Unit 10: Analytical Methods

Market Price Related Ratios

1. Price-to-Earnings Ratio (P/E) 2. Price-to-Book Ratio

Balance sheet ratios

1. Working Capital compared with Current Ratio 2. Debt-to-Equity Ratio 3. Book Value Per Share

Most testable points about ratios

- Book value is the companys theoretical liquidation value expressed on a per share basis - Growth companies have higher PE ratios than do cyclical or defensive companies - Earnings per share relates only to common stock; is assumes preferred dividends were paid.

Important points for NPV & IRR

- IRR is the method of computing long-term returns that take into consideration time value of money - The yield to maturity of a bond reflects its IRR - The investment is a good one it is has a positive NPV; stay away if the NPV is negative - NPV is generally considered more important then IRR --- When an investments IRR is equal to the discount rate / required rate of return, the NPV = 0. In an efficient market bonds should be priced so that their NPV is zero --- The quickest way to identify IRR vs NPV is that IRR is always expressed at as %, NPV never is. It is usually shown as a dollar amount. So NPV= value ($) IRR = %

Beta vs. Standard Deviation

- beta is a volatility measure of a security compared with the overall market, measuring only systematic (market) risk - SD is a volatility measure of a security compared with its expected performance and includes both systematic and unsystematic risk. *SD Measures total risk of a security or portfolio.

preferred vs common stock

- preferred stock gives no voting rights to shareholders while common stock does. Preferred shareholders have priority over a company's income, meaning they are paid dividends before common shareholders. -preferred is said to be less volital, but produces less profit. sold at face value so more expensive for company to sell.

Income in Perpetuity

Income 'forever' annual income / rate of return = lump sum deposit

Correlation

Means that securities move in the same direction -Perfectly correlated +1 (move in perfect positive linear relationship with each other -unrelated: 0 -Perfectly opposite: -1 a good way to diversify portfolio is to include investments with negative correlation. logic is when all positives go down the negatives will go up

Alpha

The measurement of a portfolio's actual or realized return in excess of (or deficient to) the expected return calculated by the capital asset pricing model (CAPM) Good news when a portfolio manager can say that they have generated a positive alpha. That mean that their investment performance is better than what would have been anticipated (total portfolio return - risk free rate) - (portfolio beta x [market return - risk free rate]) comparing performance after eliminating the risk-free rate -Portfolio managers strive for a positive alpha (returns in excess of the expected return).

Rule of 72

The number of years it takes for a certain amount to double in value -is equal to 72 divided by its annual rate of interest.

Working Capital

The working capital of a corporation is equal to its current assets minus its current liabilities (a current liability is payable within 12 months). -Because all bonds, convertible or not, issued by the corporation are long-term liabilities, they are not included in the working capital computation.

Beta

Used to measure the variability between a particular stock's (or portfolio's) movement and that of the market in general. Usually measured against S&P 500 index -beta of 1.00 tend to have market risk similar to the market as a whole -Beta of 1.50 will be considerably more volital than the market -Beta with 0.70 will be much less volital then the market -assets with negative beta can help diversify portfolio -Beta tracks a stocks co-movement with the overall market. Because the "market" has a beta of 1.0, any stock with a lower beta will generally not have price movement equal to the market. Beta is a measurement of systematic risk, and low-beta stocks have less than high beta ones.

standard deviation

a measure of the volatility of an investments projected returns, computed by using historical performance data. -statistical term that measures the amount of variability or dispersion around an average. -The larger this dispersion, the larger the variability is, the higher the SD is. The higher the SD, the larger the securities returns are expected to deviate from its average return and hence the greater the risk. -expressed as a % -an investor can use SD to compare the volatility between investments. Simply the higher the SD, the greater the volatility. (and the reverse)

Geometric Mean

any given set of numbers (n) is obtained by multiplying all of them together and taking the nth root of them -always be higher than the arithmetic mean unless all of the numbers being used are the same because the geometric mean uses imputed compounding

Earnings per share after dilution

assumes that all convertible securities, like warrants, convertible bonds, & preferred stock, have been converted into the common

