Module 4: Bond and Stock Valuation Concepts Flashcards
Basic Bond PV Formula
PV = CF1/(1 + YTM)^! + CF2/(1+YTM)^2…
Entering in Calc Bond PV Formula
N = number of payments I/YR = semiannual yield for comparable bonds PMT = Semiannual coupon pmt FV = Par Value
Yield order when Bond trading at a premium
Current Yield > YTM > YTC
Yield order when bond trading at a discount
YTC>YTM>Current Yield
Duration Definition
The average time for a bondholder to receive the interest and principal payments from a bond in present value dollars.
Duration Goal
The duration of the bond should be equal to the time horizon of financial goals
Coupons Payments Affect on Duration
The larger the coupon payments, the lower the duration. Zero coupon bonds duration actually equals it’s maturity because their only payment is at the end of the holding period
How do market interest rates affect duration
A rise in the market interest rates decreases the duration, assuming all other factors are equal.
Duration Principals Summarized
Duration is inversly related to changes in market and coupon interest rates, and it is directly related to the changes in maturity.
Duration Formula
1+YTM/YTM - ((1+YTM) + T(COUPON-YTM))/COUPON((1+YTM)^T - 1) + YTM)
Convexity
A measurement that helps to measure the impact of interest rate changes that are greater than 1%. Using duration to compute price change assumes a linear relationship between YTM and change in price. As the expected YTM change gets greater, that linear relationship does not apply
Business Statement of Cashflows
Assists in the reconciliation of the business income statement to changes between two balance sheets. For a given period, it reflects the inflows and outflows of the business and the net changes in cash between two balance sheets.
The components of Business Statement of Cashflows
- cash flow from business operations
- cash flow from business investment activities
- cash flow from financing activities, such as the issuance of additional debt or equity
Pro forma Income Statement
Similar to a Business Statement of Cashflows except that it projects for the future rather than reporting the past. Important tool for planning future business operations. Created by first estimating gross profit and total expenses for the coming year or years and then accounting for the amount of taxes due on the net profit.
Book Value
The amount of equity available to it’s shareholders - or the amount that the shareholders have invested in the company.
Company Assets - Company Liabilities
Fundamental Analysis
The process of determining the fair market value, or intrinsic value, of a security and looking for mispricing.
Fundamental Analysis Factors
- Statistics gathered from the overall economy or economic environment
- interest rates and business cycle information
- monetary policy conducted by the Federal Reserve Board of Governors, including the current amount of the money
- Fiscal policy conducted by Congress
- Industry analysis
- Stock market tendencies
Top-Down Fundamental Analysis
Begins with researching the overall economy and the current state of the secondary market.
Economic Top-Down Analysis
Factors to Consider:
- Monetary Policy
- fiscal policy
- Inflation
- Political Environment
- Currency Stability
Industry Top-Down Analysis
Some industries do well in expanding economic environments and perform poorly in contracting environments. Industry ratios and financial statistics are computed for each industry by averaging out all the individual companies.
Company Top-Down Analysis
After determining that an industry’s outlook is positive, an investor can analyze and compare individual firms’ performances within the entire industry by using financial ratios and cash flow analysis.
Bottom-Up Fundamental Analysis
Essentially the analyst conducts the analysis in a manner opposite that of the top-down proponent. The bottom-up analyst first begins with an examination of the company fundamentals by using ratio analysis and then considers the financial prospects for the industry in which the company operates.
Current Ratio
current assets/current liabilities
Acid Test or Quick Ratio
Current assets - current liabilities / liabilities
Inventory turnover ratio
cost of goods sold / average inventory
Accounts receivable turnover ratio
sales / average account receivable
fixed-asset turnover
annual sales / fixed assets
operating profit margin
EBIT / sales
Net profit margin
net income / sales
Return on Assets
net income / total assets
Return on equity
net income / equity
Debt-to-capital ratio
total debt / total capital
Debt-to-equity ratio
total debt / total equity
Times interest earned
EBIT / annual interest charges
Payout ratio
dividends / earnings
price to earnings ratio
market price per share / earnings per share
Liquidity Ratios
current ratio, acid test (quick ratio),
Activity Ratios
Inventory Turnover ratio, accounts receivable turnover, and inventory turnover
determines how rapidly assets move through the firm and how quickly payments are received
Profitability ratios
ROA and ROE measure performance and how profitable the firm is, as well as what sort of return they are getting on their capital and equity
Leverage Ratios
Debt to equity and debt to capital, measure the extent to which a company uses debt financing
Technical Analysis
An attempt by analysts to determine the demand side of the supply-demand equation for a particular stock and, therefore, to predict the direction of its future market price. Based on a belief that studying the history of a security trades and security markets will provide buying opportunities.
Technical Analysis Basic Assumptions
- The market value of any good or service is determined solely by supply and demand
- Supply and Demand are driven by many factors, including both rational behavior and irrational behavior that is caused by fear and greed.
- Security Prices move in trends that persist for long periods of time. Minor short-term fluctuations can be disregarded.
- While the causes of change in supply and demand are sometime difficult to determine, the actual change in supply and demand can be observed in market price behavior.
Contrary Opinion Rules and Indicators
Prescribe doing the opposite of what the majority of the investment community is doing.
- Mutual Fund Cash Position
- Odd-Lot Theory (Sell the opposite of what odd lots are selling, because odd lots are usually bought and sold by smaller investors.)
- Investment Advisory Opinions
- Put-Call Ratio (the higher the ratio, meaning more put contracts relative to call contracts, so investors are bearish.
Follow-the-Smart-Money Tactics
- The Barron’s Confidence Index: measure that compares the high-quality bond yield to the lower-quality bond yield. The close they are to yield, the better the economy looks.
