Session 13/14

the P/E ratio we have defined here will increase with

(1) a higher dividend payout rate, (2) a higher growth rate, or (3) a lower required rate of return. So, if the subject firm has a higher dividend payout ratio, higher growth rate, and lower required return than its peers, a higher P/E ratio may be justified.

The disadvantages of using price multiples based on comparables are

(1) a stock may appear overvalued by the comparable method but undervalued by the fundamental method, or vice versa; (2) different accounting methods can result in price multiples that are not comparable across firms, especially internationally; and (3) price multiples for cyclical firms may be greatly affected by economic conditions at a given point in time.

An investor purchased 725 shares of stock at $40 per share and posted initial margin of 60%. He subsequently sold the shares at $50 per share. Based only on this information, the investor's holding period return is closest to: A) 20%. B) 40%. C) 25%.

(50 - 40) / (40 × 0.6) = 41.67%.

If an investor purchases a stock for $40 per share with an initial margin requirement of 50% and the maintenance margin requirement is 25%, at what price will the investor get a margin call?

40(1-.5)/ (1-.25) = 26.67 a margin call is triggered at 26.67$

Using the one-year holding period and multiple-year holding period dividend discount model (DDM), calculate the change in value of the stock of Monster Burger Place under the following scenarios. First, assume that an investor holds the stock for only one year. Second, assume that the investor intends to hold the stock for two years. Information on the stock is as follows: Last year's dividend was $2.50 per share. Dividends are projected to grow at a rate of 10.0% for each of the next two years. Estimated stock price at the end of year 1 is $25 and at the end of year 2 is $30. Nominal risk-free rate is 4.5%. The required market return is 10.0%. Beta is estimated at 1.0. The value of the stock if held for one year and the value if held for two years are: Year one Year two A) $25.22 $29.80 B) $27.50 $35.25 C) $25.22 $35.25

A) $25.22 $29.80 First, we need to calculate the required rate of return. When a stock's beta equals 1, the required return is equal to the market return, or 10.0%. Thus, ke = 0.10. Alternative: Using the capital asset pricing model (CAPM), ke = Rf + Beta * (Rm - Rf) = 4.5% + 1 * (10.0% - 4.5%) = 4.5% + 5.5% = 10.0%. Next, we need to calculate the dividends for years 1 and 2. D1 = D0 * (1 + g) = 2.50 * (1.10) = 2.75 D2 = D1 * (1 + g) = 2.75 * (1.10) = 3.03 Then, we use the one-year holding period DDM to calculate the present value of the expected stock cash flows (assuming the one-year hold). P0 = [D1/ (1 + ke)] + [P1 / (1 + ke)] = [$2.75 / (1.10)] + [$25.0 / (1.10)] = $25.22. Shortcut: since the growth rate in dividends, g, was equal to ke, the present value of next year's dividend is equal to last year's dividend. Finally, we use the multi-period DDM to calculate the return for the stock if held for two years. P0 = [D1/ (1 + ke)] + [D2/ (1 + ke)2] + [P2 / (1 + ke)2] = [$2.75 / (1.10)] + [$3.03 / (1.10)2] + [$30.0 / (1.10)2] = $29.80. Note: since the growth rate in dividends, g, was equal to ke, the present value of next year's dividend is equal to last year's dividend (for periods 1 and 2). Thus, a quick calculation would be 2.5 * 2 + $30.00 / (1.10)2 = 29.80.

Which of the following sets of indexes are price-weighted? A) Dow Jones World Stock Index and Russell Index. B) Dow Jones Industrial Average and Nikkei Dow Jones Stock Market Average. C) S&P 500 Index and Dow Jones Industrial Average.

B) Dow Jones Industrial Average and Nikkei Dow Jones Stock Market Average. The Dow Jones World Stock Index, the Russell Index, the S&P 500 Index, and Morgan Stanley Capital International Index are all market-value weighted. Only the Dow Jones Industrial Average and the Nikkei Dow Jones Stock Market Averages are price-weighted.

A market's efficiency is most likely to negatively affected by: A) substantial analyst coverage of the exchange listed companies B) a ban on short selling. C) a high amount of trading activity.

B) a ban on short selling. Research supports the conclusion that short selling helps to prevent market prices from becoming overvalued, while limiting short selling has the opposite effect. More analyst coverage and more liquidity contribute to market efficiency.

An argument against using the price to cash flow (P/CF) valuation approach is that: A) cash flows are not as easy to manipulate or distort as EPS and book value. B) non-cash revenue and net changes in working capital are ignored when using earnings per share (EPS) plus non-cash charges as an estimate. C) price to cash flow ratios are not as volatile as price-to-earnings (P/E) multiples.

