RR is 10%. You are trying to find the intrinsic value

Formula: FCFo (1+g)/required rate of return-growth rate

So, 3.00(1.05)/.10-.05= $63

Question 7

What is Book to Value?

Answer 7

It’s the accounting value of the the equity shown on a balance sheet. The sum of common stock outstanding, capital in excess of par, and retained earnings.

assets- liabilities- pref. equity common

Question 8

Return on Equity. What is it/what does it tell us and what is the formula?

Answer 8

it’s a measure of a company’s profitability and if it’s increasing or decreasing and why. Its a Key component in determining earnings growth and dividend growth.

Formula: ROE= earnings available for common/common equity(net worth or book value)

Question 9

What is the Dividend Payout Ratio formula and what does it tell us?

Answer 9

Div; payout ratio= Common Dividends Paid/EPS

it’s the percentage of earnings paid to common shareholders as cash dividends

Question 10

What is EPS?

Answer 10

ROE(per share)X Book Value or net worth (per share)

Question 11

What is Modern Portfolio Theory?

Answer 11

• seeks to quantity the relationship b/w RISK AND RETURN
• assumes investors must be compensated for taking on the risk
• emphasis is on diversification

Question 12

What is YTM? What does it tell us?

Answer 12

It’s the compounded rate of return you will receive from a bond if you hold it to maturity. you are solving for IYR

• all interest payments are reinvested
• takes into account mp of a bond, capital gains/losses if held to maturity
• *ALWAYS USE SEMI ANNUAL COMPOUNDING EVEN WITH ZEROS**

EXAMPLE: Bond Sells for $875. Coupon is 8%. Maturity is 7 years. What is the YTM? (REMEMBER: to find payment, 8% X $1,000= $80)

PV: 875 +-
N: 7x2
PMT: 80/2
FV:1,000
IYR: 5.2860x2 = 10.57 (you multiple by 2 bc you did semi-annual)

Question 13

How do you calculate a bond that’s called before maturity?

Answer 13

It takes into account the possibility that a bond may be called by issues before the maturity date.

What do you do?

1. par value at maturity is replaced with the call amount.. this goes into FV
2. original maturity date is replaced with first potential call date.. this goes into N

Example: client buys a 1,000 bond issues at par maturing in 10 years. The coupon is 8% compounded annually with a market price of $1,147.20.
Per the indenture agreement: the bond may be called after 5 years for $1,050. Solve for YTC.

1st, we know payments at 80

PV: 1,147.20
FV: 1,050
N: 5
PMT: 80
IYR: 5.45

Question 14

What is the current yield? what does it tell us?

Answer 14

Current yield= annual interest in dollars/bonds current price

Ex: bond with a 10% coupon is now selling for $900. What is the current yield?
so, 1,000x10%= 100

so 100/900 (CMP)= 11.11%

Question 15

What is Taxable Equivalent Yield?

Answer 15

It’s the interest rate on taxable bonds necessary to provides the same after tax return as a municipal security. TEY.. it’s TAXABLE EQUIVALENT YIELD. NOT tax-exempt yield.

TEY= tax-exempt yield/ 1+ tax rate

NOTE!! if the tax exempt yield and tax rate are provided, you can solve this way:

taxable yield= tax-exempt yield/

Question 16

What is the Security Market Line and what does it tell us?

Answer 16

• It represents the relationship of RISK AND RETURN for efficient portfolio’s on the micro level.
• it’s for individual assets
• does not matter if portfolio is diversified or non-diversified (efficient or inefficent)

Question 17

What is the security market line formula (SML)?

Answer 17

It’s also know as the CAPM (capital asset pricing model)