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One common approach in fundamental analysis is a top-down approach which begins with the general assessment of the overall economy. Understanding the macro economy helps identify conditions that can affect specific industries. Following a macro economic analysis, fundamental analysis begins to refine its focus and look at specific industries, noting key issues that are highly relevant to businesses in that industry. Finally, analysis is concentrated on specific companies. Analyzing a specific company frequently is done by looking at financial statement analysis or ratios to assess an individual firm’s financial condition.
The balance sheet shows the financial condition of a company on a specific date – it is a snapshot of the company on one date. In general, assets are shown in order of liquidity, or the order in which the assets are expected to generate cash for investors. Liabilities and equity shown in the order in which investors line up to lay claim on the assets and income of a company.
The accounting identity shown on the balance sheet is that assets equal liabilities plus equity (A=L+E). The values of the assets, liabilities, and equity are based on a book value basis or historical cost.
The cash flow statement tracks changes in cash and is organized in three sections. (1) Operating cash flow adjusts net income for noncash items (such as depreciation) and other items (such as changes in current assets and current liabilities). (2) The second section in the cash flow statement is investing cash flows, which shows the net effects of buying and selling fixed assets. Growing companies typically are expanding operations and buying fixed assets; therefore, investing cash flows are frequently negative for growing companies. While the income statement reflects annual depreciation charges for fixed assets, the cash flow statement shows the actual upfront outlays associated with purchasing fixed assets. (3) The final section of the cash flow statement is financing cash flows, detailing the company’s use of borrowing and/or issuing new stock securities. Often, growing companies need external financial to pay for their investment in fixed assets so financing cash flows are positive.
Once the manager has calculated that three separate ratios, they may do a more focused analysis on the areas of the company that lag behind either an industry or a key competitor.
Based on these assumptions, the intrinsic value tells the investor what the investment “should” be worth. To determine whether an investment should actually be purchased, the investor compares his estimated intrinsic value with the actual market price. If the investment can be purchased at a lower price than the investor believes it is worth as predicted by intrinsic value, he or she should purchase the investment.
investment and/or its risk. Therefore, an individual investor’s estimate of intrinsic value is likely to be different than the value actually paid by the market.
There are several implications of the Gordon model:
1. The growth rate of the stock, or the capital gains yield, is the same as the rate of growth of dividends (.
2. If all transactions take place at the intrinsic value, the total expected return earned by the investor (including dividend yield and capital gains yield) is equal to the return required by the investor ().
The most difficult value to estimate in the Gordon model is growth rate of dividends. The Gordon model works well for companies that are in mature markets whose rate of growth is similar to the rate of growth in the overall economy.
Constant growth phase – a company cannot continue to grow at a rapid rate forever. At some point in the future, the company’s products will have saturated the market in which case growth must slow down. When the company matures, it is assumed to enter the constant growth phase. To calculate a stock price under the multi stage DDM, follow three steps:
1. Project dividends through the super normal growth phase
2. To determine the value of the dividends during the constant growth phase, calculate the stock’s terminal value or horizon value
3. Discount steps 1. and 2. (above) at the stock’s required rate of return.
The P/E ratio summarizes the market’s view of the projected growth of the company. To see this, note that shareholders are the residual claimholders of a company, receiving any profits that are left. If investors believe this residual claim is going to grow rapidly because of a company’s future performance, they will be willing to pay more for the stock per dollar of current income. If a company’s profits are expected to be stable or even decline, investors will pay less for the stock.
If the PEG is too high, the P/E ratio may not be justified since actual earnings growth is low.
higher price than the resistance level. As a result, a flood of sell orders come to the market depressing the stock price. Technical analysts argue that stock prices have a difficult time breaking through the resistance level.
pickers. A portfolio of stocks that were ranked 1 significantly outperforms stocks that were ranked 2, which outperform stocks that were ranked 3, etc. However, if the market is semi-strong efficient, Value Line should not be able to be such good stock pickers. This is because we could earn higher profits than the average investor by simply investing in stocks that were ranked number 1 by the Value Line publication. If the market is semi strong efficient, we should not be able to profit from public information.
while trading. Investors determine the price by discounting the cash flows of the bond at the required rate of interest. Therefore, if we observe the price that investors pay for the bond we can imply what discount rate they used:
In the bond pricing equation above, the left hand side represents the discounted value of the cash flows received and the right hand side represents the price paid today for the bond. The unknown is the discount rate (YTM). We can say this another way, solve for the discount rate so that:
Therefore, the yield to maturity is identical to the internal rate of return on the bond. In this way, the interest rate that investors require is the return that they receive if they hold the bond until maturity.
bond is high and investors require a higher DRP (and therefore a higher interest rate) to compensate them for this risk. To help investors assess the potential of default in the bond, rating agencies evaluate the financial condition of an issuer and their bond. Two popular rating agencies include Standard & Poor’s (S&P) and Moody’s.
, or
With open end funds, you transact at NAV (adjusted for loads), while the price of a closed end fund can be different from NAV. If the closed end fund sells at a “premium”, the price exceeds NAV. If the closed end fund is selling at a “discount”, the market price is below NAV.
