Stock Valuation and Ratio Analysis

Question 1

what is the constant growth dividend discount model?

Answer 1

values a company’s stock by discounting the future stream of cash flows

Question 2

what are some disadvantages to the dividend discount model?

Answer 2

• model requires a constant, perpetual growth rate of dividends
• many stocks do not pay dividends
• 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 3

describe the Price to Earnings ratio

Answer 3

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

Question 4

what is the PEG ratio?

Answer 4

the price/earnings to growth ratio compares a stock’s P/E ratio to the company’s 3-to-5 year growth rate in earnings

Question 5

what does a PEG ratio of 1 indicate?

Answer 5

the stock is fairly valued because the P/E ratio is in line with the earnings growth rate

Question 6

what does a PEG ratio of greater than 1 indicate?

Answer 6

the stock price is fully valued (or even overvalued)

Question 7

what is book value?

Answer 7

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

Question 8

describe the dividend payout ratio

Answer 8

the relationship between the amount of earnings paid to shareholders in the form of a dividend relative to the earnings per share

Question 9

what does ROE (return on equity) measure?

Answer 9

measures the overall profitability of a company

Question 10

what is dollar cost averaging?

Answer 10

allows an investor to invest the same dollar amount on a periodic basis

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 11

what is fundamental analysis?

Answer 11

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 perfomrance

Question 12

what does fundamental analysis assume?

Answer 12

• investors can determine reliable estimates of a stock’s future price behavior
• some securities may be mis-priced

Question 13

what is technical analysis?

Answer 13

the process of charting and plotting a stock’s trading volume and price movements, which will predict the future direction of stock prices long before fundamental analysis will

Question 14

what are some of the tools used in technical analysis?

Answer 14

• charting
• market volume
• short interest
• odd lot trading
• The Dow Theory
• Breadth of the Market
• Advance Decline Line

Question 15

what is the efficient market hypothesis?

Answer 15

• investors cannot consistently achieve above-average market returns
• prices reflect all information that is available and prices change very quickly to new information
• stock prices will follow a random walk

Question 16

what is the Random Walk Theory?

Answer 16

the behavior of stock prices closely resembles a random walk

it’s impossible to consistently achieve above-average market returns

Question 17

list the 3 forms of the efficient market hypothesis

Answer 17

1. weak form
2. semi-strong form
3. strong form

Question 18

what is the weak form of the efficient market hypothesis?

Answer 18

• historical information will not help investors achieve above-average market returns
• rejects technical analysis, asserts fundamental analysis will help
• security prices reflect all info and volume data

Question 19

what is the semi-strong form of the efficient market hypothesis?

Answer 19

• both historical and public information will not help investors achieve above-average market returns
• rejects both technical and fundamental analysis

Question 20

what is the strong form of the efficient market hypothesis?

Answer 20

-historical, public, and private information will not help investors achieve above-average market returns

Question 21

which form of the efficient market hypothesis supports technical analysis?

Answer 21

none

Question 22

if an investor is a proponent of index funds, which form of the efficient market hypothesis is the investor advocating?

Answer 22

strong (passive investment strategy)

Question 23

what are some examples of market anomalies?

Answer 23

• January Effect
• small firm effect
• value line effect
• P/E effect

Question 24

what is an active investment strategy?

Answer 24

investors believe the markets are inefficient, and that they can achieve above-average market returns through active investing and market timing

Question 25

what is a passive investment strategy?

Answer 25

investors believe the markets are efficient, and a buy-and-hold strategy is best

Question 26

what is strategic asset allocation?

Answer 26

a strategy that involves assessing the likely outcomes for various allocation mixes between asset classes

done every few years

Question 27

what is tactical asset allocation?

Answer 27

the investor determines expected returns for asset classes, then rebalances the portfolio to take advantage of the expected returns

performed frequently