Investments Lesson 4 Flashcards
Dividend discount model
Values company’s stock by discounting future stream of cash flows
If required rate of return decreases, stock price will __?
If dividend is expected to increase stock price will __?
Increase
Increase
Example Exam Question:
Current annual dividend $2/share. 5 years ago was $1.36/share. Expect dividends to grow at same rate. Required rate of return is 12%. Expected return on market is 14%. What is the value of a share of common stock using constant dividend growth model?
A. $11 B. $17 C. $25 D. $36 E. $54
E
Dividend discount model can be used for simple perpetual dividend growth or more complicated variable dividend growth
For variable, must start with last rate & work backwards
Example Exam Question:
Expects company will increase dividends by 7% for next 3 years, 5% for 2 years, 3% on. Recent financial statements show earnings per share of $12 & retention ratio of 60%. If require at least 8% return on investment, what is value?
A. $112.97
B. $114.04
C. $115.63
D. $116.22
B
Disadvantages of dividend discount model
Requires constant perpetual growth rate of dividends
Cannot estimate stocks without dividends
Growth rate cannot be greater than expected return
Security price becomes very sensitive to expected return when nearing growth rate
Price/Earnings Ratio
How much investor is willing to pay for each dollar of earnings
P/E = price per share/eps
Price per share = p/e x eps
Price/Earning to Growth
PEG= P/E ratio / 3-5 year growth rate in earnings
Used to determine if stock’s P/E ratio keep pace with firm’s growth rate
Equal to 1- fairly valued
Greater than 1 fully valued or overvalued
Book Value
Amount of stockholder’s equity in the firm/ how much shareholders would receive if firm liquidated
Useful to compare to firm’s stock price
Dividend Payout Ratio
DPR = Common Stock Dividend / EPS
(Formula NOT provided-memorize!)
Higher DPR, more mature company
High DPR: possibility of dividend being reduced
Low DPR: dividend may be raised thereby increasing stock price
Return on Equity (ROE)
ROE = EPS/stockholder’s equity per share
Measured overall profitability of company
Direct relationship between ROE, earnings, & dividend growth
Example Exam Question: What is ROE? EPS: $2 C/S dividend: $1 P/S dividend: $.50 Sales: $5,000,000 Shares outstanding: 1,000,000 Total equity: $7,000,000
A. 15%
B. 20%
C. 25%
D. 28.5%
D
Dividend Yield Formula:
Dividend Yield = dividend/stock price
Annual dividend as percentage of stock price
Example Exam Question; Which most likely to increase dividend? 1: div yield 10%, stock price $20, eps $2 2: 5%, $50, $2.50 3: 8%, $30, $2.40 4: 12%, $40, $5
A. 1 B. 2 C. 3 D. 4 E. None
D
Dollar Cost Averaging
Same dollar amount each month
Fundamental Analysis:
Ratio analysis on financial statements
Liquidity, activity, profitability, c/s measurements, economic data, inflation, interest rates, GDP, unemployment
Believe price driven by financial performance
Assumes:
Investors can determine reliable estimates of stock’s future price behavior
Some securities may be priced & fundamental analysis determines which ones
Technical Analysis
Charting & plotting trading volume & price movements
Will predict future direction of stock prices long before fundamental
Believe supply & demand drive price
Resistance (top level)-sell
Support (bottom level)-signal new demand
Charting
Plotting historical stock prices to determine trading pattern
50,100,200 day moving average
Market Volume
Investor sentiment
If mv is high & market goes up: positive indicator
If mv high & market goes down: negative indicator
If mv low & market up: negative
If mv low & market down: positive
Short Interest
Number of shares sold short
High short indicates “pent up” demand
Odd Lot Trading
Trades less than 100 shares
Mostly by small investors
Contrarian indicator (small investor most likely wrong so do opposite)
Dow Theory
Signals end to bull or bear market
Does not indicate what will happen, just confirms it ended
Breadth of Market
Measures number of stocks that increase in value vs number of stocks that decline in value
Advance Decline Line
Difference between number of stocks closed up vs number of stocks closed down
Efficient Market Hypothesis
Investors cannot consistently achieve above-average market returns
Prices reflect all information available & change quickly to new information
Prices follow random walk
Believe passive strategy is appropriate (buy & hold)
Random Walk Theory
Stock prices unpredictable but not arbitrary
Prices are in equilibrium
Changes in price & volume of trading generated by changing needs of investors
Weak Form of EMH
Historical info will not help achieve above average market returns
Rejects technical analysis - direct contradiction
Asserts fundamental analysis will help
Holds that security prices reflect all price & volume data
Semi-Strong Form EMH
Assets both historical & public not helpful
Rejects both technical & fundamental analysis but inside information will lead to above average returns
Strong Form EMH
No information hidden or helpful
Prices reflect all available information & react immediately to new information
Even with inside information market cannot be out performed on consistent basis
Example Exam Question:
Which form of EMH supports technical analysis?
