Stock Valuation and Ratio Analysis (Lesson 4) Flashcards
What does the constant growth dividend discount model do
- Values a company’s stock by discounting the future stream of cash flows
V = (D1/ (r-g)
r = required return
g = Dividend growth rate
D1 = Next periods dividend
If the required rate of return decreases the stock price will ____
increase
If the dividend is expected to increase the stock price will ____
increase
If the required rate or return _____ the stock price with decrease
increases
If the dividend is expected to decrease the stock price will ____
decrease
How do you use the dividend discount model with uneven cash flows
- Use the CFj keys
- inflate the dividend by the uneven growth rate and then find you intrinsic value with the uneven growth rate of the dividend times the normal growth rate
- in the last year add the uneven growth rate dividend to the intrinsic value calculated above
What are the disadvantages of the dividend discount model
- 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
What does the Price to Earnings ratio represent
- how much an investor is willing to pay for each dollar of earnings
- measure of the relationship between a stock price and its earnings
When is a P/E ratio a useful tool
- when a stock pay no dividends
What is the formula for P/E and Price per share using P/E
- P/E = Price per share / EPS
- Price per share = P/E x EPS
What does the PEG ratio do
- the Price/Earnings to Growth ratio compares a stocks P/E ratio to the company’s 3 to 5 year growth rate in earnings
- PEG Ratio = SP / 3 to 5 Year growth rate in earnings
What is the 3 to 5 year growth rate
- the historical earnings growth rate
What does the PEG ratio used to determine
- used to determine if the stocks P/E ratio is keeping pace with the firms growth rate in earnings
What does a PEG ratio equal to 1 suggest
- that the stock is fairly valued because the P/E ratio is in line with the earnings growth rate
What does a PEG ratio greater than 1 suggest
- that the stock price is fully valued (or even overvalued) because an expanding P/E ratio is contributing to the stock price appreciating more than the growth rate of earnings
What does a firms book value represent
- the amount of stockholders equity in the firm or how much the company’s shareholders would receive if the firm was liquidated
What does a book value significantly greater the stock price mean
- indicates that the firm is overvalued
What is the dividend payout ratio and what is the formula
- the relationship between the amount of earnings paid to shareholders in the form of a dividend relative to earning per share
- Dividend payout ratio = (Common stock dividend) / (Earnings per Share)
The higher the dividend payout ratio means the company is
mature
What does the return of equity measure
- the overall profitability of a company
- Direct relationship between ROE, earnings and dividend growth
What is the ROE formula
ROE = (Earnings per Share) / (Stockholders Equity per share)
What is the dividend yield formula
Dividend Yield = Dividend / Stock Price
What does dollar cost average allow an investor to do
- Invest the same dollar amount on a periodic basis, typically monthly
- Investor essentially buys high and sells low
How do you calculate the average price per share
- APPS = Total Cost / Number of shares
What is fundamental analysis 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 performance
What does ratio analysis include
- calculating liquidity, activity, profitability, and common stock measurements
What economic data would be looked at during fundamental analysis
- Inflation, interest rates, GDP, and unemployment
What does fundamental analysis believe
- stock price performance is largely driven by the financial performance of the firm
What does fundamental analysis assume
- Investors can determine reliable estimates of a stocks future price behavior
- Some securities may be mispriced
What does technical analysis the process of
- charting and plotting a stocks trading volume and price movements
- analysis of trading volume and price movements will predict the future direction of stock prices long before fundamental analysis will
Does technical analysis involve ratio analysis or analysis of financial statements
- No that is fundamental analysis
What do technical analysts believe drive a stock price
- supply and demand
What is resistance on a stock graph
- may develop when investors who bought on an earlier high may now view this as a chance to get even
- some may see it as an opportunity to take a profit
What is support on a stock graph
- may develop when a stock goes down to a lower level of trading because investors may choose to act on a purchase opportunity that they previously passed
- is a signal that new demand is coming into the market
(Tools of Technicians)
Charting
- Plotting historical stock prices to determine a pattern
- Plotting 50-, 100-, or 200- day moving average along the historical stock price
(Tools of Technicians)
Market Volume
- Insight into investor sentiment
- high volume, market goes up that’s a positive indicator of investor sentiment
- high volume, market goes down that’s a negative indicator regarding investor sentiment
- low volume, market goes up, negative indicator regarding investor sentiment
- low volume, market goes down, positive indicator regarding investor sentiment
(Tools of Technicians)
Short Interest
- The number of shares sold short gives insight into the future demand for a stock
- High short interest indicates pent up demand
(Tools of Technicians)
Odd Lot Trading
- trades less than 100 shares
- A contrarian indicator that asserts small investors are most likely wrong regarding their trades so do the opposite of the individual investor
(Tools of Technicians)
The Dow Theory
- signals an end to a bull or bear market
- does not indicate when it will happen it just confirmed that it has ended
(Tools of Technicians)
Breadth of the Market
- measures the number of stocks that increase in value verse the number of stocks that decline in value
(Tools of Technicians)
Advance Decline Line
- the difference between the number of stocks that closed up versus the number of stocks that decreased in value
What is the Efficient Market Hypothesis
- Investors cannot consistently achieve above average market returns
- prices reflect all information that is available and change very quickly to new information
- stock prices will follow a random walk
- investors that believe in EMH believe a passive investment strategy is appropriate (buy and hold index)
What is the Random Walk Theory state
- Stock prices resemble a random walk
- prices are unpredictable but not arbitrary
- Impossible to achieve above market returns
- prices reflect the all available information and true reflection of the value of that security
- Prices are in equilibrium
- price changes reflect a change in needs of investors
What are the three forms of the Efficient Market Hypothesis
- Weak form
- Semi-Strong form
- Strong Form
What is the Weak form of the Efficient Market Hypothesis
- Historical information will not help achieve above average market return
- Technical analysis does not help
- Fundamental analysis does help
- Security prices reflect all price and volume data
What is the Semi Strong form of the Efficient Market Hypothesis
- Both historical and public information will not help investors
- Technical and Fundamental analysis does not work
- Inside information is the only thing that will help
What is the Strong form of the Efficient Market Hypothesis
- Historical, public, and private information will not help
- Reflects all available information and react immediately to any new information
- Inside information does not help
- Should invest in index funds
What are market anomalies
- are exceptions to the rule that markets are truly efficient
- Do not support the EFH in any of the three forms
(Market Anomalies)
January Effect
- January tends to be a better month to invest
(Market Anomalies)
Small Firm Effect
- Small caps tend to outperform large caps
(Market Anomalies)
Value Line Effect
- Stocks that receive a Value line highest ranking of 1 outperform stocks that receive the lowest ranking 5
(Market Anomalies)
P/E Effect
- Stocks with low P/E tend to outperform stocks with a high P/E
What does the active investment strategy believe
- investors believe the markets are inefficient
- Investors can achieve above average market returns through active investing and market timing
What does the passive investment strategy believe
- believe the markets are efficient
- difficult to achieve above average market returns
- passive buy and hold strategy is best such as: laddered bonds, ETFs, barbell bonds, UITs and index investing
What is a Strategic asset allocation
- involves assessing the likely outcomes for various allocation mixes between asset classes
- done every few years
- is an active allocation strategy
What is a tactical asset allocation
- is an active allocation strategy whereby the investor determines expected returns for asset classes, then rebalances the portfolio to take advantage of the expected return
- Performed frequently
The expected rate of return provides an investor with
An approximation of the rate of return that a given security, meeting certain levels of pricing and dividends, may be expected to provide
