Lesson 4 of Investments: Stock Evaluation and Ratio Analysis

Question 1

Dividend Discount Model!

Answer 1

• The constant growth dividend discount model values a company’s stock by discounting the future stream of cash flows.
• The formula is also known as “The Gordan Growth Model” and “Intrinistic Value Formula”
• Intrinsic Value

Question 2

Dividend Discount Model Formula

Formula Given

Answer 2

V = D1 ÷ (r-g)

r = required rate of return
g = Dividend growth rate
D1 = Next period’s dividend

Exam Tip:

• Be sure to use next year’s dividend when determining the value of stock using the constant growth dividend formula.

Question 3

If D1 is not given?

Answer 3

To calculate D1 it is…

D1 = D0 x (1+g)

• Calculated using the current dividend and growth rate.

Question 4

Expected Rate of Return!

Formula Given

Answer 4

• Through a restructuring of the formula used to calculate value, you can calculate an expected return rate of return (r).
• This formula uses “price” (P), that is, market price, in place of the value (V) in the calculation as follows.

r = ( D1 ÷ P ) + g

Question 5

Example of Calculating the Intrinics Value of Stock and Expected Return of Stock

A stock recently paid a dividend of $3.25. The marlet price is $45.00 and the company’s growth rate is 6%. Your investor requires an 11% return on all investments.

1. What is the intrinsic value of this stock?
2. If he buys at market price what is the expected rate of return?
3. Is the stock over or under-valued at its current market price?

Answer 5

1)
( 3.25 x 1.06 )
÷
(0.11 - 0.06)
=$68.90

2)
((3.25 x 1.06) ÷ 45.00)
+
0.06
=13.66%

3) Undervalued - The investor beleives the stock is worth $68.90 based upon the future dividends using the constant growth dividend model; however, the stock is only trading for $45.00

Question 6

Exam Tip - Know the relationships

• Required rate of return and stock price
• Dividend and Stock Price

Answer 6

• 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.

Question 7

Exam Question

The current annual dividend of ABC Corporation is $2 per share. Five years ago the dividend was $1.36 per share. The firm expects dividends to grow in the future at the same compound annual rate as they grew during the past five years. The required rate of return on the firms common stock is 12%. The expected return on the market is 14%. What is the value of a share of common stock of ABC corporation using the constant dividend growth model?

a) $11
b) $17
c) $25
d) $36
e) $54

Answer 7

Answer: E

Step 1: Calculate growth

N = 5
I = Solve for = 8.02
PV = -1.36
PMT = 0
FV = 2.00

Step 2: Use constant growth dividend formula.

($2.00 x (1+.0802)) ÷ (.12 - 0.0802)
=$54.00

Question 8

Dividend Discount Model

• Utilization
• Variable Dividend Growth Rate

Answer 8

The dividend discount model may be utilized for

• simplisitic perpetual dividend growth rate questions or for more complicated variable dividend growth rates.

The set up for variable dividend growth rate is the same as

• for a single growth rate except you must start with the last rate and work backwords.

Question 9

Example

Answer 9

Question 10

Exam Question

Shilo is invested in an MLP that has paid an annual dividend. The energy, oil, and gas industry is really booming so she expects the company will increase dividends by 7% for 3 years, 5% for 2 years, and will hold it stable at 3% from then on. The company’s recent financial statements shoe earnings per share of $12 and a retention ratio of 60%. If Shildo requires at least a 8% rate of return on her investment, what is the value?

Answer 10

Div0 = EPS x (1-Retention) = $12 x 0.40 = $4.80
Div1 = $4.80 x 1.07 = $5.14
Div2 = $5.14 x 1.07 = $5.50
Div3 = $5.50 x 1.07 = $5.89
Div4 = $5.89 x 1.05 = $6.18
Div 5 = $6.18 x 1.05 =$6.49
Div 6 = $6.49 x 1.03= $6.68

V = 6.68 ÷ (0.08 - 0.03) = $133.60

The calculate NPV
Div0 = $0
Div1 = $5.14
Div2 = $5.50
Div3 = $5.89
Div4 = $6.18
Div5 = $6.49 + $133.60 = $140.09

Answer: $114.04 value at Current Year.

Question 11

Disadvantages of using the Dividend Discount Model

Answer 11

• 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 and
  • the security price becomes very sensitive to the expected return when nearing the growth rate.

Question 12

Price-Earnings Ratio!

Answer 12

• The Price to Earnings (P/E) ratio represents how
  
  • much an investor is willing to pay for each dollar of earnings.
  • A measure of the relationship between a stock’s price and its earnings.
• P/E ratio is a useful tool used to measure a stock
  
  • if the firm pays no dividends.
  • The relationship of price to earnings is known as the P/E multiplier, and price is arrived to as follows.