First exam
Chapter 1
Investment
The commitment of current resources (time, money, etc.) with the expectation of enhanced future benefits. In FIL 242, an investment is typically financial in nature requiring the purchase of a security in exchange for claims on the assets of the issuing company.Direct vs. indirect investments
In a direct investment, the supplier of funds and the user of funds interact directly. Excess funds from households funnel directly to the user of funds while the security created exchanges hands from the issuing company directly to the investor. With indirect investments, a direct exchange between suppliers and users of funds is compromised. A financial intermediary, such as a bank or mutual fund, is placed between the originator of the security and the ultimate supplier of the funds. During intermediation, the security held by individual households, who are supplying funds, is different from the security held by the intermediary. Example: Mutual funds buy shares directly in companies like IBM, Microsoft, and Caterpillar, but individuals buy shares of the mutual fund.Debt
Debtholders have a fixed claim on the income and the assets of the borrower. A contract establishes the size of the claim held by the lender. Debtholders get paid before equityholders do.Equity
Equity represents partial ownership in a corporation. Equityholders have claim to the residual value of income and assets of a company.Investment policy statement (IPS)
IPS is the written document that guides investors in decision making. It is frequently used by professional money managers to describe the requirements of the investor (client) and the strategies which manager is going to use to fulfill those requirements. Important components of the investment policy statement include asset allocation and security selection decisions, as well as recognizing any specific constraints.Asset allocation
Asset allocation is the broad proportions of asset classes that comprise the portfolio of an investor. Typical asset categories include stock, bonds, real estate, international investments, and cash. Example: 50% of the portfolio invested in stock, 30% invested in bonds, 10% in real estate, 5% international investments, and 5% in cash.Security selection
Security selection is the choice of the specific assets within a particular asset class, such as stocks. Whereas asset allocation describes the total percentage invested in stocks, security selection next answers which individual stocks to purchase.Capital gains
When the price of an asset increases over and above the initial purchase price, the difference between those two prices is called capital gain. If the price of the asset falls over the investment horizon the investor is said to experience a capital loss. Example: If you buy a stock for $10 and sell it for $25, you had a capital gain.Realized vs. unrealized capital gains/losses
Capital gains are realized if the investor actually sells the asset and gets cash. Realizing capital gains and losses means the investor has experienced changes in their cash position as a result of the investment.Unrealized capital gains/losses (a.k.a. “paper gains/losses”)
When the value of the investments changes but the investor has not sold the asset, the capital gain or loss is said to be unrealized.Chapter 2 - Security overview
Coupon
The contractual interest obligation a bond issuer agrees to pay to its debtholders.Face value
The underlying principal of a bond contract. It is the amount that an issuer agrees to repay at the maturity date of the bond.Maturity
Maturity is the time period after which debt is due and the issuer will repay the underlying principal or face value back to the bondholder.Sinking fund
Sinking fund is reserve fund used by the company to repay the principal amount of bonds when they mature. Companies basically reserve some money annually in the sinking fund so at the time of the maturity there will not be scarcity of funds. Investors see the accumulating funds and feel better about the company’s ability to meet their debt obligations as they come due.Term vs. serial bonds
Term bonds pay off all bonds on a single maturity date. Serial bonds are arranged so that specified principal amounts become due on staggered dates to reduce the financial stress associated with paying off a large principal amount on one particular date.Secured vs. unsecured bonds
Secured bonds are back by different types of collateral. In the case of default the borrower recovers losses to bondholders by liquidating the pledged collateral. Unsecured bonds have no explicit collateral but are just backed by faith and good image of the issuer. Unsecured bonds typically have higher interest rates to reflect the additional risk associated with the bonds. Unsecured bonds are called debentures.Senior vs. junior (subordinated) bonds
In case of default, the senior bondholders will be paid before junior or subordinated bondholders.Notes vs. bonds
Notes are debt instruments that have initial maturities (when issued) of up to 10 years. Bonds have initial maturities longer than 10 years.Municipal bonds
State or local governments offer muni bonds or municipals, as they are called, to pay for government projects. The interest that investors receive is exempt from some income taxes.Treasury securities
Debt instruments that are issued by the U.S. government. These securities are assumed to be free from default risk – that is, 100% of the time it is assumed that the U.S. government will meet all of their obligations that are due under the debt contracts.Agency bonds
A bond, issued by a U.S. government-sponsored agency. The offerings of these agencies are backed by the U.S. government, but not guaranteed by the government since the agencies are usually private companies (except Ginnie Mae). Such agencies have been set up in order to allow certain groups of people to access low cost financing, especially students and first-time home buyers. Some prominent issuers of agency bonds are Student Loan Marketing Association (Sallie Mae), Federal National Mortgage Association (Fannie Mae) and Federal Home Loan Mortgage Corporation (Freddie Mac).Price weighted index
An index that is computed by adding together all of the stock prices included in the index and dividing by a divisor. Upon establishing the index, the divisor is chosen to be the number of shares in the index. As stocks split over time, the divisor needs to be adjusted periodically. The Dow Jones industrial average is the most well known price-weighted index.Market-value weighted index
An index that is computed by comparing the market capitalization of the stocks included in the index at two different times: the index date and some initial base period.Chapter 3 - Economy
Business cycle
Business cycle represents repetitive up and down movements in the economy over a period of time. Historically, economies experience natural periods of growth and contraction. Swings in the business cycle are commonly measured by the real growth in gross domestic product (GDP).Top-down approach to investment analysis
Top-down investment analysis is a sequential process for selecting investments which begins looking at general economic issues and then works down to understand individual security issues. First, macroeconomic issues are studied. Next, the focus turns toward specific industries which are expected to thrive in different stages of the economy. Finally, individual companies are selected from those top industries.Fed funds rate
The rate that banks charge to borrow and lend excess reserves, typically on an overnight basis. The fed funds rate is the interest rate that is targeted by the Federal Reserve.Fiscal policy
Government policy related to spending and taxation. Increased spending and tax cuts are frequently used to increase economic activity.Monetary policy
Actions taken by the Federal Reserve to influence interest rates and/or the money supply. Increasing interest rates is an attempt to slow down a rapidly growing economy which has inflationary pressures. Decreasing interest rates is an attempt to spur economic activity.Budget deficit
In the U.S., the Federal government has historically spent more money than it collects in tax revenue. To make up the difference, the Federal government borrows heavily in the financial markets.Trade deficit
When a country imports more than it exports.Cyclical vs. defensive stocks
The performance of cyclical stocks is closely aligned with movements in the business cycle and performance of economy. If economy is growing, cyclical companies sell significantly more products which often increase profits. Subsequently, cyclical stocks perform well in growth stage of the economy. Defensive stocks are less susceptible to swings in the business cycle. An underlying demand exists for these products regardless of the stage of the economy.Examples of cyclical stocks include big ticket items such as housing, automobiles, luxury and leisure products (air travel). Defensive companies include health care, groceries, tobacco, and diapers.
