Chapter 14

The Supply Side Economic Theory (Reaganomics)

reduced tax rates will result in a healthier economy, which will generate more taxes to compensate for the reduced rates.

Which of the following is the most stringent test of liquidity?

(Cash + cash equivalents) / current liabilities.

Ratios at a glance

- Low debt - equity ratios are considered more conservative than high debt-equity ratios - The acid-test ratio is a more stringent measurement of liquidity than the current ratio. - Book Value is the company's theoretical liquidation value expressed on a per share basis. - Speculative companies have very high or very low PE ratios - Growth companies have higher PE ratios than cyclical companies - Earnings per share only relates to common stock; it assumes preferred dividends were paid.

Ratios used to asses the stability of a corp capitalization

1. Debt to Equity Ration: Total Long term debt / Total shareholders equity 2. Bond Ratio: Long term liabilities / Total capitalization 3. Common Stock Ratio: Common Shareholders equity / total capitalization 4. Preferred Stock Ratio: Preferred Stock / total capitalization

The FRB affect the money supply in the following 3 ways:

1. Open Market Operations: The Fed buys and sells U.S. government securities in the open market to expand and contract the money supply. 2. Change in Discount Rate: The Fed can adjust the money supply by raising or lowering the discount rate, the interest rate the Fed charges its members for short term loans. 3. Changes in Reserve Requirements: Commercial banks must deposit a certain percentage of their depositors money with the Federal Reserve. If the Fed raises the Reserve Requirement, banks must deposit more money with the Fed and therefore will have less money to lend.

Gross Domestic Product (GDP)

A nations economic output, all of the goods and services produced within the nation.

Keynesian Theory

Active government involvement in the economy is vital to the heath and stability of a nations economy. Demand for goods ultimately controls employment and prices. Too much demand causes inflation. Government's responsibility to change level of spending and taxation to manipulate the economy.

Working capital is:

Current means cash or assets that would be exchanged for cash in the ordinary course of business in the current year. In the case of liabilities, current means maturing or falling due within the current year. The net of current assets less the current liabilities implies the company has cash availability of the remainder with which to work.

Leading Indicators

Money Supply, Building Permits, New orders for consumer goods, stock prices, etc.

A consolidating market

one that stays within a narrow price range. When viewed on a graph, the trend-line is horizontal and is said to be moving sideways, meaning neither up nor down.

Retained earnings

represent the accumulated total of all earnings that have been retained in the company since its inception. It is quite possible that the company did not earn $100,000 in that particular year and does not have $100,000 in cash.

Financial Leverage

A company's ability to use long term debt to increase its return on equity.

Which of the following is most likely to be regarded as a defensive stock?

A defensive stock maintains future earnings that are likely to withstand an economic downturn. Typical examples are stocks of those firms that supply basic consumer necessities such as foodstuffs. A stock selling at an extremely high PE ratio is indicative of a speculative company or one that can decline in value rapidly.

fundamental analyst

A fundamental analyst is concerned with the economic climate, the inflation rate, how an industry is performing, a company's historical earnings trends, how it is capitalized, and its product lines, management, and balance sheet ratios. A technical analyst is concerned with trading volumes or market trends and prices.

Inflation

A general increase in price.

efficient market hypothesis (EMH)

A market index fund is a favorite strategy of those who believe in the efficient market hypothesis, which holds that all relevant information has already been taken into account by the market, and it is pointless to try to outperform the broader market indexes.

Inventory Turnover Ratio

A measure of efficiency regarding the management on inventory within a business or company.

Random Walk Theory

Academic theory maintaining that the direction of stock or market prices are unpredictable.

A company's changing from straight line to accelerated depreciation will:

Accelerated depreciation increases charged expenses during the early years of equipment life but decreases charged expenses during the later years.

Leading Economic Indicators:

Money supply. C) Orders for durable goods. D) New housing permits.

Working Capital

Amount of capital or cash a company has available. Current Assets - Current Liabilities = Working Capital

Capital in excess of par

Amount of money over par.

Dividend Payout Ratio

Measures the proportion of earnings paid to stockholders as dividends. Annual dividends per common share / Earnings per Share (EPS)

Short Interest Theory

Refers to the number of shares sold short.

Consumer Price Index (CPI)

Measures the rate of increase or decrease in a broad range of consumer prices such as food, housing, clothing etc. Computed each month. Uses a constant dollar for inflation.

