Investment general concepts

Question 1

Limit order.

Answer 1

A limit order is a take-profit order placed with a bank/brokerage to buy or sell a set amount of a financial instrument at a specified price or better.

Question 2

What is the different between a market order and a limit order?

Answer 2

• A market order deals with the speed of execution and completion of the trade, the price is secondary.
• A limit order deals primarily with the price: if the security’s value is currently resting outside of the parameters set in the limit order, the transaction does not occur.

Question 3

How does a limit order work?

Answer 3

A broker receives a security trade order and that order is processed at the current market price.

Question 4

Why are stock market transactions not guaranteed to execute?

Answer 4

All stock market transactions can vary significantly based on the timing and size of the order and the liquidity of the stock.

Question 5

Why are market fluctuations a risk for market orders?

Answer 5

Because the price of the stock may change between the time the broker receives the order and the time the trade is executed.

Question 6

When does a market order placed after trading hours will be filled?

Answer 6

It will be filled at the market price on open the next trading day.

Question 7

What is the advantage of a limit order?

Answer 7

A limit order offers the advantage of being assured the market entry or exit point is at least as good as the specified price.

Question 8

What are the conditions in which a limit order is especially useful?

Answer 8

When an asset is:

1. thinly traded.
2. highly volatile.
3. has a wide bid-ask spread.
4. is not listed on a major exchange, so that finding its actual price is difficult.

Question 9

What are the cons of a limit orders?

Answer 9

1. Should the actual market price never fall within the limit order guidelines, the order may fail to execute.
2. Another possibility is that a target price may finally be reached, but there is not enough liquidity in the stock to fill the order when its turn comes.
3. A limit order may sometimes receive a partial fill or no fill at all due to its price restriction.

Question 10

What is the effect of the bid-ask spread on a limit order?

Answer 10

Both the ask price and the bid price must fall to the trader’s specified price.

Question 11

What is the Internal Rate of Return (IRR)?

Answer 11

Internal rate of return, also referred as “economic rate of return” or “discounted cash flow rate of return” is a discount rate that makes the net present value (NPV) of all cash flows from a particular project equal to zero. IRR calculations rely on the same formula as NPV does.

Question 12

What is omitted from the IRR?

Answer 12

The use of “internal” refers to the omission of external factors, such as the cost of capital or inflation, from the calculation.

Question 13

What is the Net-Present-Value (NPV) formula?

Answer 13

• C_t = net cash inflow during the period t
• C_o = total initial investment costs
• r = discount rate
• t = number of time periods

Question 14

How to calculate IRR?

Answer 14

To calculate IRR using the formula, one would set NPV equal to zero and solve for the discount rate r.

Question 15

What is the Net-Present-Value (NPV)?

Answer 15

Net present value (NPV) is the difference between the present value of cash inflows and the present value of cash outflows. NPV compares the value of a dollar today to the value of that same dollar in the future, taking inflation and returns into account.

Question 16

What are the advantages and disadvantages?

Answer 16

Advantages:

• The NPV method is a direct measure of the dollar contribution to the stockholders.
• The IRR method shows the return on the original money invested.

Disadvantages:

• The NPV method does not measure the project size.
• A multiple IRR problem occurs when cash flows during the project lifetime are negative (i.e. the project operates at a loss or the company needs to contribute more capital).

Question 17

When does the NPV and IRR give conflicting answers?

Answer 17

For mutually exclusive projects either because of the timing of cash flows and/or project size.

Question 18

What is the Price-to-Earnings (P/E) ratio?

Answer 18

Also referred as price multiple or earnings multiple, it the ratio for valuing a company that measures its current share price relative to its per-share earnings. In essence, the P/E ratio indicates the dollar amount an investor can expect to invest in a company in order to receive one dollar of that company’s earnings.

Question 19

What are the investor expectations with respect to the P/E ratio?

Answer 19

• In general, a high P/E suggests that investors are expecting higher earnings growth in the future compared to companies with a lower P/E.
• A low P/E can indicate either that a company may currently be undervalued or that the company is doing exceptionally well relative to its past trends.
• When a company has no earnings or is posting losses, in both cases P/E will be expressed as “N/A.”

Question 20

What are the limitations of the P/E ratio?

Answer 20

• When comparing companies from different sectors which earn money different and with a different timeline.
• An individual company’s P/E ratio is much more meaningful when taken alongside P/E ratios of other companies within the same sector: e.g. an individual company’s high P/E ratio, for example, would be less cause for concern when the entire sector has high P/E ratios.
• Moreover, because a company’s debt can affect both the prices of shares and the company’s earnings, leverage can skew P/E ratios as well. For example, suppose there are two similar companies that differ primarily in the amount of debt they take on. The one with more debt will likely have a lower P/E value than the one with less debt.
• As opposed to price, earnings are often reported by companies themselves and so can be manipulated.

Question 21

What are the disadvantages of NPV as an investment criterion?

Answer 21

• Sensitivity to discount rates, and pegging a % number to an investment to represent its risk premium is not an exact science.
• Different levels of risks through the entire time horizon means using different discount rates for each time period, making the model even more complex and possibly inaccurate (more discount rates to peg).
• Exclusion of the value of any real options that may exist within the investment. E.g. startup with opportunity to expand in 3 years.

Question 22

What is valuation?

Answer 22

Valuation is the process of determining the current worth of an asset or a company.

Question 23

What is the market value?

Answer 23

The market value of a security is determined by what a buyer is willing to pay a seller, assuming both parties enter the transaction willingly.

Question 24

How earnings impact valuation?