Sector rotation
A portfolio strategy which attempts to move money into different industries based on economic conditions. For example, investing in cyclical stocks during times of economic growth and switching to defensive industries as the economy shrinks.Chapter 4 - Individual security risk and return
Dollar return
Investing in securities brings two potential sources of returns: income and capital gains. The total dollar return includes both of these sources.Total percentage return (a.k.a. holding period return or HPR)
The total dollar return per dollar invested. You can also break the total percentage return into its components, called capital gains yield and income yield.Capital gains yield
The percentage return earned from capital gains.Income yield
The percentage return earned from income. The income yield is a generic term that is used for any investment. More commonly, the return from income goes by alternate names depending on the specific asset. For stocks, it is called dividend yield and for bonds, it is called current yield.Dividend yield
The percentage return earned from a dividend paying stock. In the financial press, dividend yield is the annual return from income (dividends) if a stock is purchased today at the current market price.Current yield
The percentage return earned from a coupon-paying bond. It is calculated as the total annual interest income from the bond divided by its current price. Current yield indicates the returns that investor will receive strictly from income over the coming year if they purchase the bond today.APR (annualized percentage rate or return)
HPR is the return over a period which is typically less than one year in length. APR is the HPR on an annual basis and is calculated by multiplying HPR by the number of periods in a year. APR does not account for compounding.EAR (effective or equivalent annual rate or return)
HPR is the return over a period which is typically less than one year in length. EAR assumes the original amount invested is compounded each period throughout the year.Internal rate of return
The Internal rate of return (IRR) is the discount rate that equates the present value of inflows with the present value of outflows. IRR determines the return from an investment by explicitly accounting for the timing of the cash flows involved during the investment horizon.Variance
The variance measures the average squared deviation from expected. It is a measure of uncertainty, or surprise, that may be experienced when investing in a security. To calculate the variance, first one needs to calculate the arithmetic average return. Then, compute the squared difference between each observation and the arithmetic average return.Standard deviation
The square root of the variance.Arithmetic average return
The simple average return, computed by adding up all of the periods’ returns and divided by the number of periods. Arithmetic return does not account for compounding and is therefore used as a one-period prediction of returns.Geometric average return
A measure of the average compound rate of growth of an initial investment in a portfolio over an entire investment horizon. Geometric average return assumes that the portfolio is reinvested fully each period. To calculate geometric average return, the returns of each period should be compounded. Then take the nth root of the compounded return.Market risk
Market risk refers to uncertainty that is common to all securities in a particular market (such as the stock market). All securities in the market are similarly affected by changes in interest rates, unemployment, and other general economic phenomena.Firm specific risk
Uncertainty that is unique to a company such as a strike, the outcome of unfavorable litigation, or a natural catastrophe. This type of risk does not affect other companies.Liquidity risk
The uncertainty that a security can be sold quickly at close to its fair market value.Default risk
Credit risk is the risk that a company or individual will be unable to pay the contractual interest or principal on its debt obligations. This type of risk is of particular concern to investors who hold bonds in their portfolios.Risk aversion
Wanting to avoid risk unless adequately compensated for it which is the attitude of most investors. As an example, if two investments have the same expected return, the one with lower risk would be preferred by risk averse investors. A riskier investment has to have a higher expected return in order to provide an incentive for a risk-averse investor to select it.The excess compensation (return), over and above the risk free rate, or .
Margin
The margin relates to an investor’s equity position when investing. When buying on margin, it is the proportion that is contributed by the investor. When selling stock, it is the additional collateral required by the lender of the shares. Margin is defined as:Maintenance margin and margin call
When buying a stock on margin, the broker lends money to the investor. When short selling stock, an investor lends shares to the short seller. In these transactions, the lenders require some security to protect them against the risk of default of the investor. Equity represents the available cushion to the lender. In order to be sure that this cushion remains sufficient, the lender puts a lower bound on the margin of investment positions. If the margin falls below the maintenance margin, the investor receives a margin call which is a request for additional equity. If the investor fails to either pay off part of the loan or contribute more equity to their account, the lender will close out the position immediately.Exam 2
Chapter 5 – Portfolio risk and return
Correlation
Correlation is a statistical measure of the co-movement between two numbers and is denoted by the Greek letter rho (r). The correlation coefficient is between -1 and +1. Perfect positive correlation (r) implies that the two numbers always move in the same direction – as one number increases, the second number always increases. Perfect negative correlation (r) describes two numbers that always move in the opposite direction. If correlation equals zero, there is no relationship between the numbers – they are independent.Investment opportunity set
The investment opportunity set shows all of the available combinations of risk and return when securities are combined in a portfolio. When portfolios are formed with only two securities (assets I and J), the investment opportunity set is a line on a risk/return graph. If the correlation between the securities is +1, the investment opportunity set is a straight line between securities I and J. If the correlation between the securities is -1, the investment opportunity set intersects the vertical axis, meaning there is a specific combination of the two securities which eliminates risk completely. Typically, the correlation between securities is positive but less than +1. The investment opportunity set in this case is a curve.Diversifiable risk
This is also known as nonsystematic risk, firm specific risk, and unique risk. This portion of an investment’s risk results from events that are unique to the individual security. Since this risk is unique to it a specific security, it’s correlation with other securities is less than +1. Adding more securities that are less than perfectly correlated with the rest of the portfolio yields diversification benefits.Systematic risk
Also known as market risk or beta risk. This portion of an investment’s risk is attributable to forces that affect ALL investments. Since market risk affects all securities, it cannot be diversified away.Diversification
A technique that is used to lower the overall risk in a portfolio. Diversification works best when combining assets that have low correlation with the rest of the portfolio. Diversification benefits are achieved when adding securities that are less than perfectly correlated with the rest of the portfolio. Diversification works because firm specific risk is less than perfectly correlated among all investments in a portfolio. However, market risk cannot be diversified away since it is inherent in all securities.Beta
This is a measure of the amount of market risk inherent in an individual security. Bet is a relative measure of systematic risk where the beta of the market (i.e., the average security) is defined to have . An alternative interpretation is that beta is the sensitivity of the individual security’s returns to changes in the market. Cyclical companies are highly affected by the state of the economy. Therefore, cyclical companies returns are more volatile than the average security and . On the other hand, defensive companies are not as volatile as the overall market and therefore defensive companies have . Beta is estimated by measuring an individual security’s returns relative to the returns on the market. To measure this sensitivity, we must run a regression.Capital asset pricing model (CAPM)
CAPM determines the returns that investors demand based on the risk inherent in a particular security. CAPM is a specific form for the risk-return tradeoff in finance. CAPM says that investors should not be compensated for taking on firm specific risk since it can be diversified away. The only relevant risk according to CAPM is market risk as measured by beta. The specific form of the risk-return tradeoff is linear – the more risk a security has (as measured by beta) the higher the return.The market risk premium is the excess return that the average security earns over and above the risk free rate (). The market risk premium is one way to assess the level of risk aversion of the entire market at any point in time. When the market is very risk averse, they require a significantly higher return in order to place their money at risk. In these cases the market risk premium increases.
