Investment management competencies Flashcards
Risk
he riskiness of a portfolio is defined as the standard deviation of the portfolio’s expected returns. Standard deviation is a measure of volatility.
Goals of portfolio managers
to achieve the highest rate of return possible given the asset class he or she is investing in while minimizing risk.
Correlation
If two stocks have a strong negative correlation, they will tend to move in opposite directions.
Portfolio risk vs. a single security’s risk
Rather than look at risk at the individual security level, portfolio managers must constantly measure the risk of an entire portfolio
Diversification
When the term “diversification” is used, it usually means building a portfolio that includes securities from different asset classes, like stocks and bonds
- If you add a risky stock into a portfolio that is already risky, how is the overall portfolio risk affected?
In modern portfolio theory, if you add a risky stock into a portfolio that is already risky, the resulting portfolio may be more or less risky than before.
- How do you calculate a company’s Days Sales Outstanding?
Average accounts receivable/sales x 365 days
- How do you calculate a company’s current ratio?
Current assets (cash, accounts receivable, etc)/current liabilities (accounts payable and other short-term liabilities)
A high current ratio indicates that a company has enough cash (and assets they can quickly turn into cash, like accounts receivable) to cover its immediate payment requirements on liabilities.
Looking at its balance sheet you calculate that its current ratio went from 1.5 to 1.2. Does this make you more or less likely to buy the stock?
Less likely. This means that the company is less able to cover its immediate liabilities with cash on hand and other current assets than it was last quarter.
- Xeron Software Corporation’s days sales outstanding have gone from 58 days to 42 days. Does this make you more or less likely to issue a Buy rating on the stock?
More likely. When the company’s days sales outstanding (DSOs) decreases, it means the company is able to collect money from its customers faster.
- What kind of stocks would you issue for a startup? Can you issue debt?
A startup typically has more risk than a well-established firm. The kind of stocks that one would issue for a startup would be those that protect the downside of equity holders while giving them upside. Hence the stock issued may be a combination of common stock, preferred stock and debt notes with warrants (options to buy stock). Debt, other than a small business loan, is not usually issued here, as the company doesn’t typically have stable operations yet.
- When should a company buy back stock?
When it believes the stock is undervalued, has extra cash and believes it can make money by investing in itself. This can happen in a variety of situations. For example, if a company has suffered some decreased earnings because of an inherently cyclical industry (such as the semiconductor industry), and believes its stock price is unjustifiably low, it will buy back its own stock. On other occasions, a company will buy back its stock if investors are driving down the price precipitously. In this situation, the company is attempting to send a signal to the market that it is optimistic that its falling stock price is not justified. It’s saying: “We know more than anyone else about our company.
- Is the dividend paid on common stock taxable to shareholders? Preferred stock? Is it tax deductible for the company?
The dividend paid on common stock is taxable on two levels in the U.S. First, it is taxed at the firm level, as a dividend comes out from the net income after taxes (i.e., the money has been taxed once already). The shareholders are then taxed for the dividend as ordinary income (O.I.) on their personal income tax. Dividend for preferred stock is treated as an interest expense and is tax-free at the corporate level.
- When should a company issue stock rather than debt to fund its operations?
There are several reasons for a company to issue stock rather than debt. If the company believes its stock price is inflated it can raise money (on very good terms) by issuing stock. Second, if the projects for which the money is being raised may not generate predictable cash flows in the immediate future, it may issue stock. A simple example of this is a startup company.
of startups generally will issue stock rather than take on debt because their ventures will probably not generate predictable cash flows, which is needed to make regular debt payments, and also so that the risk of the venture is diffused among the company’s shareholders. A third reason for a company to raise money by selling equity is if it wants to change its debt-to-equity ratio. This ratio in part determines a company’s bond rating. If a company’s bond rating is poor because it is struggling with large debts, the company may decide to issue equity to pay down the debt. Fourth, the debt markets might not be able to handle additional issuance of debt (and vice versa).
- Why would an investor buy preferred stock?
- An investor that wants the upside potential of equity but wants to minimize risk would buy preferred stock. The investor would receive steady interest-like payments (dividends) from the preferred stock that are more assured than the dividends from common stock.
- The preferred stock owner gets a superior right to the company’s assets should the company go bankrupt.
- Acorporationwouldinvestinpreferredstockbecausethedividendson preferred stock are taxed at a lower rate than the interest rates on bonds.
- Why would a company distribute its earnings through dividends to common stockholders?
Regular dividend payments are signals that a company is healthy and profitable. Also, issuing dividends can attract investors (shareholders). Finally, a company may distribute earnings to shareholders if it lacks profitable investment opportunities.
