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Business Finance > Module 7: Stocks (Equity) and Their Value > Flashcards

Module 7: Stocks (Equity) and Their Value Flashcards

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1
Q

Review… The price of a bond is equal to the _______ value of the bond’s future cash flows.

The price of a share is equal to the ________ value of the stock’s future cash flows.

A
  • present
  • present
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1
Q

What is the big difference between stocks and bonds?

A
  • With bonds, all cash flows are laid out in advance (we know what they are and when we’ll receive them)
  • With stocks, there are no PROMISED cash flows and they don’t end at some pre-specified time.
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2
Q

What are the 2 basic types of common stock cash flows?

A
  1. Dividend
  2. Sell Price
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3
Q

Unlike with a bond where it will mature and we will get back a final cash flow at the end, a stock will continue to exist, so the way to get that final cash flow is to ______ the stock.

A

sell

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4
Q

When we go to sell stock, how do we estimate what that price will be in the future?

A

Assume those dividends are going to keep going on and that whoever buys the stock will want the PRESENT value of those FUTURE dividends.
(So, oftentimes we can ignore the sell price and just think about what the future dividends are going to be).

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5
Q

What are the 3 basic patterns of dividend growth (patterns we can use when assuming a dividend will just continue on)?

A
  1. No growth
  2. Constant growth
  3. Non-constant growth
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6
Q

Which pattern of dividend growth does this describe:
simplest pattern; in this case, the dividends are just constant over time.

A

No growth

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7
Q

The no growth pattern for dividend growth is less common for _________ stock.

A

regular; (more like for preferred stock, which is like a hybrid between debt and equity; it oftentimes will have a stated dividend (which will be constant over time and follow this pattern)

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8
Q

Which pattern of dividend growth does this describe:
- see this pattern with mature companies
- they pay out a dividend pretty regularly and as long as things are going well, this dividend tends to steadily increase over time.

A

Constant growth

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9
Q

In the case of a constant growth pattern for dividend growth, our stock will look like a _________ _________.

A

growing perpetuity

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10
Q

Which pattern of dividend growth does this describe:
- what gets used for younger, less mature companies that are growing rapidly
- oftentimes, we’ll assume that there’s gonna be some period where that growth rate will continue to be high, and then at some point the company does mature and that dividend growth will slow down.

A

non-constant growth

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11
Q

T or F: With no/zero growth, dividends increase in dollar amount (just a regular perpetuity).

A

False; they DO NOT increase in dollar amount (just a regular perpetuity)

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12
Q

T or F: With zero growth, dividends are paid every period forever.

A

True (also true for constant growth)

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13
Q

How do you calculate the price of a share of stock with zero-growth dividends?

A

The price of a share of stock (today; PV) is: P0 = D / r (which means next years dividend divided by r)

(same formula as regular perpetuity)

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14
Q

In the zero-growth pattern for dividend growth, the price of a share of stock stays constant over time if _____ doesn’t change.

A

r

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15
Q

T or F: When solving for price of a share with a zero growth pattern dividend, you need to put the % sign in the equation for r.

A

True

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16
Q

When interest rates go up, stock/equity prices (go up/fall).

This is (different/the same) as bond prices.

A
  • fall
  • the same
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17
Q

If interest rates go up for stock, this would (hurt/help) our return.

A

hurt (bc prices fall so we wouldn’t be able to sell it for as much)

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18
Q

When interest rates go down, stock/equity prices (fall/go up).

So, lower interest rates (help/hurt) our return.

A
  • go up
  • help (bc prices go up so we could sell the stock for more now)
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19
Q

T or F: Equity/stock prices tend to be more sensitive to changes in interest rate than bond prices.
If true, why?

A

True; because they don’t have an end to cash flows and the longer-term it is, the more sensitive it will be to changes in interest rate.

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20
Q

Which is a more realistic assumption for common stock:
Zero growth or constant growth?

A

Constant growth

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21
Q

For ________ growth, dividends increase at a fixed rate, g, each period.

A

constant

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22
Q
  • How do you calculate the price of a share of stock for constant growth dividends?
  • This is just the PV formula for a (regular/growing) perpetuity.
  • What assumption does this formula make?
A
  • P0 = (D1 / (r-g))
  • growing
  • that r > g (discount rate is greater than growth rate)
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23
Q

T or F: For constant growth dividends, if we want the price today, we need next year’s dividend. If we want the price 5 years from now, we need the dividend 6 years from now. It is always the following dividend we use to get the price today.

A

True

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24
Q

For constant growth dividends, price increases over time at rate ___ IF ___ doesn’t change.

A

g (growth rate) ; r (discount rate)

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25
Q

How would you calculate next year’s dividend if given the following info:
- THIS year’s dividend: $10
- Growth Rate: 5%
- Required Return (by market): 8%

A

10 x (1 + 5%)

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26
Q

What button do we use on the calculator to get our rate of return (discount rate) on constant growth dividend problems?