Question 13

P/E Formula

Not given on exam

Answer 13

• P/E = Price Per Share ÷ EPS

OR

• Price Per Share = P/E x EPS

Question 14

Example of P/E

3 Ways P/E Can be Asked

(1) Ice cream corp has earnings per share of $3.00, and its stock price is trading at $40 per share. What is its P/E ratio?

(2) Ice cream corp is trading at $50 per share and has a P/E ratio of 20. What is its EPS?

(3) Ice cream corp has EPS of $3 and a P/E of 20. What is its stock price?

Answer 14

(1) P/E = Stock Price ÷ EPS
P/E = $40.00 ÷ $3.00
P/E = $13.33

(2) P/E = Stock Price ÷ EPS
20 = $50.00 ÷ x
=20x = $50.00
EPS = $2.5

(3) P/E = Stock Price ÷ EPS
20 = x ÷ 3
Stock Price=$60 per share

Question 15

PEG Ratio!

Answer 15

• The Price/Earnings to Growth (PEG) ratio compares
  
  • a stock’s P/E ratio to the company’s 3-to-5 year growth rate in earnings.
• The 3-to-5 growth rate in earnings is the historical earnings growth rate.
• The PEG ratio is used to determine if the stock’s P/E ratio
  
  • is keeping pace with the firm’s growth rate.
• A PEG ratio equal to 1 suggests
  
  • that the stock is fairly valued because the P/E ratio is in line with the earnings growth rate.
• A PEG ratio greater than 1 suggests
  
  • that the stock price is fully valued (or even overvalued) because an expanding P/E ratio is contributing to the stock price appreciating more than the growth rate of earnings.

Question 16

PEG Ratio Formula

Not given

Answer 16

(Stocks P/E Ratio)
÷
(3 to 5 Year growth rate in Earnings)

Question 17

Book Value!

Answer 17

A firm’s book value represents

• the amount of stockholder’s equity in the firm or how much the company’s shareholders would receive if the firm was liquidated.

The book value per share is useful to compare

• to the firm’s stock price.

If the stock price is significantly higher than the firm’s book value,

• it may indicated that the firm is overvalued.

If the book value per share is equal to or higher than the firm’s stock price,

• it may indicate the firm is being undervalued.

Question 18

Dividend Payout Ratio!

Answer 18

The dividend payout ratio is the relationship between

• the amount of earnings paid to shareholders in the form of a dividend,
• relative to earnings per share.

Typically, the higher the dividend payout ratio,

• the more mature the company.

A high dividend payout ratio may also indicate

• the possibility of the dividend being reduced.

A low payout dividend payout ratio may indicate

• that the dividend may increase, thereby increasing the stock price.

Question 19

Dividend Payout Ratio Formula

Not given on CFP exam. Memorize

Answer 19

Common Stock Dividend
÷
Earnings Per Share

Question 20

Dividend Payout Ratio Example

Cole’s Car Inc has the following information. What is the dividend payout ratio?

EPS: $2.00
C/S Dividend: $1.00
P/S Dividend: $0.50
Sales: $5,000,000
Share outstanding: 1,000,000
Total Equity: $7,000,000

Answer 20

=$1.00 ÷ $2.00

=50%

Question 21

Return on Equity (ROE)!

Answer 21

Measures the overall profitability of a company.

• This is a direct relationship between
  
  • ROE,
  • earnings and
  • dividend growth.

Question 22

ROE Formula

Not On exam

Answer 22

Earnings Per Share
÷
Shareholders Equity Per Share

Question 23

Exam Question ROE

Cole’s Car Inc has the following information. What is the dividend payout ratio?

EPS: $2.00
C/S Dividend: $1.00
P/S Dividend: $0.50
Sales: $5,000,000
Share outstanding: 1,000,000
Total Equity: $7,000,000

Answer 23

$2.00

÷
($7,000,000÷1,000,000)

= 2.00 ÷ 7.00
28.57%

Question 24

Dividend Yield Formula!

Answer 24

The dividend yield formula states the annual dividend as a percentage of the stock price.

Formula:

• Dividend Yield = Annual Dividend ÷ Stock Price

Exam Tip:

• Compare to dividend to EPS to figure out which dividend needs to increase their dividend.
  
  • Pg. 70 investments

Question 25

Exam Question Dividend Yield

Question 26

Strategies to Reduce Investor’s Risk!

Answer 26

• Dollar Cost Averaging

Question 27

Dollar Cost Averaging

Answer 27

• Dollar cost averaging allows an investor to
  
  • invest the same dollar amount on a periodic basis, typically monthly.
• By investing the same dollar amount each month,
  
  • an investor buys fewer shares when the price increases and
  • more shares when the price decreases.