- Short Sales by Specialists: if a specalists total short sales are 65% or more, that is a bearish sign. 40% or less, that’s a bullish sign.
Other Market Indicators for Technical Analysis
- Breadth of Market - markets change vs the number of stocks that have changed in the same direction
- Short Interest - If a large number of shares have been sold short but not covered, this indicates a large demand for shares, which feeds a bull market.
- Stocks above their 200day moving averages -
Volume Trading Basics
a price increase on trading volume that is heavy relative to the stock’s normal trading volume is an indication of bullish activity (excess demand). A price decline on trading volume that is heavy relative to the stock’s normal trading volume is an indication of bearish activity (excess supply).
Stock Price and Volume Techniques
- The Dow Theory
- Support and Resistance Levels
- Moving-Average Lines
- Relative Strength
- Graphs
The Dow theory
Based on past stock price and volume information, trends seem to fall into three types - major, intermediate, and short-run. In the Dow theory, both the industrial average and the transportation average are expected to confirm each other for a trend to be considered valid.
Relative Strength
Once a trend begins, it will continue until some major event causes a change in direction. So when a company or industry group is outperforming the market, it will continue to do so.
Fundamental and Technical Analysis Concepts related to Modern Portfolio Theory
The efficient market hypothesis states that technical analysis is of no help in any of the three forms of the EMH: the strong form, the semistrong form, and the weak form. Fundamental analysis can help in the weak form of the hypothesis.
Leverage’s affect on ROE
A more leveraged company will have a greater return on equity, because there is less equity in the company.
Leverage’s affect on ROAq
A more leverage company will have less return on assets compared to it’s return on equity because the company has more debt to offset it’s assets.
Leverage’s affect on Net Income
More leverage means more interest payments that need to be made, thus reducing the Net Income of the company that employs high leverage.
Dividend Growth Rate Formula (to be used in the dividend discount model)
g = ROE x RR g = dividend growth rate ROE = Return on Equity RR = Earnings retention rate (1-dividend payout rate)
Retention Rates affect on Dividend Growth Rate
Positive relationship, if the retention rate increases, the dividend growth rate increase and vice versa.
Different Stock Valuation Concepts
- No-Growth (perpituity Dividend Discount Model)
- Constant Growth Dividend Discount Model
- Multistage Growth Dividend Discount Model
- Discounted Free Cash Flow Model
- Discounted Earnings Model
No-Growth (Perpetuity) Dividend Discount Model
When the dividend is expected to remain constant, the no-growth (perpetuity) dividend discount model may be used to calculate the stock’s intrinsic value. This situation is most frequently encountered with preferred stocks.
V = Dividend0/required return
Constant growth dividend discount model
“Gordon Model” is used to determine the intrinsic value of a stock when dividends are growing at a constant rate.
V = D1/r-g D1 = dividend paid at the end of period 1 g = the constant dividend growth rate
- This model is most appropriate for valuing mature companies
Multistage Growth Dividend Discount Model
Assumes that the growth rate of the stock’s dividend is not constant but rather changes. Follow three step process:
- Compute the value of each future dividend until the growth rate stabilizes
- Use the constant growth dividend discount model to compute the remaining instrinsic value of the stock at the beginning of the year in which the dividend growth rate stabilizes.
- Use the uneven cash flow method to solve for the net present (intrinsic) value of the stock.
**This model is most appropriate for valuing companies in the growth phase.
Discounting Free Cash Flow Model
For companies that don’t pay a dividend. Free cash flow to equity is the company’s operating cash flow less it’s current year’s capital investments and debt repayments (including any outstanding or cumulative preferred dividends payable). The discounted free cash flow model is mathematically equivalent to the constand growth dividend discount model except that the current year’s dividend is replaced by the free cash flow to equity on a per share basis.
V = FVFE1/r-g
Discounted Earnings Model
“Capitalized Earnings Method” discounts earnings instead of cash flows as in the dividend growth models.
V = E/Rd
Rd (discount rate)
Several problems exist with the discounted earnings model:
- earnings do not represent cashflow to the corp
- Method fails to account for the residual value of any corporate assets at the end of the reporting period.
Valuation Metrics
- P/E ratio
- PEG Ratio
- Price to Free Cash Flow (P/FCF) RAtio
- Price to sales (P/S) ratio
P/E ratio
current market price / earnings per share. Provides the investor with an idea of what the market is willing to pay for the company’s earnings. It is compared to both market and industry benchmarks.
PEG Ratio
PEG = P/E / g g = expected growth rate.
This ratio is a measure of relative value that can be used to compare companies with different growth rates. The belief is that companies with a low PEG ratio will have higher future rates of return and are good value stocks.
Price to Free Cash Flow Ratio
P/FCF = 1+g/r-g g = expected rate of the company's earnings r = required return
The lower the ratio compared to it’s peers, the more valuable the stock may be
Price to Sales
An indication of how much an investor is willing to pay for a specific revenue stream - in this case, the company’s annual sales. It does not take into account the subject company’s net income. Is not generally considered to ba good complement to the P/E ratio.
P/S = market price per share / sales per share
Intrinsic Valuation Methods
- constant growth dividend discount model
- multistage growth dividend discount model
- no growth dividend discount model
discounted free cash flow mode
Relative Value MEthods
- P/E ratio
- PEG ratio
- Price to free cash flow ratio
- Price to sales ratio
Financial Leverage Affects
- Earnings Per Share, Return on Equity and Shareholder Risk
Which of these statements concerning technical analysis is CORRECT?
- The focus of technical analysis is market timing with an emphasis on price changes
- Technicians concentrate on past stock movements to forecast future stock price movements
NOT: Technical analysis is focused on the process by which stock prices rapidly adjust to new information