A

IRR (internal rate of return)

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27
Q

For ________ growth, dividends have some period of supernormal growth.

A

non-constant

(some period where dividends are not constant). You can assume a high constant growth for the whole period, project each year’s growth individually, or anything in between.

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28
Q

With non-constant growth dividends: - at some point you must assume that growth will ______.
- As long as we can _______ that point, we can calculate a price – what we will call a _______ _______.

A
  • slow
  • forecast
  • terminal value
29
Q

the price at some point in the future where we do have constant growth rate and we can pull everything back to today to get the price.

A

terminal value

30
Q

What are the 3 steps for non-constant growth dividends?

A
  1. Project the dividends in the high growth period
  2. Calculate the terminal value (which is just some future price)
  3. Discount the terminal value and the high growth dividends. (bring all of this back to what it’s worth to use today)
31
Q

T or F: can only use the constant growth formula (the Dt / (r-g)) once we’ve hit a dividend where all the future dividends will grow at a constant growth rate.

A

True

32
Q

Recall the dividend growth model: P0 = D1 / (r-g)
Which part of this model can we NOT really observe directly?

A

r– the required rate of return

33
Q

What is the formula to calculate required rate of return (by rearranging the dividend discount model)?

A

r = (D1 / P0) + g

34
Q

This is the formula for required rate of return: r = (D1/ P0) + g

  • The first part, (D1/P0), is called ______ ________.
  • The second part, g, is called _______ _______ ________.
A
  • dividend yield
  • capital gains yield (called this bc capital gains is just the return you get from the price going up)
35
Q

T or F: as long as this model– (P0 = D1 / (r-g)) – holds, then the Price will just go up by whatever g is each year. (ex: if g is 4%, the price will go up 4% each year, and this will be our capital gains yield)

A

True

36
Q

the portion of a stock’s return that comes from its dividend (the payments).

A

dividend yield

37
Q

the portion of a stock’s return that comes from the change in the stock’s price.

A

capital gains yield

38
Q

Our total return on a stock is just what two things added together?

A

Dividend yield + Capital Gains yield

39
Q

What are 3 ways to estimate the dividend growth rate?

A
  1. Look at past growth (would do this for a mature company bc it’s likely that it’ll continue to grow steadily each year)
  2. Look to the industry at large/peers (good for a newer company that’s growing faster; we can look at other companies in that industry to figure out what a good long term growing rate will be)
  3. Look to the economy (economy tends to grow 2 or 3% a year; in the really long term, there’s no way for a company to grow faster than the economy (otherwise you’re larger than the entire economy)
40
Q

So far, we’ve been doing a fundamental analysis where we are getting the PV of future cash flows to figure out the price for stock. Another common metric used is called _______ _______.

A

market multiples

41
Q

What are 4 market multiples?

A
  1. Price to Earnings (PE) Ratio
  2. Price to Sales Ratio
  3. Price to Cash Flow
  4. Price to Book
42
Q

What is the PE Ratio?

A

Price / Net Income

43
Q

The idea of PE ratio is that what we ultimately want to pay for a company is its _______.

A

profits (So, if a company has more profits, we’re happy to pay more, but otherwise, not so much)

44
Q

What is the formula for getting the fair price of stock using PE Ratio?

A

Pt = Benchmark PE Ratio x EPSt (Net Income)

45
Q

T or F: It’s okay for companies to have a higher P/E Ratio if they’ve got faster growth.

A

True

46
Q

How do you figure out what’s a good/reasonable PE ratio to pay for a company?

A

Typically you look at similar companies that are in the same industry that have similar types of growth opportunities ( (ex: if we want to figure out what a reasonable P/E Ratio is for Walmart, we could look at other mature companies in the retail space, like Costco)

47
Q

For the PE ratio, in principle, we’d like to use (forward looking/past) earnings.
Why?
What’s the downside of using this?

A
  • forward looking
  • because what we really care about is future earnings
  • we have to estimate them (not certain what next year’s earnings will be)
48
Q

T or F: Just like with dividends, if it’s a mature company, we can probably take a reasonable guess at what forward looking earnings will be for PE Ratio use.

A

True

49
Q

Oftentimes, for PE ratio, we’ll use (forward looking/past) earnings because we don’t have to guess; measure is more concrete.

A

past

50
Q
  • P/E ratio isn’t just used for companies. Oftentimes, this is used as a measure of ______ _______.
  • In this case, instead of looking at an individual company’s P/E ratio, we would look at the total _____ ______ of all the companies / total ______ of all the companies (getting like a marketwide P/E Ratio).
A
  • market bubbles
  • market value
  • earnings
51
Q

If the PE Ratio falls when using it as a measure of market bubbles, this can happen in two ways:

A
  1. Companies have to get much more profitable (if earnings rose without prices changing, then the ratio could come down)
  2. Prices have to fall
52
Q

Generally, when the P/E Ratio is (high/low), these are good buying opportunities (stocks are relatively cheap). When it’s (high/low), this may be a caution that the market is overvalued (and possibly you should sell).