B) non-cash revenue and net changes in working capital are ignored when using earnings per share (EPS) plus non-cash charges as an estimate. Items affecting actual cash flow from operations are ignored when the EPS plus non-cash charges estimate is used. For example, non-cash revenue and net changes in working capital are ignored. Both remaining responses are arguments in favor of using the price to cash flow approach.

In contrast with a typical forward contract, futures contracts have: A) less liquidity. B) standardized terms. C) greater counterparty risk.

B) standardized terms. Futures are forward contracts that trade on exchanges and have standardized terms, in contrast with forward contracts, which are customized instruments. A futures clearinghouse reduces counterparty risk by guaranteeing the performance of buyers and sellers. Futures contracts trade on organized exchanges and are more liquid than forward contracts.

The disadvantages of using PBV ratios are:

Book values are affected by accounting standards, which may vary across firms and countries. Book value may not mean much for service firms without significant fixed costs. Book value of equity can be made negative by a series of negative earnings, which limits the usefulness of the variable.

Preference shares will have the most risk for the investor if the shares are: A) callable and cumulative. B) non-callable and non-cumulative. C) callable and non-cumulative.

C) callable and non-cumulative. Preference shares (preferred stock) has more risk for the investor if they are non-cumulative than if they are cumulative, because with cumulative preference shares the firm must pay the holder any omitted dividends before it can pay any dividends to common shareholders. Callable shares have more risk for the investor than non-callable shares because the call option limits their potential for price appreciation.

The competitive forces identified by Michael Porter include: A) threat of substitutes and rivalry among suppliers. B) power of existing competitors and threat of entry. C) rivalry among existing competitors and power of buyers.

C) rivalry among existing competitors and power of buyers. Porter's five competitive forces are: (1) rivalry among existing competitors; (2) threat of entry; (3) threat of substitutes; (4) power of buyers; (5) power of suppliers.

The formula for the value of preferred stock with a perpetual dividend is

D / kp

semi-strong efficient

If the market is semi-strong efficient, portfolio managers should use passive management because neither technical analysis nor fundamental analysis will generate positive abnormal returns on average over time.

unsponsored depository receipt

In an unsponsored DR, the depository bank retains the voting rights. Depository receipts (DRs) represent ownership in a foreign firm and are traded in the markets of other countries in local market currencies. A bank deposits shares of the foreign firm and then issues receipts representing ownership of a specific number of the foreign shares.

An analyst projects the following pro forma financial results for Magic Holdings, Inc., in the next year: Sales of $1,000,000 Earnings of $200,000 Total assets of $750,000 Equity of $500,000 Dividend payout ratio of 62.5% Shares outstanding of 50,000 Risk free interest rate of 7.5% Expected market return of 13.0% Stock Beta at 1.8 If the analyst assumes Magic Holdings, Inc. will produce a constant rate of dividend growth, the value of the stock is closest to:

Infinite period DDM: P0 = D1 / (ke - g) D1 = (Earnings × Payout ratio) / average number of shares outstanding = ($200,000 × 0.625) / 50,000 = $2.50. ke = risk free rate + [beta × (expected market return - risk free rate)] ke = 7.5% + [1.8 × (13.0% - 7.5%)] = 17.4%. g = (retention rate × ROE) Retention = (1 - Payout) = 1 - 0.625 = 0.375. ROE = net income/equity = 200,000/500,000 = 0.4 g = 0.375 × 0.4 = 0.15. P0 = D1 / (ke - g) = $2.50 / (0.174 - 0.15) = 104.17.

An investor buys 400 shares of a stock for $25 a share. The initial margin requirement is 50%, and the maintenance margin requirement is 25%. At what price would an investor receive a margin call? A) $30.00. B) $16.67. C) $21.88.

Margin call trigger price = [25(1 - 0.5)] / (1 - 0.25) = 16.67.

If the efficient markets hypothesis is true, portfolio managers should do all of the following EXCEPT: A) Minimize transaction costs. B) Work more with clients to better quantify their risk preferences. C) Spend more time working on security selection.