Security market line (SML)
A graph of the capital asset pricing model equation. The security market line illustrates the required return demanded by investors based on the amount of risk inherent in a security. After determining the return that investors demand (or want), securities are analyzed to estimate what the expected return of the stock might be based on a company’s prospects. Finally, investors compare the required return vs. what they expect security to earn. When securities plot above the security market line, it more than adequately compensates investors for the risk embedded in the security. When securities plot above the line, it is a good investment or said another way, it is undervalued by the market. Securities that fall below the SML are bad investments and should be sold.Modern portfolio theory
This is a two step approach that is used to determine the optimal portfolio for individual. In step one, we determine the efficient frontier which determines the best portfolios in terms of risk and return. In step two, we overlay an investor’s indifference curves to determine which portfolio on the efficient frontier is optimal for that particular investor.Efficient portfolio and efficient frontier
An efficient portfolio provides the highest possible return for a given level of risk or equivalently has the lowest level of risk for it given level of return. There are no feasible portfolios that are superior to an efficient portfolio for a given level of risk or return. The efficient frontier illustrates all of the efficient portfolios for any given level of risk.Indifference curves
An indifference curve illustrates the risk and return tradeoff for an individual investor. A single indifference curve indicates the additional return required to take on additional risk to leave the investor as happy as before. Each indifference curve shows a constant level of utility (or happiness) for a particular investor. Extremely risk averse investors require a significant extra return for taking on a little bit of risk, which implies that the indifference curves are quite steep. More tolerant Investors only require small additional return for taking on large amounts of risk which leads to relatively flat indifference curves. There is one indifference curve for every level of happiness for an individual investor. Investors desire to be on the highest indifference curve, that is, the one that is furthest to the northwest on a risk/return graph.Chapter 6 – Fundamental analysis of stocks
Fundamental analysis
The study of the financial affairs of a company or security for the purpose of better understanding its future prospects. With fundamental analysis, investors try to understand all aspects of a business, from the management to its products to its current financial condition. In essence, fundamental analysis is learning as much about a company as possible to help understand what its future prospects may be.One common approach in fundamental analysis is a top-down approach which begins with the general assessment of the overall economy. Understanding the macro economy helps identify conditions that can affect specific industries. Following a macro economic analysis, fundamental analysis begins to refine its focus and look at specific industries, noting key issues that are highly relevant to businesses in that industry. Finally, analysis is concentrated on specific companies. Analyzing a specific company frequently is done by looking at financial statement analysis or ratios to assess an individual firm’s financial condition.
Balance sheet
Also known as the statement of financial position. The left hand side of the balance sheet shows the assets owned by the company, or what the company owns. Assets are what the company uses in its operations to produce cash flows for investors. The right hand side of the balance sheet shows how the company financed those assets. Liabilities and equity are different types of claims on a company’s assets or how cash received from assets is distributed to those who contributed to pay for the assets.The balance sheet shows the financial condition of a company on a specific date – it is a snapshot of the company on one date. In general, assets are shown in order of liquidity, or the order in which the assets are expected to generate cash for investors. Liabilities and equity shown in the order in which investors line up to lay claim on the assets and income of a company.
The accounting identity shown on the balance sheet is that assets equal liabilities plus equity (A=L+E). The values of the assets, liabilities, and equity are based on a book value basis or historical cost.
Income statement
The accounting identity on the income statement is revenue minus expenses equal profit. Whereas the balance sheet shows the financial condition of the company at one point in time, the income statement indicates financial performance over an entire period, such as a year, a quarter, or a month.Cash flow statement
The bottom line of the income statement is net income or profit. However, there are several differences between accounting profit and cash. For example, depreciation is an expense that reduces the reported accounting profit on the income statement. However, depreciation is not a cash expense, but rather an accounting convention – spreading the cost of a fixed asset over its useful life. Another difference between cash and profit is when sales are made using credit. The sale increases net income, but since the customer is using credit we have not received the cash from the sale.The cash flow statement tracks changes in cash and is organized in three sections. (1) Operating cash flow adjusts net income for noncash items (such as depreciation) and other items (such as changes in current assets and current liabilities). (2) The second section in the cash flow statement is investing cash flows, which shows the net effects of buying and selling fixed assets. Growing companies typically are expanding operations and buying fixed assets; therefore, investing cash flows are frequently negative for growing companies. While the income statement reflects annual depreciation charges for fixed assets, the cash flow statement shows the actual upfront outlays associated with purchasing fixed assets. (3) The final section of the cash flow statement is financing cash flows, detailing the company’s use of borrowing and/or issuing new stock securities. Often, growing companies need external financial to pay for their investment in fixed assets so financing cash flows are positive.
