Investments: Stock Valuation And Ratio Analysis Flashcards
Dividend Discount model
- provides intrinsic value of a stock by discounting the future stream of cash flows
- also known as the Gordon growth model and intrinsic value formula
Expected rate of return
Calculate an expected rate of return (r)
- this formula uses market price (P), in place of value (V)
- provided on exam don’t memorize
Exam Tip: Dividend Discount model
- if the required rate of return decreases, the stock price will increase
- if the dividend is expected to increase, the stock price will increase
- if the required rate of return increases, the stock price will decrease
- if the dividend is expected to decrease, the stock price will decrease
Dividend discount model example
Disadvantages - Dividend Growth Rate model
- the model requires a constant, perpetual growth rate of dividends
- many stocks do not pay dividends so the security value may not be estimated with this model
- the growth rate of dividends cannot be greater than the expected return becomes very sensitive to expected return when nearing the growth rate.
Dividend discount model - Variable Dividend Growth rates
Price-Earnings (P/E) Ratio
- represents he much an investor is willing to pay for each dollar if earning.
- measure of relationship between a stocks price and its earnings.
- useful tool used to value a stock if the firm pays no dividends.
The Price/earnings Growth (PEG) Ratio
- Compares a stocks P/E ratio to the company’s 3 to 5 year growth rate in earnings (historical growth rate)
- used to determine if the stocks P/E ratio is keeping pace with the firms growth rate in earnings.
- PEG ratio = 1 - means the stock is fairly valued because P/E ratio is in line with earnings growth rate.
- PEG ratio > 1 - suggest stock is fully or overvalued because an expanding P/E ratio is contributing to the stock price appreciating more than growth rate of earnings.
What is book value?
- book value represents the amount of stockholders equity in the firm or how much the company’s shareholders would receive if firm was liquidated.
- useful to compare to stocks price.
- stock price > book value - firm is overvalued
- stock price =or< book value - firm is undervalued.
Dividend payout ratio
- formula not on exam sheet
- relationship between amount of earnings paid to shareholders in the firm of a dividend, relative to earnings per share.
- higher the dividend payout ratio = company more mature, possibility of dividend being reduced
- low dividend payout ratio = dividend may increase therefore increasing stock price
Dividend payout ratio - example
Return on Equity (ROE)
- measures overall profitability of the company.
- not in CFP formula sheet MEMORIZE
- direct relationship between ROE, earnings and dividend growth
Return on equity example
Dividend Yield Formula
-states the annual dividend as a percentage of stock price
Dividend Yield example
Dollar cost averaging
The investor buys fewer shares when the price increases and more shares when the price decreases.
Fundamental Analysis
- assumes investors can determine reliable estimates of a stocks future price behavior
- some securities may be mispriced and through fundamental analysis, it can be determined which securities are mispriced.
- process of conducting ratio analysis on the balance sheet and income statement to determine future financial performance and a forecasted stock price.
- ratio analysis includes calculating liquidity, activity, profitability and common stock measurements.
- also looking at economic data (Inflation, Interest Rates, GDP, and unemployment) determine how the economy will impact various industries.
Technical analysis
- analysis of the trading volume and price movements will predict the future direction of stock prices long before fundamental analysis will.
- technical analyst, believe supply and demand drive a stock price.
Resistance and support
Resistance - may develop when investors who bought on an earlier high may now view this as a chance to get even or take profit
Support - may develop because investors may choose to act on a purchasing opportunity that previously passed
Charting
- plotting of historical prices to determine a trading pattern
- plotting 50,100, or 200 day moving average along with historical stock prices.
Market volume
- provides insight into investor sentiment.
Market volume high and market goes up, positive indicator of investor sentiment
Market volume high and market goes down, negative indicator
Market volume low and market goes up, negative indicator
Market volume low and market goes down, positive indicator.
Short interest
- number of shares sold short gives insight into future demand for a stock.
- high short interest indicates pent up demand
Odd Lot Trading
- trades less than 100 shares, done by small investors.
- contraction indicator - small investors are most likely wrong so do the opposite of individual investors
The Dow Theory
Signals an end to a bull or bear market.
Confirms it has ended not when it will happen.
Breadth of the market
Measures number of stocks that increase in value versus the number of stocks that decline in value.
Advance Decline Line
Difference between the number of stocks that closed up versus the number of stocks that decreased in value.
Efficient Market Hypothesis (EMH)
- investors cannot consistently achieve above average market returns.
- prices reflect all information that is available and change very quickly to new information
- stock prices will follow a “random walk”
- investors who believe in the efficient market hypothesis, believe a passive investment strategy is appropriate. Buy and hold
Random Walk Theory
- the behavior of stock prices closely resembles a random walk
- stock prices are unpredictable but not arbitrary.
- prices that exist on securities are the best incorporation of all available information and a true reflection of value.
- prices are in equilibrium
- changes in price and volume of trading are generated by changing needs of investors.
What are the three forms of efficient market hypothesis?
- Weak form
- Semi-strong form
- Strong form
What is weak form of efficient market hypotheses?
- historical info will not help investors achieve above average returns
- rejects technical analysis, believes fundamental analysis
- holds that security pricing reflects all price abs volume data.
What is the semi strong form of the Efficient Market Hypothesis?
- neither historical or public information will help investors achieve above average market returns.
- rejects technical analysis and fundamental analysis
- Insider information will lead to above average market returns.
What is the strong form of the efficient market hypothesis?
- historical, public and private information will not help investors achieve above average returns
- prices reflect all available information and react immediately to any new information
- even with insider information the market cannot be outperformed consistently
What are market anomalies?
Exceptions to the rule that markets are truly efficient:
January effect
Small firm effect
Value line effect
P/E effect
-do not support the efficient market hypotheses in any of its forms
January effect
January tends to be a better month because of tax loss selling in November and December
Followed by investors getting back into market in January.
Small firm effect
Small caps tend to outperform large caps
Value line effect
Stocks that receive value lines highest ranking (1) outperform stocks that receive the lowest ranking (5)
P/E effect
Stocks with a low PE ratio tend to outperform stocks with a high P/E ratio.
Active investment strategy
- investors believe markets are inefficient
- can achieve above average market returns through active investing and market timing.
Passive investment strategy
- investors believe markets are efficient, difficult to achieve above average returns
- prefer passive buy and hold strategy 
Passive strategies - laddered bonds, EFTs, barbell bond strategy, UITs, and Index Investing
Strategic asset allocation
- assessing the likely outcomes for various allocation mixes between asset classes
- active allocation strategy
- performed very few years
Tactical asset allocation
- investor determines expected returns for asset classes, then rebalances to take advantage of expected returns
- performed frequently
- active strategy