Answer 24

EPS is an indicator of company profit because the more earnings a company can generate per share, the more valuable each share is to investors. Analysts also use the price-to-earnings (P/E) ratio for stock valuation, which is calculated as market price per share divided by EPS.

Question 25

What is intrinsic value?

Answer 25

• Intrinsic value, however, refers to the perceived value of a security based on future earnings or some other company attribute unrelated to the market price of a security.
• Intrinsic value is also used in options pricing to indicate the amount that an option is “in the money.”

Question 26

How can the intrinsic value be computed?

Answer 26

• Using fundamental analysis to look at both qualitative aspects of the business: business model, governance, and target market factors.
• Using quantitative aspects of the business: ratios and financial statement analysis.

Question 27

What is discounted cash flow (DCF)?

Answer 27

Discounted cash flow (DCF) is a valuation method used to estimate the attractiveness of an investment opportunity. DCF analyses use future free cash flow projections and discounts them, using a required annual rate, to arrive at present value estimates. A present value estimate is then used to evaluate the potential for investment. If the value arrived at through DCF analysis is higher than the current cost of the investment, the opportunity may be a good one.

Question 28

What is the DCF formula?

Answer 28

DCF = [CF₁ / (1+r)¹] + [CF₂ / (1+r)²] + … + [CF_n / (1+r)ⁿ]

• CF = cash flow
• r = discount rate (WACC)

Question 29

What is the compound annual growth rate (CAGR)?

Answer 29

The CAGR is the mean annual growth rate of an investment over a specified period of time longer than one year.

Question 30

How to calculate the CAGR?

Answer 30

Divide the value of an investment at the end of the period in question by its value at the beginning of that period, raise the result to the power of one divided by the period length, and subtract one from the subsequent result.

Question 31

What is a bond?

Answer 31

A bond is a fixed income investment in which an investor loans money to an entity (typically corporate or governmental) which borrows the funds for a defined period of time at a variable or fixed interest rate.

Question 32

For what bonds are used?

Answer 32

Bonds are used by companies, municipalities, states and sovereign governments to raise money and finance a variety of projects and activities.

Question 33

How are called owners of bonds?

Answer 33

Debtholders or creditors of the issuer.

Question 34

What is working capital?

Answer 34

Working capital, also known as net working capital, is the difference between a company’s current assets, like cash, accounts receivable (customers’ unpaid bills) and inventories of raw materials and finished goods, and current liabilities, like accounts payable.

Working capital is a measure of both a company’s operational efficiency and its short-term financial health.

Working Capital = Current Assets - Current Liabilities

Question 35

What does the working capital ratio measure?

Answer 35

The working capital ratio (current assets/current liabilities), or current ratio, indicates whether a company has enough short-term assets to cover its short-term debt.

• A good working capital ratio is considered anything between 1.2 and 2.0.
• A ratio of less than 1.0 indicates negative working capital, with potential liquidity problems.
• A ratio above 2.0 might indicate that a company is not using its excess assets effectively to generate maximum possible revenue.

Question 36

What is a security?

Answer 36

A security is a fungible, negotiable financial instrument that holds some type of monetary value. It represents an ownership position in a publicly-traded corporation (via stock), a creditor relationship with a governmental body or a corporation (owning that entity’s bond), or rights to ownership as represented by an option.

Question 37

What are the 3 types of securities?

Answer 37

1. Equity security: represents ownership interest held by shareholders in an entity (a company, partnership or trust), realized in the form of shares of capital stock, including shares of both common and preffered stock.
2. A debt security represents money that is borrowed and must be repaid, with terms that stipulates the size of the loan, interest rate and maturity or renewal date.
3. Hybrid securities combining characteristics of both debt and equity securities.

Question 38

What are holders of equtity securities entitled to?

Answer 38

• They are not entitled to regular payments, although equity securities often do pay out dividends.
• They may be able to profit from capital gains when they sell the securities.
• They have some control of the company on a pro rata basis, via voting rights.

Question 39

What happens to holders of an equity security whose company is bankrupt?

Answer 39

They share residual interest after all obligations have been paid out to creditors.

Question 40

What are holders of of debt securities entitled to?

Answer 40

They are generally entitled to regular payment of interest and repayment of principal regardless of the issuer’s performance, along with any other stipulated contractual rights (which do not include voting rights). They are typically issued for a fixed term, at the end of which they can be redeemed by the issuer.

Question 41

What does it mean that debt securities are secured or unsecured?

Answer 41

• Secured: backed by collateral.
• Unsecured: not backed by collateral, but may be contractually prioritized over other uncsecured, subordinated debt in the case of a bankruptcy.

Question 42

What are examples of debt securities?

Answer 42

• Government and corporate bonds.
• Certificates of deposits (CDs).
• Collateralized securities (CDOs and CMOs).

Question 43

What are examples of hybrid securities?

Answer 43

• Equity warrants.
• Convertible bonds.
• Preference shares.

Question 44

What are equity warrants?

Answer 44

Options issued by the company itself that give shareholders the right to purchase stock within a certain timeframe and at a specific price.

Question 45

What are convertible bonds?

Answer 45

Bonds that can be converted into shares of common stock in the issuing company.

Question 46

What are preference shares?

Answer 46

Company stcoks whose payments of interest, dividends or other returns of capital can be prioritized over those of other stockholders.

Question 47

What are preferred stock special?

Answer 47

Although preferred stock is technically an equity security, it’s often treated as a debt security, because it “behaves like a bond”: It offers a fixed dividend rate and is a popular instrument for income-seeking investors. It is essentially fixed-income security.