Minimize transaction costs. In an efficient market all stocks are properly priced and reflect all publicly available information. Therefore, individual selection of stocks is not important the only thing that is relevant is the portfolio's beta.

maintenance margin requirement

To ensure that the loan is covered by the value of the asset, an investor must maintain a minimum equity percentage, called the maintenance margin requirement, in the account. This minimum is typically 25% of the current position value, but brokers may require a greater minimum equity percentage for volatile stocks. If the percentage of equity in a margin account falls below the maintenance margin requirement, the investor will receive a margin call, a request to bring the equity percentage in the account back up to the maintenance margin percentage. An investor can satisfy this request by depositing additional funds or depositing other unmargined securities that will bring the equity percentage up to the minimum requirement. If the investor does not meet the margin call, the broker must sell the position.

margin call

a request to bring the equity percentage in the account back up to the maintenance margin percentage. An investor can satisfy this request by depositing additional funds or depositing other unmargined securities that will bring the equity percentage up to the minimum requirement. If the investor does not meet the margin call, the broker must sell the position.

Global depository receipts

are issued outside the U.S. and the issuer's home country and are most often denominated in U.S. dollars. Depository receipts issued in the United States and denominated in U.S. dollars are called American depository receipts.

Cost of equity for a firm

can be defined as the expected equilibrium total return in the market on its equity shares, or as minimum rate of return that investors require as compensation for the risk of the firm's equity securities.

Real assets include

commodities, real estate, durable equipment, and other physical assets. Bonds and stocks are classified as financial assets.

The semi-strong form of the EMH

holds that security prices rapidly adjust without bias to the arrival of all new public information. As such, current security prices fully reflect all publicly available information. The semi-strong form says security prices include all past security market information and nonmarket information available to the public. The implication is that an investor cannot achieve positive risk-adjusted returns on average by using fundamental analysis.

The difference between a price and total return index

is that cash distributions are included in a total return index. The two will differ when the constituent securities make cash distributions over the period. Otherwise, the two versions will be the same.

Stop loss sell orders

limit sell orders that are placed below market price. When the share price drops to the designated price, a sell order is executed protecting the investor from further declines.

Continuous markets

markets where trades occur at any time the market is open (i.e. they do not need to be open 24 hours per day). Setting one negotiated price is a method used in major continuous markets to set the opening price.

Enterprise value (EV)

measures total company value: EV = market value of common and preferred stock + market value of debt - cash and short-term investments EBITDA is frequently used as the denominator in EV multiples because EV represents total company value, and EBITDA represents earnings available to all investors.

informationally efficient markets

one in which the current price of a security fully, quickly, and rationally reflects all available information about that security. This is really a statistical concept. An academic might say, "Given all available information, current securities prices are unbiased estimates of their values, so that the expected return on any security is just the equilibrium return necessary to compensate investors for the risk (uncertainty) regarding its future cash flows." This concept is often put more intuitively as, "You can't beat the market." If financial markets are informationally efficient, active investment strategies cannot consistently achieve risk-adjusted returns superior to holding a passively managed index portfolio. In addition, a passive investment strategy has lower transactions costs than an active management strategy.

Contracts include

orwards, futures, options, swaps, and insurance contracts

Reconstitution

refers to changing the securities that make up an index. Reconstitution of an index is required if one of its constituent securities goes out of existence (for example, a maturing bond or an expiring futures contract) or no longer meets the requirements to be included in the index.

overreaction effect

refers to stocks with poor returns over three to five-year periods that had higher subsequent performance than stocks with high returns in the prior period. The result is attributed to overreaction in stock prices that reverses over longer periods of time.

loss aversion

refers to the tendency of investors to be more risk averse when faced with potential losses than they are when faced with potential gains. Put another way, investors dislike a loss more than they like a gain of an equal amount.

statutory voting system

shareholder can vote in each separate board election based on the number of shares she owns.

industry experience curve

shows the cost per unit relative to output. The curve declines because of increases in productivity and economies of scale, especially in industries with high fixed costs.

Weak form of the efficient markets hypothesis

states that current security prices fully reflect all currently available security market data. Thus, past price and volume (market) information will have no predictive power about the future direction of security prices because price changes will be independent from one period to the next. In a weak-form efficient market, an investor cannot achieve positive risk-adjusted returns on average by using technical analysis.

The strong form of the EMH

states that security prices fully reflect all information from both public and private sources. The strong form includes all types of information: past security market information, public, and private (inside) information. This means that no group of investors has monopolistic access to information relevant to the formation of prices, and none should be able to consistently achieve positive abnormal returns.

A well-functioning securities market includes the following characteristics:

timely and accurate information on price and volume of past transactions. timely and accurate information on the supply and demand for current transactions. liquidity (as indicated by low bid-ask spreads). marketability. price continuity. depth (many buyers and sellers). operational efficiency (low transaction costs). informational efficiency (rapidly adjusting prices).