Debt Service Ratio

Reflects a company's ability to meet the principal and interest payments on its bonds. EBIT / annual interest + principal payments

Valuation Ratios

Used by analysts to compare companies within an industry as well as in different industries

Laffer Curve

As tax rates increase from low levels, tax revenue increases. As tax rates continue to rise there comes a point where people won't work as much or as hard. With tax rates at 100%; no one would work, and there would be no tax revenue.

Book Value per Share

Assets - Liabilities - Intangibles - Par value of Preferred Stock / Shares of common stock outstanding

Technical Analysis

Attempts to predict the direction of prices on the basis of historic price and trading volume patterns

Capitalization

Combined sum of its long term debt and equity accounts.

Fundamental Analysis

Concentrates on broad-based economic trends, current business conditions within an industry, and the quality of a particular corporation

Balance Sheet consists of:

Current Assets - Cash & Equivalents - AR - Inventory - Prepaid Expenses Fixed Assets - Property - Plant - Equipment Other Assets - nonphysical such as trademarks, goodwill, etc. Liabilities - Current Liabilities: due for payment within next 12 mo. (i.e. AP, accrued wages payable, current long term debt) - Long term Liabilities: due for payment after 12 mo. (i.e. mortgages on property, outstanding corp bonds, etc.)

Quick Assets

Current Assets - inventory

Current Ratio

Current Assets / Current Liabilities

The Federal Reserve Board (FRB)

Determines monetary policy and takes action to implement it's policies. (i.e. acting as agent in the US Treasury, regulating the US money supply, printing of currency, etc) They determine how much money is available for businesses and consumers.

EBIT

Earnings before interest and taxes. It's a company's profit from business operations.

EBITDA

Earnings before interests, taxes, depreciation and amortization.

EBT

Earnings before taxes.

Stagnation

Economists define stagnation as prolonged periods of slow or little economic growth accompanied by high unemployment.

Lagging indicators

Factors that change after the economy has begun a new trend and serve as a confirmation of new trend. (i.e. Corp profits, duration of unemployment, ratio of inventories to sales, etc.)

Coincident Indicators

Factors that vary directly with the business cycle. (i.e. numbers of hours worked, income, employment levels, industrial income, etc)

Balance of Payments

Flow of money between the U.S. and other countries. Surplus: more money flowing into the country than out Deficit: more money flowing out of the country than in

Disintermediation

Flow of money from traditional, low yielding savings accounts to higher yielding investments in the market place without the bank acting as a middle man.

Modern Portfolio Theory

Focuses on the relationship of all investments in the portfolio.

Monetarist Theory

Monetarists believe that money supply is the major determinant of price levels. A well-controlled, moderately increasing money supply leads to price stability. The reserve requirement, discount rate and open market operations are tools used to regulate the economy.

Supply-side Economics

Government should allow market forces to determine prices of all goods. They believe the government should reduce spending and taxes.

Fiscal Policy

Governmental budget decisions which include increases or decreases in: - federal spending - money raised through taxes - federal budget deficits or surpluses inefficient means to solve short-term economic problems

Cyclical Industries

Highly sensitive to business cycles and inflation trends. Produce durable goods such as cars.

Capital Stock at par

Includes common and preferred stock listed at par which is the total dollar value assigned to stock certificates when a corporation's owners first contributed capital.

Defensive Industries

Least affected by normal business cycles. Decline less and incline less during times of bear and bull markets. Companies in Defensive Industries generally produce non-durable consumer goods.

Parts of the Money Supply

M1: Most readily type of money. Consists of currency in circulation and money that can be converted into currency immediately. M2: Time Deposits (less than $100k). (i.e. Money Market Fund, Savings Account, CD's, etc.) M3: Time Deposits (more than $100k) with repurchase agreements longer than one day.

Short Interest High

Means a bullish market

Coincidental Indicators

Numbers of Hours worked, employment levels, personal income, industrial production, GDP

Retained Earnings

Profits that have not been paid out in dividends.

Newspaper reports indicate that the GDP has been declining steadily over the past 2 quarters. This would suggest:

Recession is 6 consecutive months of economic decline. Depression is 6 consecutive quarters of economic decline.

Business Cycle

Stage 1. Expansion: Increased business activity Stage 2. Peak Stage 3. Contraction: When it's declining from its peak Stage 4. Trough: When it levels out

Shareholders Equity

Stockholders' claims on a company's assets after all of its creditors have been paid. Total assets less total liabilities. There are three types of shareholders equity: Capital Stock at par, Capital in Excess of Par and Retained Earnings

Income Statement

Summarizes a company's revenues and expenses for a fiscal period. You can use this statement to judge the efficiency and profitability of a company's operation.