Liquidity ratios
Liquidity ratios show the ability of the company to meet its short term obligations. Two common equity ratios are the current ratio and the quick ratio.Asset management ratios
These ratios determine the ability of management to use assets in an efficient manner. Since ultimately investors have to contribute funds to purchase assets, good managers create more sales from fewer assets. Examples of asset management ratios are total asset turnover, inventory turnover, fixed asset turnover, and days of sales outstanding.Debt management ratios
These ratios determine how effectively debt is being used by an organization. In order to understand the appropriate use of debt, we must understand first the amount of debt that the company is using. This is determined by the debt ratio, the debt to equity ratio, or the equity multiplier. After we understand the amount of debt the company uses, we need to evaluate how well the company is meeting the interest expense on its outstanding debt. The TIE (times interest earned) ratio evaluates the number of times that interest expense can be paid by the operating income of the company.Profitability ratios
These ratios help investors understand how all of the operations of a company translate to the bottom line, or the net income of the company. Companies that manage their expenses (including operating costs, interest expenses, and taxes) have higher profitability ratios. Three profitability ratios include net profit margin, return on assets, and return on equity.Dupont analysis
Also known as ROE decomposition. Dupont analysis helps managers determine the drivers of ROE.Once the manager has calculated that three separate ratios, they may do a more focused analysis on the areas of the company that lag behind either an industry or a key competitor.
Chapter 7 – Stock valuation
Par value (of stocks)
The par value of stock is no longer a very useful concept. At one time, the par value was the initial offer price and the issuing company agreed to not offer additional shares below the existing par value. In this way, investors could be sure that future shareholders would not receive a better price if the company offered more stock. Nowadays, companies and the financial markets are closely scrutinized by the Securities and Exchange Commission so that investors can feel more confident when buying new shares of stock. Most stocks today do not have par values, or if they do, they are ridiculously low (such as one penny).Book value of equity
The book value of equity per share is calculated by taking the common equity value shown in the balance sheet and dividing by the number of shares outstanding. Book value refers to the amount that is shown in the financial statements which is typically based on historical cost. The balance sheet shows the accounting identity . Solving this equation for equity, . Given that assets are recorded based on historical cost, it is likely that the book value of assets shown on the balance sheet grossly underestimates the true market value of those assets. As a result, the book value of equity is a poor estimate of the true market value of the company. In some instances, it may be considered a worst case, lower bound for a company’s stock price.Intrinsic value
Refers to the present value of future cash flows of an investment. To determine intrinsic value, investors need to make assumptions about: future cash flows and the required discount rate.Based on these assumptions, the intrinsic value tells the investor what the investment “should” be worth. To determine whether an investment should actually be purchased, the investor compares his estimated intrinsic value with the actual market price. If the investment can be purchased at a lower price than the investor believes it is worth as predicted by intrinsic value, he or she should purchase the investment.
Market value
This is the price that investors are currently paying for a particular investment. It is likely that the overall market is making different assumptions about the future cash flows of aninvestment and/or its risk. Therefore, an individual investor’s estimate of intrinsic value is likely to be different than the value actually paid by the market.
Dividend discount model (DDM)
DDM is an approach that is used to determine the value of the stock by discounting all dividends that are expected to be paid in the future. Since stocks have no stated maturity date, this requires investors to project dividends forever. The discount rate is based on an assessment of the stock’s risk, commonly estimated using CAPM.Constant growth dividend discount model or the Gordon model
The Gordon model is a specific case of the DDM where dividends are expected to grow at a constant rate (forever. Mathematically, the infinite series of discounting all future dividends collapses to a simple formula:There are several implications of the Gordon model:
1. The growth rate of the stock, or the capital gains yield, is the same as the rate of growth of dividends (.
2. If all transactions take place at the intrinsic value, the total expected return earned by the investor (including dividend yield and capital gains yield) is equal to the return required by the investor ().
The most difficult value to estimate in the Gordon model is growth rate of dividends. The Gordon model works well for companies that are in mature markets whose rate of growth is similar to the rate of growth in the overall economy.
Sustainable growth rate
This is a calculation that determines how much a company could comfortably grow if it reinvests profits back into the organization. Since ROE is a measure of the (accounting) rate of return on a business, the sustainable growth rate is determined by considering the percentage of these profits that are reinvested back into the company.Multi stage dividend discount model
Since many companies do not exhibit constant growth, the Gordon model is inappropriate for valuing their stock. Frequently, new companies grow rapidly at first, then growth slows as the company’s products and industry matures. The multi stage DDM still attempts to find the present value of all future dividends. But instead of assuming that these dividends increase at a constant rate forever, the multi stage DDM uses two distinct stages: Super normal growth phase – during a company’s early formative stages, it is experiencing rapid growth in dividends.Constant growth phase – a company cannot continue to grow at a rapid rate forever. At some point in the future, the company’s products will have saturated the market in which case growth must slow down. When the company matures, it is assumed to enter the constant growth phase. To calculate a stock price under the multi stage DDM, follow three steps:
1. Project dividends through the super normal growth phase
2. To determine the value of the dividends during the constant growth phase, calculate the stock’s terminal value or horizon value
3. Discount steps 1. and 2. (above) at the stock’s required rate of return.
Dividend payout ratio
There are two things that companies can do with earned profits: pay them out as a dividend or reinvest them back into the company. The percentage of profits or earnings that are distributed to shareholders as cash dividends is called the dividend payout ratio.Retention ratio (or plowback ratio)
Instead of paying dividends, the retention ratio is the percentage of profits or earnings that a company reinvests back into the organization.P/E ratio
The P/E Ratio is a measure of how much investors are paying for each dollar of current profit.The P/E ratio summarizes the market’s view of the projected growth of the company. To see this, note that shareholders are the residual claimholders of a company, receiving any profits that are left. If investors believe this residual claim is going to grow rapidly because of a company’s future performance, they will be willing to pay more for the stock per dollar of current income. If a company’s profits are expected to be stable or even decline, investors will pay less for the stock.