Question 28

Steps to to determine average cost per share?

Answer 28

1. Take the Total Cost ÷ Per Share Price to determine the number of shares purchased.
2. Add the number of shares and total dollar amount invested.
3. Take the Total Cost ÷ Total Number of Shares

Question 29

Example of Collar Cost Averaging

Answer 29

Question 30

Fundamental Analysis!

Answer 30

• Fundamental analysis is the process of
  
  • conducting ratio analysis on the balance sheet and income statement to determine future financial performance and
  • a forecasted stock price based upon that future financial performance.
• Ratio analysis includes
  
  • calculating liquidity,
  • activity,
  • profitability, and
  • common stock measurements.
• Fundamental analysis also includes a look at
  
  • economic data to determine how the economy will impact various industries.
  • Economic data would include: inflation, interest rates, GDP, and unemployment.
• Fundamental analysts believe that a stock price performance is largely driven by the financial performance of the firm.
• Fundamental analysis assumes:
  
  • Investors can determine reliable estimates of a stock’s future price behavior.
  • Some securities may be mispriced, and through fundamental analysis, it can be determined which securities are mispriced.
• Financial Statement Analysis and Economic data is what Fundamental Analysts consider.

Question 31

Technical Analysis!

Answer 31

• Technical analysis is the process of
  
  • charting and plotting a stock’s trading volume and price movements.
  • Analysis of the trading volume and price movements will predict the future direction of stock prices long before fundamental analysis will,
• Technical analysis does not involve ratio analysis or
  
  • analysis of financial statements as fundamental analysis does.
• Technical analysts, who conduct technical analysis,
  
  • believe supply and demand drive a stock price.
• Aims to predcit
  
  • future pricing based on past pricing and
  • volume patterns.
• Resistance may develop when investors who bought on an earlier high may now view this as a chance to get even.
  
  • Some may see this as an opportunity to take a profit.
• Support may develop when a stock goes down to a lower level of trading because investors may choose to act on a purchase opportunity that they previously passed.
  
  • This is a signal that new demand is coming into the market.

Question 32

Tools of Technicians

Answer 32

• Charting
• Market Volumes
• Short Interest
• Odd Lot Interest
• The Dow Trading
• Breadth of the Market

This is everything technicians consider for their Analysis in Technical Analysis.

Question 33

Charting

Answer 33

• Charting involves the plotting of historical stock prices to determine a trading pattern.
• Charting also involves plotting a 50-,100-, or 200-day moving average along with the historical stock prices.

Question 34

Market Volume

Answer 34

• Market Volume is the amount of stocks traded per period.
• Market volume gives technicians insight into investor sentiment.
• If market volume is high and the market goes up, that’s a positive indicator regarding investor sentiment.
• If market volume is high and the market goes down, that’s a negative indicator regarding investor sentiment.
• If market volume is low and the market goes up, that’s a negative indicator regarding investor sentiment.
• If market volume is low and the market goes down, that’s a positive indicator regarding investor sentiment

Question 35

Short Interest

Answer 35

• The number of shares sold short gives insight into the future demand for a stock.
• Stock that was sold short eventually needs to be purchased.
• A high short interest indicates “pent-up” demand.
  • Pent up is a rapid increase in demand, following a period of subdued spending.

Question 36

Odd Lot Trading

Answer 36

• Odd lot trading are trades less than 100 shares.
• Most odd lot trading is done by small investors.
• Odd lot trading is a contrarian indicator that asserts small investors are most likely wrong regarding their trades, so,
• do the opposite of the individual investors.

Question 37

The Dow Theory

Answer 37

• The Dow Theory signals an end to a bull or bear market.
• It does not indicate when it will happen, it
• just confirms that it has ended.
• Bear: Falling drop in investment prices.
• Bull: Rising prices and optimism.

Question 38

Breadth of the Market

Answer 38

• Breadth of the market measures the number of stocks that increase in value versus the number of stocks that decline in value.

Question 39

Advance Decline Line

Answer 39

• The advance decline line is the difference
• between the number of stocks that closed up
• versus the number of stocks that decreased in value.

Question 40

Exam Tip

Answer 40

Not likely you will need to know the defintions of each technical approach.

Known what technicans consider in their analysis.

Question 41

Efficient Market Hypothesis (EMH)!

Answer 41

• Random Walk Theory
• Three Forms of the Efficient Market Hypothesis

Question 42

What is the Efficient Market Hypothesis (EMH)!

Answer 42

• 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, such as buying and holding an index.

Question 43

Random Walk Theory

Answer 43

This theory states that:

• The behavior of stock prices closely resembles a random walk.
• Prices of stocks are unpredictable but not arbitrary.
• It’s impossible to consistently achieve above-average market returns.
• At any given moment,
  
  • prices that exist on securities are the best incorporation of all available information and
  • a true reflection of the value of that security.
• Prices are in equilibrium.
• Changes in price and volume of trading are generated by changing needs of investors.

