Review Flashcards
NPV
Net Present Value
- The NPV relies on a discount rate that may be derived from the cost of the capital required to invest, and any project or investment with a negative NPV should be avoided.
- One important drawback of NPV analysis is that it makes assumptions about future events that may not be reliable.
- A positive NPV indicates that the projected earnings generated by a project or investment—in present dollars—exceeds the anticipated costs, also in present dollars. It is assumed that an investment with a positive NPV will be profitable.
IRR
Internal Rate of Return
- Very similar to NPV except that the discount rate is the rate that reduces the NPV of an investment to zero. This method is used to compare projects with different lifespans or amounts of required capital.
- Although the IRR is useful, it is usually considered inferior to NPV because it makes too many assumptions about reinvestment risk and capital allocation.
TMV
NPV uses discounted cash flows due to the time value of money (TMV). The time value of money is the concept that money you have now is worth more than the identical sum in the future due to its potential earning capacity through investment and other factors such as inflation expectations. The rate used to account for time, or the discount rate, will depend on the type of analysis undertaken. Individuals should use the opportunity cost of putting their money to work elsewhere as an appropriate discount rate—simply put, it’s the rate of return the investor could earn in the marketplace on an investment of comparable size and risk.
ROE
Return on equity (ROE) is a measure of financial performance calculated by dividing net income by shareholders’ equity. Because shareholders’ equity is equal to a company’s assets minus its debt, ROE is considered the return on net assets. ROE is considered a gauge of a corporation’s profitability and how efficient it is in generating profits.
ROA
Return on assets (ROA) is an indicator of how profitable a company is relative to its total assets. ROA gives a manager, investor, or analyst an idea as to how efficient a company’s management is at using its assets to generate earnings.
ROA is displayed as a percentage; the higher the ROA is, the better.
ROI
Return on investment (ROI) is a performance measure used to evaluate the efficiency or profitability of an investment or compare the efficiency of a number of different investments. ROI tries to directly measure the amount of return on a particular investment, relative to the investment’s cost.
To calculate ROI, the benefit (or return) of an investment is divided by the cost of the investment. The result is expressed as a percentage or a ratio.
Valuasi
Valuation is the analytical process of determining the current (or projected) worth of an asset or a company. There are many techniques used for doing a valuation. An analyst placing a value on a company looks at the business’s management, the composition of its capital structure, the prospect of future earnings, and the market value of its assets, among other metrics.
- Absolute valuation models attempt to find the intrinsic or “true” value of an investment based only on fundamentals. Looking at fundamentals simply means you would only focus on such things as dividends, cash flow, and the growth rate for a single company, and not worry about any other companies. Valuation models that fall into this category include the dividend discount model, discounted cash flow model, residual income model, and asset-based model.
- Relative valuation models, in contrast, operate by comparing the company in question to other similar companies. These methods involve calculating multiples and ratios, such as the price-to-earnings multiple, and comparing them to the multiples of similar companies.
Fundamental analysis is often employed in valuation, although several other methods may be employed such as the capital asset pricing model (CAPM) or the dividend discount model (DDM).
EBIT
Earnings Before Interest and Taxes (EBIT)
Earnings before interest and taxes (EBIT) is an indicator of a company’s profitability. EBIT can be calculated as revenue minus expenses excluding tax and interest. EBIT is also referred to as operating earnings, operating profit, and profit before interest and taxes.
EBIT (earnings before interest and taxes) is a company’s net income before income tax expense and interest expenses are deducted.
EBIT is used to analyze the performance of a company’s core operations without the costs of the capital structure and tax expenses impacting profit.
EBIT is also known as operating income since they both exclude interest expenses and taxes from their calculations. However, there are cases when operating income can differ from EBIT.
EBIT = Revenue − COGS − Operating Expenses Or EBIT = Net Income + Interest + Taxes where: COGS = Cost of goods sold
COGS
COGS = Cost of goods sold
Cost of goods sold (COGS) refers to the direct costs of producing the goods sold by a company. This amount includes the cost of the materials and labor directly used to create the good. It excludes indirect expenses, such as distribution costs and sales force costs.
Benchmark
A benchmark is a standard against which the performance of a security, mutual fund, or investment manager can be measured. Generally, broad market and market-segment stock and bond indexes are used for this purpose. It’s an element of a Sigma Six black belt.
COC
Cost of capital is a company’s calculation of the minimum return that would be necessary in order to justify undertaking a capital budgeting project, such as building a new factory.
The term cost of capital is used by analysts and investors, but it is always an evaluation of whether a projected decision can be justified by its cost. Investors may also use the term to refer to an evaluation of an investment’s potential return in relation to its cost and its risks.
Weighted Average Cost of Capital (WACC)
A firm’s cost of capital is typically calculated using the weighted average cost of capital formula that considers the cost of both debt and equity capital.
Each category of the firm’s capital is weighted proportionately to arrive at a blended rate, and the formula considers every type of debt and equity on the company’s balance sheet, including common and preferred stock, bonds, and other forms of debt.
What Is the Cost of Debt?
The cost of debt is the effective interest rate that a company pays on its debts, such as bonds and loans. The cost of debt can refer to the before-tax cost of debt, which is the company’s cost of debt before taking taxes into account, or the after-tax cost of debt. The key difference in the cost of debt before and after taxes lies in the fact that interest expenses are tax-deductible.
What Is the Cost of Equity?
The cost of debt is the effective interest rate that a company pays on its debts, such as bonds and loans. The cost of debt can refer to the before-tax cost of debt, which is the company’s cost of debt before taking taxes into account, or the after-tax cost of debt. The key difference in the cost of debt before and after taxes lies in the fact that interest expenses are tax-deductible.
Cost of equity is the return that a company requires for an investment or project, or the return that an individual requires for an equity investment.
The formula used to calculate the cost of equity is either the dividend capitalization model or the CAPM.
The downside of the dividend capitalization model—despite being simpler and easier to calculate—is that it requires that the company pays a dividend.
The cost of capital, generally calculated using the weighted average cost of capital, includes both the cost of equity and the cost of debt.
Payback Period
The term payback period refers to the amount of time it takes to recover the cost of an investment. Simply put, the payback period is the length of time an investment reaches a break-even point.
EMH
What Is the Efficient Market Hypothesis (EMH)?
The efficient market hypothesis (EMH), alternatively known as the efficient market theory, is a hypothesis that states that share prices reflect all information and consistent alpha generation is impossible.
The efficient market hypothesis (EMH) or theory states that share prices reflect all information.
The EMH hypothesizes that stocks trade at their fair market value on exchanges.
Proponents of EMH posit that investors benefit from investing in a low-cost, passive portfolio.