PEG ratio
The P/E ratio is a measure of market perceived growth. As people perceive a company’s growth rate to increase, so does the price of the stock and consequently its P/E ratio. Investors may check the relationship between market perceived growth as proxied by the P/E ratio and the company’s actual growth rate using the PEG ratio.If the PEG is too high, the P/E ratio may not be justified since actual earnings growth is low.
Chapter 8 – Technical analysis
Technical analysis
Technical analysis uses price movements and volume data to assess market sentiment about a particular stock or the overall market. Technical analysts do not attempt to find the intrinsic value of a stock and they ignore the underlying business of companies or its products. Instead, they focus on supply and demand forces that have historically affected the market for a stock.Dow theory
One of the earliest forms of technical analysis, Dow theory suggests that the overall market has three specific trends. The primary trend is the market movement over long periods of time. Secondary trends move against the primary trend but are only temporary in nature – overall the market is still moving in the primary trend direction. Finally, tertiary or daily fluctuations in the market are irrelevant. The goal of Dow theory is to identify the primary long-term trend.Arms ratio or trin
A technical indicator that incorporates volume to weight the importance of price movements. Technical analysts argue that price moves with heavy volume are more important than price movements with light volume. The Trin ratio is one approach to incorporate volume into a technical indicator. If Trin > 1.0, then people were trading more heavily in the stocks that declined in value indicating a bearish training session. If Trin < 1.0, then people were trading more heavily in stocks that advanced indicating a bullish trading session.On balance volume (OBV)
A cumulative measure of the market sentiment of a stock that incorporates the volume of trades. Each day, if the stock price INCREASES, the volume of that day is ADDED to the cumulative OBV. If the stock price DECLINES during the day, volume is subtracted from OBV. Market sentiment is measured based on the trend in OBV.Market breadth
A simple comparison of the number of stocks advancing versus declining on any particular day.Advance/decline line
A measure of cumulative market breadth. Instead of looking at market breath on any one particular day, the advance/decline line accumulates the net advancing shares (the number of advancing stocks minus the number of declining stocks) over time. Technical analysts then look at the trend in the cumulative advance/decline line to make an assessment of market sentiment.Short selling
A strategy that is designed to profit from falling stock prices. To short sell a stock, one must borrow shares from another investor and sell them in the marketplace. Later, the investor must go back into the market to repurchase shares and return them to the lender (called covering their short position). If the short seller can sell the securities at the start of the transaction at a higher price than they cover their short position, they will earn a profit. In other words, they profit when the stock price falls.Odd lot
A trading order of less than 100 shares, i.e, less than a round lot. Most odd lot transactions are done by small investors.Line chart
A graph of stock prices which simply connects the closing stock prices at the end of each period (typically daily prices).Bar chart
A graph of stock prices. For each period, the top of the line indicates the highest trading price during the trading period, the bottom of the line indicates the lowest trading price of the period, a tick mark pointing to the left of the line indicate the opening price during the period, and a tick mark to the right indicates the closing price for the period.Point and figure chart
Unlike line charts and bar charts, the point and figure chart has no explicit time dimension. Using X’s to indicate increasing prices, point and figure charts track only significant price moves in a specific stock. O’s each column in a point and figure chart shows a price reversal.Moving average chart
Instead of graphing the closing price on each day, the moving average takes the average closing price over a number of days. The point of moving averages is to downplay any specific day and smooth out daily fluctuations. When more days are included in a moving average, you get a smoother resulting line. Shorter moving averages follow the daily prices more closely and are more volatile than longer moving averages.Support level
A support level is an apparent or perceived lower bound for the price of a stock. Each time the stock price approaches the support level, it appears to bounce away from that price. Technical analysts argue that support levels represent underlying demand for a security when a stock price falls too low. At that point, technical analysts argue that investors’ recognize that the stock surely has value at the support level. The buying pressure that results forces prices up.Resistance level
A resistance level is an apparent or perceived upper bound for the price of a stock. As the stock price rises, traders in the market believe the fundamentals of the company do not justify ahigher price than the resistance level. As a result, a flood of sell orders come to the market depressing the stock price. Technical analysts argue that stock prices have a difficult time breaking through the resistance level.
Chapter 9 – Market efficiency
Efficient market hypothesis (EMH)
By using some type of information available in the market, the efficient market hypothesis suggests that no investor can consistently outperform everybody else in the market. There are three different forms of the EMH which is differentiated by the type of information the investor is trying to exploit. The implication is that there are no discernible strategies that can help an investor do better than investing in a portfolio of stocks that is randomly chosen. The efficient market hypothesis is a controversial topic, and there appears to be evidence both for and against efficiency.Weak form market efficiency
If the market is weak form efficient, then investors who use historical price information cannot earn higher returns. The weak form of market efficiency says that stock prices do not follow a pattern. Technical analysts use historical information and analyze price trends and statistics from historical data. Therefore, technical analysts believe the market is not weak form efficient. If, in fact, the market is weak form efficient, then technical analysts are wasting their time.Day of the week effect or weekend effect
This is an anomaly to weak form efficiency. Historically, returns on Monday are negative while the returns on other days of the week are all positive and approximately the same.January effect or small firm effect
This is an anomaly to weak form efficiency. Historically, the returns in January have been higher than other months of the year. In addition, the magnitude of the difference between January and other months is much greater for small stocks.Semi strong market efficiency
If the market is semi strong efficient, than investors who use all publicly available information cannot earn higher returns. The semi-strong form of market efficiency says that by incorporating all types of information about the economy, an industry, and a company, this will not allow investors to reap abnormal rewards. Fundamental analysts attempt to study the financial condition of companies and exploit public information to earn higher returns. If the market is a semi strong efficient, then fundamental analysts are wasting their time.Value Line enigma
Value Line is an investment publication that ranks stocks from 1 (good time to buy the stock) to 5 (bad time to buy the stock). Value Line’s rankings show that in fact they are good stockpickers. A portfolio of stocks that were ranked 1 significantly outperforms stocks that were ranked 2, which outperform stocks that were ranked 3, etc. However, if the market is semi-strong efficient, Value Line should not be able to be such good stock pickers. This is because we could earn higher profits than the average investor by simply investing in stocks that were ranked number 1 by the Value Line publication. If the market is semi strong efficient, we should not be able to profit from public information.