A
  • low
  • high
53
Q

How do you calculate Price to Sales Ratio?
In what instance would you use this ratio?

A
  • Price to Sales Ratio = Price / Sales
  • If company doesn’t have earnings (ex: fast growing companies may not be profitable yet; they’re spending a lot to try and gain market share)
54
Q

The (PE/Price to Sales) ratio is not as good of a ratio as (PE/Price to Sales) ratio because we not only have to worry about differences in growth rates, but also differences in ______ ________.

A
  • Price to Sales
  • PE
  • profit margins

(summed up, there’s more variation in terms of what is a reasonable price to sale ratio for a company vs. price to earnings where we just have to worry about differences in growth rates)

55
Q

Another market multiple:
We could also do Price to Cash Flow.
Sometimes people like to use cash flow measures more than earnings because they’re less _________ by accounting gimmicks.

A

maniputable

56
Q
  • Another market multiple is Price to Book, where Book is just the ______ _____ of ________.
  • Why is measure of value commonly used?
A
  • Book Value of Equity
  • historically, Price to Book ratio has done a better job at predicting future returns than other ratios.
57
Q

When we do a measure like price per share, it’s telling us what we think a company should be worth based on their earnings and other companies. So, say that our price per share is $27.60.
If we’re priced less than that in the market (ex: stock trading in market for $20), then it looks like it’s a (buy/sell) opportunity.
If it were priced high relative to $27.60, (ex: priced at $50 in market), that’s a (buy/sell) opportunity (currently overpriced).

A
  • buy
  • sell

(If price per share is higher than what it’s priced at in market, then we should buy. If price per share is lower than what it’s priced at in the market, then we should sell it.)

58
Q

represents ownership in the company; our main type of equity

A

Common Stock

59
Q

________ Stockholders have voting rights. What are the two types of voting?

A
  • Common
    1. Straight voting → directors elected one at a time
    2. Cumulative voting → directors elected all at once; usually seen as being better for minority shareholders; this way makes it less likely that one person will control the entire board, and therefore the company
60
Q

T or F: Common Stock is required to pay dividends.

A

False; can pay dividends, although not required to.

61
Q

Common Stock can have different _______ of stock.

A

Classes

(historically, not very common; oftentimes, this will be like a certain type of share that’s held by the founder of the company that will maybe give them more voting rights than other people; or maybe a special type for employees so they’re able to control the company over outside shareholders)

62
Q

________ Stock is Often described as a debt/equity hybrid. (probably more like (debt/equity) than (debt/equity))

A

Preferred; debt; equity

63
Q

T or F: Preferred stock always has voting rights.

A

False; they may, but only if dividends have been missed.

64
Q

Which stock gets paid first: preferred or common?

A

preferred

65
Q

Preferred Stock has _______ dividends. This is similar to a bond coupon, however there’s a difference. What is this difference?

A
  • stated
  • difference: preferred stock doesn’t mature (company doesn’t have to pay it back at some point in the future) and the preferred shareholders are not able to force the company into bankruptcy (this is not an obligation the way debt is). Typically if the company is not paying the stated dividends on the preferred, they will not be able to pay any dividends to the common shareholders either.
66
Q

Stated dividends for preferred stock can either be ________ or _________.

What’s the difference between the two?

A
  • cumulative; non-cumulative
  • Cumulative: have to pay ALL missed dividends before paying common shareholders
  • Non-cumulative: just have to pay CURRENT dividends to preferred, then can pay common shareholders.
67
Q

Preferred stock has stated _________ value.

A
  • liquidating
    (even though stocks don’t mature at any point, it will have some stated value that the company has the right to buy it back at if they don’t want to have to keep paying the preferred dividends in the future; they can retire it)
68
Q

The distinction between stock markets (primary vs. secondary, dealers vs. brokers) are a lot less important now since most trading happens _________.

A

electronically

69
Q

Match the following descriptions to if it describes primary or secondary markets:
1. shares are traded among current and future owners
2. shares are issued by the company (mostly happens only when a company first goes public; mostly allocated to large institutional investors, not individual investors)

A
  1. secondary
  2. primary
70
Q

Match the following descriptions to if it describes dealers or brokers:
1. matches buyers and sellers (ex: like a real estate person will show you other peoples homes– they don’t own the homes. They can’t sell it to you and they’re not gonna buy your home from you, but they’ll help you find somebody)
2. own the stock (ex: think like a car person owns those cars and you can purchase it from them, and oftentimes they’ll purchase your car that you’re currently driving, so they have inventory there that you’re buying from or selling into)

A
  1. brokers
  2. dealers

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