Valuation of Stocks and Bonds Flashcards
Required rate of return is directly related to what
level of anticipated risk
The higher the risks, the higher the what and the lower the what.
Higher the risks, higher the required rate of return and lower NPV
If a person pays too much for an investment, their returns will be higher or lower than the required/expected?
Returns will be lower than the required/expected if you pay too much
If your required IRR is 8% and an investment pays $100 a year - to get the required IRR what would you be willing to pay?
$100/.08 = $1,250
Why are stocks more difficult to value than bonds?
no maturity date, dividends are variable and uncertain
Some ways to value stocks
-capitalized earnings
-dividend growth model
-ratio analysis
-book value
Capitalized Earnings:
Stock has expected earnings of $1.05 and required rate of return (cap rate) of 8%. What is the intrinsic value of the stock?
1.05/.08 = $13.125
Capitalized Earnings Formula
Expected earnings/required rate of return (cap rate)
Dividend of $3.50 per year on a stock is expected to continue in perpetuity. If our required rate of return is 10% what is the value of the stock?
$3.50/.10 = $35
Dividend Growth Formula
D one/required rate of return - g
Stock has annual earnings of $3.50 that are expected to grow by 5% a year. Required rate of return is 10% = what is the value of the stock?
$3.50 * 1.05 / .10 = $73.50
Stock has annual earnings of $3.50, expected to grow at 5% a year, our required rate of return is 10% and you paid $50 for the stock what is your expected return?
$3.50 * 1.05 / 50 + 5% = 12.35%
If you pay less than intrinsic value, will your expected return be higher or lower?
higher
Dividend growth valuation model
V = dividend* growth rate / required rate- growth rate
D is dividend
r = required rate of return (from CAPM)
g = dividend growth rate
Expected rate of return
r = D * growth rate /Current price + g
g is dividend growth rate
Price to Earnings
price/earnings
$20.41/$2.875 = 7.14
Investor is paying 7.14 times earnings
OR $7.14 for every $1 of earnings
Some weaknesses to price to earnings
- diff definition of earnings for diff co’s
- diff in estimated earnings
- question of appropriate multiple
Price to free cash flow
Price/free cash flow per share
$20.41/$1.04 = 19.62
Investor paying 19.62 times free cash flow
Companies stock is 20x free cash flow which is $1 per share what is fair value
20 * 1 = $20
Book value definition
assets - liabilities - preferred stock - intangible assets like goodwill
Book value per share is $2.25
P/B should be 8.0
What is the book value
8 * 2.25 = $18.00
value is 8 times book value
Price is $45.50
Earnings are $6.50
Growth is 10%
What is peg ratio
$45.50/6.50 = 7
7/10 = .7
.7 is PEG
When comparing 2 stocks, would you take the stock with a higher or lower PEG ratio?
lower
Top down analysis
Economy -> sectors -> Industry -> individual companies
Bottom up strategy
companies considered based on their own merit w/o regard for economic outlook
Look at: management, history, biz model, growth prospects etc
Ratio Analysis
used in fundamental analysis - calculation of financial ratios using info from balance sheet and income statement
Time series analyis
same firm or several firms over a period of time
Cross-sectional analysis
several firms in same industry at a given time
Balance sheet includes
assets, liabilities, equity
Income Statement includes
revenue, expenses
Liquidity ratios measure what
firm’s capacity to meet its current obligations as they come due
Quick ratio
Current assets - inventory/Current liabilities
Why is inventory not included in quick ratio?
Because inventory might not be able to be quickly sold and thus can’t contribute to firm’s liquidity
Activity ratio shows
how rapidly assets flow through the firm
Rapid turnover of inventory does what
generates cash to meet current liabilities in a timely manner
Receivables turnover formula
annual credit sales (or sale) / account receivable
Inventory Turnover
sales/average inventory
OR
CGS/avg inventory
Average collection period
receivables/sales per day
Fixed asset turnover ratio
annual sales/fixed assets
long term fixed assets would include property, plant, and equipment
4 activity ratios (turnover)
inventory turnover, receivables turnover, fixed asset turnover, average collection period
Profitability ratios measure what
how profitably the firm is being run or how efficiently they are using assets
Gross profit margin
(think g for cgs)
revenues - CGS / Sales
Operating Profit Margin
Earnings before interest and taxes/sales
Net profit margin
net income/sales
Return of Assets
net income/total assets
Return (what do you make) on Equity
net income/equity
Return on Common
Equity net income - preferred stock dividends/Common equity
ROE using DuPont System
net income/sales * sales/assets * assets/equity
Operating profit margin measures what
EBIT/Sales
measures how much the firm earns on sales before considering how the firm is financed or how much it pays in taxes
Measuring gross profit, operating profit, and net profit allows an analyst to do what
computing all 3 ratios lets the analyst determine if diff in net income are result of differences in cost of goods sold, operations, interest expense or taxes
Debt ratios measure what
extent to which a firm uses financial leverage
2 ways to measure debt
debt to assets or debt to equity
Usage of debt is one of the sources of what type of risk
diversifiable unsystematic risk, i.e. financial risk
Usage of debt might result in higher EPS but
does not mean a higher stock price because investors might be unsure if EPS would counteract the debt/risk
Debt to Equity
debt/equity
Debt to Total Assets
debt/total assets
Coverage ratio (times interest earned)
earnings before interest and taxes / interest expense
Times Interest Earned measures what
does EBIT outweigh interest expense - measures the safety of the interest payments
Businesses make interest payments out of what
operating income
What firms might use modest amounts of debt financing
firms with conservative management or firms that don’t need a ton of debt to grow
What is a sign of successful use of leverage
larger return on its equity than assets
Bank use of debt example
- bank earns < 1% on assets
- typical bank equity is 5-10% of its sources of funds
- large amount of debt financing and small interest paid for obligations increases equity return to 12-15%
How long would it take for a series EE bond to double?
20 years
Series EE bonds are purchased at what value relative to face value?
1/2 face value
Minimum/maximum purchase price on Series EE bond
$25 for $50 face value bond
$5000 for $10k face value bond
Does a zero coupon bond have reinvestment risk?
No, they dont pay interest so theres no interest to reinvest
Cumulative Preferred Stock
Must pay all unpaid dividends from prior year before paying dividend to common
Do open ended mutual funds issue new shares or redeem existing shares from shareholders?
Yes
Would a mutual fund company buy a GIC?
No a pension company would use a GIC