Analysts who are most interested in confirming a market trend would use:

Technical analysis involves the confirmation of market and pricing trends through charts and market indicators. The decision to buy or sell stock is made by these trends rather than by analysis of specific issuer financial information, as used by fundamental analysts.

Technical Analyst

Technical analysts are more interested in forecasting market trends and securities prices than in studying individual corporations. Therefore, they are concerned with market prices, trading volumes, changes in the Dow Jones Industrial Average, reversals, support and resistance levels, advance/decline lines, short interest, and many other factors that might help them time buying and selling decisions. Fundamental analysts, on the other hand, concentrate on a stock's intrinsic quality and are concerned with PE ratios and earnings per share.

The Federal Reserve sets which of the following?

The Fed is responsible for setting the reserve requirement, the discount rate, and the initial margin requirement for nonexempt securities. The federal funds rate, charged in bank-to-bank borrowing, is a market rate of interest. While it is heavily influenced by Fed action, it is not set by the Fed. and neither is the prime rate, which is the rate large banks charge their most creditworthy customers for unsecured loans.

If the yield curve becomes inverted, a likely cause would be that the Fed has:

The Fed's influence on rates is primarily on the short end of the yield curve. Both the discount rate, which it sets, and the federal funds rate, which it influences, are short-term rates. The Fed tightens short-term credit when the economy appears to be overheating. To slow things down, the Fed raises short-term rates to extremely high levels.

Which of the following tools is most often used by the Federal Reserve Board to control the money supply?

The Federal Reserve Board has 3 tools to influence the money supply: the discount rate, the reserve requirement, and open market operations. The purchase and sale of government securities by the Federal Open Market Committee (FOMC) is the most frequently used tool of the Fed.

he Consumer Price Index (CPI) is released:

The U.S. Bureau of Labor Statistics releases the CPI monthly.

All of the following actions will increase the deficit in the U.S. balance of payments

U.S. foreign aid. C) Americans buying Japanese cars. D) investments by U.S. firms abroad.

Prime Rate

The prime rate is the rate of interest charged by banks to their best customers. The prime rate reacts to the FRB's tools, but it is not one of them.

Price to Earnings (PE) ratio

The relationship between the prices of different stocks compared with the earnings that accrue to one share of stock. Current Market Price of Common share / Earnings per Share (EPS)

Stagflation

The unusual combination on inflation and high unemployment

Dow Theory

To confirm the end of a major market trend Primary Trend: 1yr or more Secondary Trend: 3-12 weeks Short Term Fluctuations: Hours or Days

Federal Reserve Tactics

To expand or stimulate an economy: - Buy US government securities - Lower the discount rate - Lower the reserve requirement To tighten credit and prevent inflation: - Sell US government securities - Increase the discount rate - Increase the reserve requirement.

Earnings Per Share (EPS)

What remains after payment of interest, taxes, and preferred dividends. EPS = Earnings available to common / Number of shares outstanding

Spin Off

When one company sells all of the shares of another it owns, this is called a spin-off.

Shareholders Equity

affected by gains, losses, new invested capital, and cash distributions (dividends) to shareholders.

Current Yield

annual dividends per common share / market value per common share

Business development companies (BDCs), also known as growth development companies

created to assist small companies while still in the initial stages of development. They allow smaller nonaccredited investors to invest in more speculative startup ventures usually considered more suitable for accredited investors. They can be both listed and traded on US exchanges or nontraded, but with nontraded BDCs illiquidity or the risk of being able to exit the investment easily should be a primary suitability consideration.

Expansions in the business cycle are characterized by

increasing consumer demand for goods and services, increasing industrial production, and rising stock markets and property values. Each of the remaining characterizations would more likely be associated with periods of contraction in the economic business cycle.

The asset coverage ratio

measures the tangible and monetary assets of a company in relation to its outstanding debt obligations. It is but one tool that can be utilized to assess the overall strength or weakness of a company's financial health.

Leading Indicators

money supply, building permits, new orders for consumer goods, machine tool orders, stock prices and changes in consumer and business borrowing.

A leading indicator predicts economic trends. Such indicators include

steel shipments, stock market indices, manufacturing orders, and housing starts.

disintermediation

the flow of money from traditional, low-yielding savings accounts to higher- yielding money market instruments. Typically occurs when the Federal Reserve Board tightens the money supply and interest rates rise faster in the marketplace than at bank accounts.

Technical analysts

try to predict the market by examining price and volume trends. They expect the market will act in the future as it has in the past. Technical analysts are not interested in the fundamental aspects of a company, such as its financial statement ratios.