Unit 10 Flashcards
Define future value.
what an amount invested today at a given rate will be worth at some period in the future
Define present value.
value today of the future cash flows of an investment discounted at a specific interest rate to determine the present worth of those future cash flows
If actual return is less than expected:
If actual return is higher than expected:
PV will be higher
PV will be less
If the actual return is less than expected:
If the actual return is higher than expected:
FV will be lower
FV will be higher
Rule of 72
to find the number of years for an investment to double, divide the number 72 by the interest rate the investment pays
What is NPV?
It is the difference between an investment’s PV and its cost
- NPV is expressed in dollar amounts
PV - market price = NPV
What is the internal rate of return?
IRR is the discount rate (r) that makes the NPV of an investment equal to 0
It’s difficult to calculate, must be determined by a trial-and-error princess called iteration
Practical use for common stock is limited to those companies paying stable dividends
IRR is the method of computing long-term returns that takes into consideration:
The time value of money
The yield to maturity of a bond reflects its:
IRR
The investment is a good one if it has:
a positive NPV; stay away if the NPV is negative.
When an investment’s IRR is equal to the discount rate,
the NPV = 0. In an efficient market, bonds should be priced so that their NPV is 0.
IRR is always expressed as ___ whereas NPV is expressed as as ____.
IRR = %
NPV = $
Define mean, median, mode and range.
Mean = average
Median = midpoint of distribution
Mode = most common value
Range = difference between the highest and lowest returns
When comparing the arithmetic mean to the geometric mean,
the arithmetic mean will always be higher, unless all of the numbers being used are the same, in which case they will be equal. The reason is because the geometric mean uses imputed compounding.
Define income in perpetuity.
Means income “forever.”
Annual income/expected rate of return = lump sum required for that income perpetually
Beta/Beta Coefficient
(mean the same thing)
Measures the variability between a stock/portfolio’s movement and that of the market in general.
- 50 = more volatile than market
- 70 = less volatile than market
Negative betas move inversely with the market
Beta recommendations for clients:
Conservative clients need securities with low positive betas
Aggressive clients will find betas in excess of 1.00 suitable
Positive alpha
investment performance is better than what would have been anticipated, given the risk in terms of volatility that was taken (outperforming the market)
Negative alpha
underperforming the market
What is the formula for alpha?
(total portfolio return - risk-free rate) - (portfolio beta x [market return - risk-free rate])
Risk-free rate on the exam will always be
the 91-day (13 week) T-bill
Define standard deviation.
measure of the volatility of an investment’s projected returns, computed by using historical performance data
- expressed in %
The higher the SD,
larger the security’s returns are expected to deviate from its average return, and greater the risk/volatility
Lower SD would be more suitable for:
conservative investors
A security has an expected return of 12% and a SD of 5%. An investor can expect returns to range between:
between 7%-17% about ⅔ of the time and within 2%-22% about 95% of the time.
(The SD gets doubled.)
Correlation
securities move in the same direction
strong/perfect correlation → two securities prices move in a perfect positive linear relationship with each other
\+1 = perfectly correlated 0 = unrelated -1 = perfectly opposite directions
Index funds attempt to achieve:
perfect correlation (+1) with the index they are mirroring (S&P 500). It is not a goal to exceed the performance, only to match it.
One of the best ways to increase the diversification of a portfolio is to
include investments with a negative correlation.
Working Capital
amount of liquidity capital or cash a company has available (measure of the firm’s liquidity)
Formula: current assets - current liabilities
Factors that increase working capital:
- Issuing securities
- Profits from the business operations
- The sale of noncurrent assets, such as equipment no longer in use
Factors that decrease working capital:
- Declaring cash dividends
- Paying off long-term debt whether at maturity
- Net operating losses
Current Ratio
expresses current assets and current liabilities as a ratio of one to the other
Formula: current assets/current liabilities
Higher the ratio = more liquid the company is
Quick Asset Ratio (Acid Test Ratio)
quick assets/current liabilities
Quick assets = current assets - inventory
Even stricter test of a company’s ability to meet its short-term obligations
Debt-to-Equity Ratio
measure of financial leverage being used by a company
Formula: debt / total capital(equity)
Book Value Per Share
reflects the liquidating value of the company
Formula: (tangible assets - liabilities - par value of preferred) / shares of common stock outs.
Earnings Per Share (EPS)
measures the value of a company’s earnings for each common share
Formula: earnings available to common / # of shares outstanding
Earnings available to common → the remaining earnings after the preferred dividend has been paid
relates to common stock only, preferred stockholders have no claims to earnings beyond the stipulated preferred stock dividends
Earnings Per Share After Dilution
assumes that all convertible securities, such as warrants, convertible bonds, and preferred stock, have been converted into the common
Because there is more common stocks, EPS is reduced (diluted)
Current Yield (Dividend Yield)
Formula: annual dividends per common share / market value per common share
Dividend Payout Ratio
measures the proportion of earnings paid to stockholders as dividends
Formula: annual dividends per common share / EPS
In general, older companies pay out larger % of earnings as dividends
Utilities as a group have an especially high payout ratio
Price-to-Earnings Ratio (P/E)
provides investors with a rough idea of the relationship between the prices of different common stocks compared with the earnings that accrue to one share of stock
Formula: current market price of common share / earnings per share (EPS)
Growth companies usually have a higher P/E than do cyclical companies
Investors should be aware of extremely high or extremely low PEs (speculative stocks often sell at one extreme or the other)
Some fundamental analysts feel that the company’s ______ is more valuable than the PE ratio because different accounting methods can impact earnings much more than sales.
price to sales ratio
Price-to-Book Ratio
reflects the market price of the commons tock relative to its book value per share
Book value is the theoretical value of a company (stated in dollars per share) in the event of liquidation and bears little or no relationship to the stock’s current trading price
Book value is the:
company’s theoretical liquidation value expressed on a per share basis
Growth companies have higher PE ratios than:
do cyclical or defensive companies.
Earnings per share are related only:
to common stock; it assumes preferred dividends were paid.