Current Yield (Dividend Yield)

expresses the annual dividend payout as a percentage of the current stock price. Annual dividends per common share / current market value per common stock computing the return ON your investment. take return and put it "ON" your investment

Exhausting the Principal

how long money will last -shortcut calculation: divide the money invested by the money the investor wants to withdraw at the end of each year. Then pick the next highest answer Ex: $100,000 invested / $12,000 withdrawn each year =8.33 and then pick next highest answer

Present Value (PV)

is the formal term for value today of the future cash flows of an investment discounted at a specified interest rate to determine the present worth of those future cash flows PV=FV/(1+r)^n Formula says that the PV of an investment = the investments FV discounted at (divided by an interest rate over a time period by n (1+r)^n called the discount factor

Dividend Payout ratio

measurers the proportion of earnings paid to stockholders as dividends = annual dividends per common share / EPS -the dividend payout ratio is dividends paid out of earnings made.

Earnings Per Share (EPS)

measures the value of a companys earnings for each common share earnings available to common / # of shares outstanding -Earnings available to common are the remaining earnings after the preferred dividend has been paid -relates to common stock only. Preferred shareholders have no claims to earnings beyond the stipulated preferred stock dividends

Price-to-Earnings Ratio (P/E)

provides investors with a rough idea of the relationship between the prices of different common stocks compared with the earnings that accrue to one share of stock = current market price of common share / EPS -Investors should beware of extremely high or extremely low PEs -When a company has a high P/E ratio, it means that investors are placing greater value on expected growth in earnings.

Price-to-Book Ratio

reflects the market price of the common stock relative to its book value per share book value: the theoretical value of a company (stated in dollars per share) in the event of liquidation & bears little or no relationship to the stocks current trading price.

Discounted Cash Flow (DCF)

techniques that takes into account the time value of money. - Both net present value (NPV) and internal rate of return (IRR) take the time value of money into account.

***Net Present Value (NPV)

the difference between an investment's present value and its contemporaneous cost (current market value, CMV) -NPV is expressed in dollar amount NPV=PV-CMV Any time the net present value is greater than zero (a positive NPV), the internal rate of return(IRR) is greater than the required rate of return and the investment should be made. If the net present value is zero, then the internal rate of return equals the required rate of return.

Range

the difference between the highest and lowest value in a distribution

Internal Rate of Return (IRR)

the discount rate that makes the NPV of an investment equal to zero -can be thought of as the r in PV & FV -dificult to calculate, it must be determined by trial/error called iteration. -IRR takes into consideration the time value of money -IRR can be used to determine whether an investment meets the investors required rate of return. Ex: if an investor requires an investment return of 10% and the IRR of a proposed investment is 12%, the investor will view that investment as attractive because it returns a higher rate than the investors required rate

Future Value (FV)

the formal term that indicated what an amount of invested today at a given rate will be worth at some period in the future. The FV of a dollar invested today depends on the: -rate of return it earns (r) and (using an estimated rate) -number of years over which it is invested FV=PV(1+r)^n not required to know formula or calculate

Book Value Per Share

the liquidation value of the enterprise: assume we sold all our assets, paid back everyone we owe and get rid of intangible assets (goodwill, patents, trademarks, copyrights) and then split what is left among the shareholders. From the fund that are left after pay liabilities, we give the preferred shareholders back their par (or stated) value and the rest belongs to the common stockholders tangible assets - liabilities - par value of preferred / shares of common stock outstanding *Book value reflects the liquidating value of the company -The computation of book value per share is basically net tangible worth per share of common stock.

Mean (or Arithmetic Mean)

the measure of center found by adding all of the data values and dividing the total by the number of data values -average -will always be greater than the geometric mean. geometric could be equal but never greater.

Median

the middle value in a distribution; if even number, add 2 middle and divide by 2

Mode

the most frequently occurring value in a distribution

risk free rate

the rate of return that can be earned with certainty -on exam will always us 91-day (13-week) US Treasury bill.