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CIMA > Section II.B. Equity > Flashcards

Section II.B. Equity Flashcards

1
Q

Market capitalization

A
  • The value of a company determined by multiplying its current market price times the number of common shares outstanding
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2
Q

Growth (style)

A
  • A classification of style
  • Growth investments seek investments with strong growth potential (e.g., above average earnings growth expectations)
  • The market price of growth investments is often higher than some fundamental value of the underlying company stock
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3
Q

Value (style)

A
  • Strategy of investing in stocks at less than intrinsic value
  • Identifying undervalued stocks or assets
  • Market price is lower than some fundamental valuation of company stock
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4
Q

Volatility (defensive vs. dynamic)

A
  • Defensive stocks are less susceptible to economic conditions and cycles (e.g., food, power, water, gas)
  • Dynamic stocks offer greater growth opportunities, albeit with greater risk
  • Defensive and Dynamic Index measures total company risk as a combination of earnings variability, return on assets, leverage, and volatility (Russell Investments)
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5
Q

Developed markets

A
  • Markets that include stable political environment, a stable currency, financial and accounting regulations, liquidity, and established financial markets with a long history
  • Examples: United States, Japan, Germany, U.K.
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6
Q

Emerging markets

A
  • Markets with some form of market exchange and liquidity in its financial markets
  • These markets are not, however, as advanced as developed markets
  • Not considered as efficient as developed markets, nor do they have comparable accounting or legal standards
  • Examples: China, Brazil, India, Russia
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7
Q

Frontier markets

A
  • Newly developed markets in underdeveloped regions
  • Potential markets for significant growth and expansion
  • Risks include lack of liquidity, political instability, lack of regulation, reporting or accounting standards, currency fluctuations
  • Also known as “pre-emerging markets”
  • Examples: African nations, certain southeast Asian nations, much of Central and South America, Eastern Europe
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8
Q

Dividend discount valuation

A
  • An equity valuation method that theorizes a stocks’s value is worth the amount of discounted, future dividends
  • It’s formula uses an expected dividend yield and growth rate to calculate the company’s intrinsic value
  • Dividend discount model is used to determine a stock’s value by discounting the value of its expected dividends back to present value
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9
Q

Free cash flow

A
  • Financial measurement of a company’s ability to enhance shareholder value, grow, or expand
  • A measure of financial profitability by subtracting capital expenditures from operating cash flow
  • Shows the cash a company can generate after paying to maintain and expand its capital asset base
  • Removes depreciation and capital expenditures from the earnings calculation
  • Formula: FCF = EBIT (1 - tax rate) + depreciation & amortization - change in working capital - capital expenditure
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10
Q

Weighted average cost of capital (WACC)

A
  • Calculation to determine the total cost of capital, equity, debt, preferred, etc.
  • Each category is weighted proportionately to determine the overall cost of funds
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11
Q

Fundamental analysis

A
  • Models a company’s value by assessing its current and future profitability
  • The purpose is to identify mis-priced stocks relative to some measure of “true” value derived from financial data
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12
Q

Book value

A
  • The value at which an asset or liability is carried on a balance sheet
  • Value of a company based on assets minus intangible assets minus liabilities
  • Book values are based on historical cost, not actual market values
  • It is possible, but uncommon, for market value to be less than book value
  • “Floor” or minimum value is the liquidation value per share
  • Tobin’s Q is the ratio of market price to replacement cost
  • Book value per share = (assets - liabilities) / shares outstanding = shareholder equity / shares outstanding
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13
Q

Book-to-market ratio

A
  • A measure of an asset’s value calculated by dividing the asset’s book (accounting) value by its market value
  • A positive value indicates that the market is discounting the asset (stock may be undervalued)
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14
Q

Intrinsic value

A
  • The “true” value according to a model
  • Also referred to as book value
  • Represents the actual financial worth of a company
  • For options, it is the difference between the strike price and the underlying stock price
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15
Q

Market value

A
  • The consensus value of all market participants
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16
Q

Holding period return (HPR)

A
  • The ratio of the change in the value of the investment, accounting for any cash flows received or less any cash flows paid out, divided by the beginning value of the investment
  • The expected HPR may be more or less than the required rate of return, based on the stock’s risk
  • Formula: expected HPR = [(end of period value - beginning period value) + income] / beginning value
17
Q

Capital Asset Pricing Model (CAPM)

A
  • A theoretical model that attempts to explain the relationship between risk and expected return
  • The model holds that investors should be compensated for both the time value of money and risk taken
  • The formula allows one to calculate the expected return of an asset = (risk free rate) + (market risk premium x the beta of the asset)
18
Q

Statement of financial position

A
  • A financial statement on a given date that subtracts liabilities from assets and shows either a positive or negative net worth
  • For a company, the term “shareholder equity” is used for net worth
  • Also called a balance sheet
19
Q

Statement of cash flows

A
  • A financial statement that measures all movements of cash, in or out of the company
  • Also known as “cash flow statements”, these reports can be broken into operating, investing, and financing activities
20
Q

Current ratio

A
  • A measurement of balance sheet liquidity that divides current assets by current liabilities
  • Differs from acid test ratio in that it includes inventory in the calculation
  • The higher the number, the more liquid a company is considered
  • A.K.A. the liquidity ratio, cash asset ratio, cash ratio
21
Q

Quick ratio (acid test ratio)

A
  • Measures balance sheet liquidity by dividing current assets (cash + short-term investments + receivables) by current liabilities
  • The larger the number, the greater the company’s liquidity
22
Q