Growth stock
These are stocks of companies that are expected to experience significant growth in profits over the coming years. As a result, people bid up the current price of the stock and the P/E ratio is high. History shows that in general stocks with low P/E ratios (value stocks) outperform high P/E ratio stocks (growth stocks).Value stock
Relative to growth companies, value companies are not expected to experience significant growth in profits since they operation in industries that are stable and mature. The P/E ratio on value stocks is low. History shows that in general stocks with low P/E ratios (value stocks) of perform high P/E ratio stocks (growth stocks).Strong form market efficiency
If the market is strong form efficient, then prices reflect all information, both public and private. Insiders of companies (such as the CEO or the board of directors) frequently have more information about a company than external investors. But if the market is strong form efficient, then insiders cannot profit from their private information. However, studies have shown that insiders can exploit their insider information and earn higher profits than other investors. Therefore, studies suggest that the market is not strong form efficient. This is why there are insider trading restrictions in the U.S.Active portfolio management
An active trader is one that performs significant research and analysis when picking investments. If the market is efficient, careful research is worthless and active managers are wasting their time and effort. Any money spent on research reports is therefore wasted (if the market is efficient).Passive portfolio management
Passive investors do not perform any research when selecting investments. Instead, passive investors simply try to replicate the market’s return by investing in a portfolio that mimics the return on a popular index such as the S&P 500.Exam 3
Chapter 10 – Bond valuation
Yield to maturity (or yield)
The yield to maturity is the interest rate required by bond investors. While we do not observe interest rates in the market, the yield to maturity is often implied from the prices observedwhile trading. Investors determine the price by discounting the cash flows of the bond at the required rate of interest. Therefore, if we observe the price that investors pay for the bond we can imply what discount rate they used:
In the bond pricing equation above, the left hand side represents the discounted value of the cash flows received and the right hand side represents the price paid today for the bond. The unknown is the discount rate (YTM). We can say this another way, solve for the discount rate so that:
Therefore, the yield to maturity is identical to the internal rate of return on the bond. In this way, the interest rate that investors require is the return that they receive if they hold the bond until maturity.
Nominal interest rate (r)
The nominal interest rate is the rate that we observe in the financial markets. There is a wide variety of interest rates that exist in the market – an interest rate for the U.S. government, one for high quality corporations, one for low quality corporations, one for short term debt, one for personal loans, etc. The actual rate that we observe for each of these markets is called the nominal interest rate. Investors determine the required interest rate to compensate them for several items:Real rate of interest (r*)
The real rate of interest is the compensation that lenders receive in an inflationless and risk-free world. The real rate of interest represents the underlying supply and demand of loanable funds in the financial markets. Note that changes in the real rate of interest affect all borrowers. For example, if the economy improves, the demand for money increases forcing up the real rate of interest. As a result, all interest rates in the economy increase.The inflation premium is the compensation demanded by lenders to cover the loss of purchasing power over the length of the loan. If expected inflation increases, lenders demand a higher interest rate from borrowers.
A lender receives the cash flows promised under a bond as long as the borrower remains creditworthy. The default risk premium is the additional compensation demanded by bond investors for the uncertainty associated with the borrower meeting the obligations due under the bond. If the financial condition of the borrower is impaired, then the risk of investing in the
bond is high and investors require a higher DRP (and therefore a higher interest rate) to compensate them for this risk. To help investors assess the potential of default in the bond, rating agencies evaluate the financial condition of an issuer and their bond. Two popular rating agencies include Standard & Poor’s (S&P) and Moody’s.
Many investors are reluctant to lend their money for long periods of time. Therefore, the interest rate on long-term loans is typically higher than the interest rate on short term loans. The extra compensation that investors demand for lending money on a long-term basis rather than short term is the maturity premium.
Some bonds, such as treasury securities, had a very liquid secondary market. This means that as investors would like to sell the bond they can quickly do it in these liquid markets. However, many bonds are not traded actively. If a bond cannot be sold quickly at close to its fair market value, investors demand an extra return for this lack of marketability. Bonds that are not actively traded have higher interest rates because of the liquidity risk premium.
When a bond is callable, the investor faces uncertainty as to when they will receive the proceeds of the bond. If the bond is held to maturity, they receive face value. However, because of the call feature, the investor may receive the proceeds much sooner. It is likely that a bond is called for refinancing purposes which means that a bondholder is forced to reinvest the proceeds from the bond at the worst possible time – when interest rates are low. To compensate the investor for this risk, investors demand a call premium. (Note that the call premium described here is different from the call premium embedded into a call schedule).