Question 44

Three Forms of the Efficient Market Hypothesis

Answer 44

• Weak Form
• Semi-Strong Form
• Strong Form

Question 45

Weak Form

Answer 45

• Historical information will
  
  • not help investors achieve above-average market returns.
• The weak form rejects
  
  • technical analysis and asserts that fundamental analysis will help an investor achieve above-average returns.
• Holds that security prices reflect
  
  • all price and volume data.
• Is in direct contradiction with technical analysis,
  
  • which attempts to predict future pricing based on the study of past pricing and volume patterns.

Historical is the same as Technical Analysis.

Question 46

Sem-Strong Form

Answer 46

• The semi-strong theory asserts that
  
  • both historical and public information will not help investors achieve above-average market returns.
• The semi-strong theory rejects both technical and fundamental analysis but
  
  • inside information will lead to above-average market returns.
• Reflected through public information.

Question 47

Strong Form

Answer 47

• The strong theory asserts that historical, public and private information will
  
  • not help investors achieve above-average market returns.
• The strong theory suggests that stock prices reflect
  
  • all available information and react immediately to any new information.
• The strong theory holds that even with
  
  • inside information the market cannot be out preformed on a consistent basis.

For index funds.

Question 48

Summary of Efficient Market Hypothesis

Guess what the price reflects + what is the advanatge through?

Answer 48

Question 49

Exam Question

Which of the following forms of the efficient market hypothesis supports technical analysis?
a) Strong.
b) Semi-Strong.
c) Weak.
d) All of the above.
e) None of the above.

Answer 49

Answer: E
All three forms suggest that technical analysis will not help you achieve above average market returns.

Question 50

Exam Question

If an investor is a proponent of index funds, which of the following forms of the efficient market hypothesis is the investor advocating?
a) Strong.
b) Semi-Strong.
c) Weak
d) All of the above.
e) None of the above.

Answer 50

Answer: A
The EMH asserts that investors cannot achieve above-average market returns; therefore, investors should take a passive investment strategy. Serni-strong does also reject fundamental and technical analysis, but does believe inside information will help out perform the market. Strong is the better choice in this question.

Question 51

Market Anomalies!

Answer 51

Market anomalies are exceptions to the rule that markets are truly efficient. Some anomalies that we see in the market include:

• January Effect: January tends to be a better month because of tax loss selling in November and December followed by investors getting back into the market in January.
• Small Firm Effect: Small caps tends to outperform large caps. It’s easier for them to grow revenues and earnings faster than a large cap.
• Value Line Effect: Stocks that receive Value Line’s highest ranking (1) outperform stocks that receive
  the lowest ranking (5).
• P/E Effect: Stocks with a low P/E ratio tend to outperform stocks with a high P/E ratio.
• Also Presidential Elections

If the EMH was correct, why do we see anomalies in the marketplace?

• Market anomalies do not support the efficient market hypothesis in any of the three forms.

DON’T NEED TO KNOW THE EXAMPLES

Question 52

Investing Strategies!

Answer 52

• Active Investment Strategies
• Passive Investment Strategies

Question 53

Active Investment Strategy

Answer 53

• Investors believe the markets are inefficient.
• Investors can achieve above-average market returns
  • through active investing and market timing.

Question 54

Passive Investment Strategy

Answer 54

• Investors believe the markets are efficient, and
• it’s difficult to achieve above-average market returns.
• A passive buy-and-hold investment strategy is best.
• Passive investment strategies are buy-and-hold strategies such as
  
  • laddered bonds,
  • ETFs,
  • barbell bond strategy,
  • UITs, and
  • index investing.

Question 55

Strategic Asset Allocation

Answer 55

• A strategy that involves assessing the likely outcomes for various allocation mixes
  
  • between asset classes.
• Strategic asset allocation is done every few years.
• Strategic asset allocation is an active allocation strategy.

Question 56

Tactical Asset Allocation

Answer 56

• Tactical asset allocation is an active allocation strategy
  
  • whereby the investor determines expected returns for asset classes,
  • then rebalances the portfolio to take advantage of the expected returns.
• Tactical asset allocation is performed frequently.

Question 57

Exam Question - Investment Strategies

Lindsay is your client, and she believes that you can help her improve her returns by assisting her with her investment selections. What type of method is appropriate?
a) Laddered bonds and UITs.
b) Strategic asset allocation.
c) Passive investment in ETFs.
d) Dollar cost averaging in index funds

Answer 57

Answer: B
Strategic asset allocation is the only active investment strategy.