Cap-weighted index

A
  • Also known as a “market-value weighted index”
  • Weights individual companies or stocks based on their market capitalization, thus, larger stocks receive proportional representation in the index
  • The value of a cap-weighted index may be computed by summing the value of all market capitalizations and dividing by the number of stocks in the index
  • Advantages:
    1.) The total return of the index roughly mirrors the change in total market value of all stocks
    2.) Rebalancing this type of index is simple
    3.) Since the index automatically adjusts to changes in stock prices, it is easy to create a tax efficient mutual fund or ETF to track this type of index
  • Disadvantages:
    1.) If stock prices reflect emotions over the short term, then the index will systematically own too much of overpriced stocks and too little of bargain priced stocks
    2.) The index is heavily influenced by the few companies with the largest market capitalizations - for instance the top 20 stocks in the S&P 500 index can account for one-third of the total index
  • Examples: NYSE Composite, S&P 500, NASDAQ Composite, Hang Seng (Hong Kong), Russell 2000, Wilshire 5000, MSCI EAFE
23
Q

Fundamentally weighted index

A
  • A type of market index where selection and weighting criteria are based on factors such as revenue, dividends, or book value (i.e., measurements of fundamental analysis)
24
Q

Equal weighted index

A
  • An index in which all securities or components are given equal (the same) weighting
  • Advantages:
    1.) The index is highly diversified with all stocks in the universe equally weighted
    2.) As opposed to market cap weighting, the index does not overweight overpriced stocks and underweight underpriced stocks - pricing errors are random
    3.) Easy to construct relatively tax efficient ETFs and mutual funds
    4.) Usually adds 1-2 percent in annual return over long periods after expenses vs. market cap weighted indexes
  • Disadvantages:
    1.) No distinction is made between the relative or absolute valuation of stocks within the universe
    2.) Difficult to keep the stocks in the index equally weighted due to constant price fluctuations
    3.) Difficult for this type of index to manage substantial amounts of money due to the need to invest equal amounts in both the largest and smallest stocks
25
Q

Price to earnings (PE or P/E) ratio

A
  • A common valuation measurement calculated by dividing the share price of a security by its current or future earnings per share
  • Can also be calculated by dividing the market capitalization by the total earnings
  • Current PE ratio = share price / current earnings per share
  • Future PE ratio = share price / expected earnings per share
26
Q

Shiller PE ratio

A
  • Also known as the “cyclically adjusted (CAPE) PE”
  • Smooths out fluctuations in earnings due to the business cycle
  • Uses earnings per share figures adjusted for inflation and averaged over 10 years as the denominator
  • CAPE ratio formula = share price / 10-year earnings average adjusted for inflation
27
Q

Price to earnings growth ratio (PEG)

A
  • Measures both value and growth of a security by dividing the PE ratio (previous 12 months) by the anticipated earnings growth percentage
  • Employs the PE ratio and relates it to a firm’s expected growth rate (EGR)
  • Reflects the firm’s potential value of a share of stock
  • PEG ratio = (P/E) / EGR
  • It is theorized that PEG ratios represent the following:
    1.) If PEG = 1 to 2: the firm’s stock is in the normal range of value
    2.) If PEG < 1: the firm’s stock is under valued
    3.) If PEG is > 2: the firm’s stock is overvalued
28
Q

Price-to-book ratio

A
  • Calculated by dividing the stock price by book value per share
  • Also calculated by dividing the market capitalization by the book value
  • This metric compares a stock’s price to its accounting or book value

PB ratio = share price / [(assets - liabilities) / shares outstanding]

29
Q

Q ratio (Tobin’s Q)

A
  • Developed by James Tobin (Yale)
  • A valuation model that says the actual value of all companies should equal to the replacement cost of their assets
  • A value under 1 indicates an undervalued equity while a ratio of greater than 1 implies the stock is overvalued
  • Formula = total market value of firm / replacement cost of assets - liabilities
30
Q

Price-to-sales ratio

A
  • Calculated by dividing stock price by revenue generated by sales
  • Generates a value per unit of sales
  • Lower values may indicate market undervaluation
  • P/S ratio = stock price / 12 month sales per share
31
Q

Return on Assets (ROA)

A
  • Measures how well company management is utilizing its assets to generate operating income
  • Calculated by dividing earnings before income and tax payments by total assets
  • ROA = EBIT / assets ~ or ~ EBIT / (liabilities + owner equity + retained earnings)
  • ROA = (EBIT / sales) (sales / assets) = margin x turnover
  • Note: sometimes ROA may be defined as ROA = net earnings (i.e., after taxes and interest payments) / assets
  • Can be broken down into two components:
    1.) operating margin (operating earnings per dollar of revenue) AND
    2.) turnover (how much revenue is generated per dollar of assets)
  • Comparison of financial ratios across firms should factor in industry norms - for example, two firms could enjoy a similar ROA, but one has, relative to the other, high turnover and low margins
32
Q

Return on Equity (ROE)

A
  • Measures how well company management is performing for shareholders (i.e., profitability)
  • Calculated by dividing after-tax earnings by shareholder equity (i.e. book value)
  • Can also be calculated by dividing earnings per share by book value per share
  • ROE = net earnings / shareholder’s equity = net earnings / book value = earnings per share (aka EPS) / book value per share
  • P/B = P/E x ROE
  • When adding the impact of taxation and debt, ROE = (net profit / equity) = (1 - tax rate)[ROA + (ROA - i)(D/E)], where:
    1.) net profit = earn after taxes & interest
    2.) i = interest paid
    3.) ROA = EBIT / assets
    4.) D/E = debt as % equity, or the debt-equity ratio

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