Yield curve
The yield curve is a depiction of interest rates by the length of the loan (or maturity). Typically, long-term rates are higher than short term rates, and the yield curve is upward sloping. This is called a normal yield curve. When short term rates are higher than long-term rates the yield curve is inverted. Two other shapes of the yield curve that have been experienced in the U.S. are flat yield curves and humped yields curves. While not exactly correct, the terms “yield curve” and “the term structure of interest rates” are often used interchangeably.Investment grade bond
Investment grade bonds have high credit quality as indicated by their bond rating. Investment grade bonds are rated BBB or better by S&P (or Baa by Moody’s).Junk bond (or speculative grade bond)
Junk bonds have lower credit quality than investment grade bonds as indicated by their bond rating. Junk bonds have ratings of BB or worse by S&P (or Ba by Moody’s).Premium bond
When a bond sells for more than its face value it is called a premium bond. Bonds sell at a premium because the coupon rate exceeds the yield.Discount bond
When a bond sells for less than its face value it is called a discount bond. Bonds sell at a discount from face value because the coupon rate is less than the yield.Par bond
When a bond sells at approximately its face value it is called selling at par. Bonds sell at par when the coupon equals the yield.Yield to call
The yield to call is the return on a bond (more specifically the IRR) assuming the bond is called on the first possible call date. The calculation is very similar to the YTM, but instead of receiving the face value at maturity, the bondholder receives the call price on the first possible call date. This is a better measure of return for bonds that are selling at a significant premium since it is likely that the bond will be called in this case.Realized yield
The realized yield is the return on a bond (more specifically the IRR) when the bond is sold prior to its maturity. The calculation is very similar to the YTM, but instead of receiving the face value at maturity, the bondholder receives the selling price of the bond on the date that the investor relinquishes the bond.Callable bond
Callable bonds give the borrower (the bond issuer) the right to redeem the bond prior to its maturity at its discretion. If the bond is called, the bondholder must relinquish the bond in exchange for payment. The call schedule indicates each date that the bond can be redeemed prior to maturity along with the call price that must be paid if the bond is retired. If the bond is called, the bondholder receives not only the face value of the bond, but an additional amount called the call premium. If interest rates fall, borrowers will want to refinance their loans by issuing new debt at lower interest rates and using the proceeds to pay off higher interest debt.The call schedule shows the dates that bond issuers may redeem the bonds as well as the associated prices they must pay to bondholders. When a bond is issued, there is an initial period during which time the bond cannot be called. After this call protection period ends, the call schedule shows the call price which must be paid to bondholders upon early redemption. The call price includes not only the repayment of face value, but an additional amount called the call premium. In most cases, the call premium is highest on the first call date and declines over time.
Treasury STRIPs
The STRIPs program is where investment bankers purchase Treasury bonds that pay semiannual coupons and then sell the individual coupons as separate zero coupon bonds in the financial markets. STRIPs are securities that have no cash flow until the maturity of the bond.Duration
Duration is a measure of the interest rate sensitivity of a bond. Specifically, there are two duration measures: Macaulay and modified duration. Macaulay duration looks at the average time at which the value of the bond is received by the investor. For a zero coupon bonds, the entire value of the bond is received on one date – the maturity of the bond. Therefore, the Macaulay duration of zero coupon bonds is equal to its maturity. For coupon paying bonds, some of the value of the bond is derived from coupon payments which are spread out over the life of the bond. Therefore the average time that the value of the bond is received is less than its maturity. Macaulay duration is related to interest rate changes through the modified duration. Modified duration is a direct measure of a bond’s interest rate sensitivity. To calculate modified duration: Modified duration is an estimate of the percentage change in the bond price for a 1% change in interest rates. Or: Where is the change in the interest rate (or yield).Chapter 11 – Investment companies
Unit investment trusts (UITs)
Unit investment trusts are unmanaged investment companies. UITs take the contributions of investors and invest in a portfolio that stays fixed throughout the life of the UIT.Portfolio turnover
Turnover indicates how much trading is done in the portfolio of an actively managed investment company. Loosely, turnover indicates the percentage of the portfolio that changes each year. If portfolio turnover is equal to 50%, this means that half of the portfolio changes each year. Higher turnover indicates more trading which typically leads to higher management fees.Closed end funds
A closed end fund is an actively managed investment company. Like most stocks that trade on an exchange (e.g., IBM, GE, or MSFT), the number of shares in a closed and fund is fixed at any point in time. In order to purchase a closed end fund, and investor must find a willing seller in the secondary market. Unlike mutual funds, the price of closed and funds may deviate from the value of the underlying portfolio (as indicated by net asset value (NAV)).Open and fund, a.k.a. mutual funds
Mutual funds are actively managed investment companies. Unlike closed end funds, the number of shares in a mutual fund changes daily. Investors who are interested in a particular mutual fund simply contact the fund to buy or sell shares of a portfolio. The open end fund will create new shares for investors or redeem shares upon request. When buying and selling mutual funds, investors transact at NAV (adjusted for loads), which is usually determined only once per day by the mutual fund.Exchange traded funds (ETFs)
ETFs are investment vehicles that have features of both closed end and open end funds. Like closed end funds, ETFs trade continuously on an exchange allowing investors the opportunity to buy and sell shares multiple times during the trading day. However, like an open end fund, ETFs have a flexible number of shares that exist at any point in time. Typically, ETFs are designed to replicate the return of a common market index (such as the S&P 500 or the Dow Jones industrial average) or a specific sector of the market (such as a particular industry like pharmaceuticals or technology).Front end load
A front end load is a sales charge (fee) in a mutual fund that is applied when shares are purchased. When an investor purchases shares of a mutual fund that has a front end load, the load is subtracted before buying additional shares at NAV. To determine how much front ended mutual fund shares sell at, the investor must determine the “offer price”:, or
Back end load (redemption fee)
A back end load is a sales charge (fee) in a mutual fund that is applied when the investor sells shares back to the mutual fund. The proceeds from the sale of mutual fund shares are reduced by the size of the back end load. Commonly, these fees are reduced the longer the investor holds the shares. If the back end load disappears after an investor holds the shares, it is also called a contingent deferred sales charge (CDSC).12b-1 fees
12b-1 fees are sales charges (fees) in a mutual fund that is applied each and every year that an investor holds shares, reducing the return earned by a mutual fund shareholder.Operating/management fees
Each year, investment companies incur expenses associated with running a portfolio of investments. These include salaries paid to portfolio managers (management fees) as well as administrative costs (operating fees). Funds that are more actively traded typically have higher fees.Net asset value (NAV)
NAV is price per share representing the fractional ownership claim on the underlying portfolio value of an investment company. NAV is determined as follows:With open end funds, you transact at NAV (adjusted for loads), while the price of a closed end fund can be different from NAV. If the closed end fund sells at a “premium”, the price exceeds NAV. If the closed end fund is selling at a “discount”, the market price is below NAV.
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