A. Strong B. Semi-Strong C. Weak D. All E. None
E
Example Exam Question:
If an investor is proponent of index funds, which is investor advocating?
A. Strong B. Semi-Strong C. Weak D. All E. None
A
Market Anomalies
Exceptions to rule that markets are truly efficient
Some anomalies include:
January Effect: January better month because tax loss sellers getting back in market
Small Firm Effect: small caps outperform large caps/ easier to grow revenues & earnings faster
Value Line Effect: stocks that receive value line’s highest ranking (1) outperform those that receive lowest (5)
P/E Effect: stocks with low p/e outperform high p/e
Market anomalies __ support EMH in __ form?
Do not support in any form
Active Strategy
Believe markets inefficient
Achieve above average returns through active investing & market timing
Passive Strategy
Believe markets are efficient
Difficult to achieve above average returns
Buy & hold strategy
Examples: laddered bonds, etfs, barbell bond strategy, UITs, index investing
Strategic Asset Allocation
Assess likely outcomes for various allocation mixes between asset classes
Every few years
Active
Tactical Asset Allocation
Active
Investor determines expected returns for asset classes, then rebalance
Performed frequently
Example Exam Question:
Client believe you can help improve returns by assisting her with investment selections. What method is appropriate?
A. Laddered bonds & UITs
B. Strategic asset allocation
C. Passive investment in etfs
D. Dollar cost averaging in index funds
B
Lesson 4 Review:
Which form of EMH directly refutes technical analysis?
A. Strong
B. Semi-strong
C. Weak
D. All
C
Lesson 4 Review: Which are tools of technical analysts? 1. Market indicators 2. Price indicators 3. Volume indicators 4. Charting
A. 1,3
B. 2,4
C. 2,3,4
D. 1,2,3,4
D
Lesson 4 Review:
Which of following is fundamental analyst unlikely to be using?
A. Financial statements
B. Bar charts
C. 10k reports
D. Executive interviews
B
Lesson 4 Review:
How does user of intrinsic value formula arrive at appropriate rate of return (r or k)?
A. By using CAPM
B. By using Arbitrage Pricing Model
C. By using Jensen’s model
D. By using Expected Rate of Return model
A
Lesson 4 Review:
What is significance of calculation for expected rate of return?
A. Provides investor with knowledge as to guaranteed rate that will be received on given investment
B. Provides investor with rate of return that a given security meeting certain levels of pricing & dividends may be expected to provide
C. Provides investor with knowledge of expectations regarding return specific to given portfolio at any level of risk
D. Provides investor with required rate of return that must be plugged into intrinsic value formula
B
Lesson 4 Review:
What methodology can be used to price (or value) stock if that stock is growth stock that pays no dividends?
A. P/e multiplier
B. Intrinsic value model
C. SML Equation
D. Constant growth model
A
Lesson 4 Review:
Structure passive equity portfolio strategy. Which would you not recommend?
A. Benchmark portfolio
B. ETFs
C. UIT
D. Market timing
D
Lesson 4 Review:
Stock pays dividend of $2. Grow at 10%. $40/share. Require return 14%. Undervalued or overvalued?
A. Intrinsic is $50, so overvalued
B. Intrinsic $50, undervalued
C. Intrinsic $55, overvalued
D. Intrinsic $55, undervalued
D
Lesson 4 Review:
If firm has EPS of $5, dividend $1, P/E ratio 22, std dev 12%, what is dividend payout ratio?
A. 5%
B. 10%
C. 15%
D. 20%
D
Lesson 4 Review:
Which ratio gives investor insight into whether stock’s p/e multiplier is keeping pace with earnings growth rate?
A. PEG
B. P/E ratio
C. Dividend yield
D. Lognormal distribution
A
