CFP Investments - Lesson #4 - Stock Valuation & Ratio Names

Strategic Asset Allocation

- a strategy that involves assessing the likely outcomes for various allocation mixes between asset classes -strategic asset allocation is done every few years -strategic asset allocation is an *active* allocation strategy (long-term look at portfolio's risk objective, rebalancing)

Book value

-a firm's book value represents the amount of stockholder's equity in the firm or how much the company's shareholders would receive if the firm was liquidated -the book value per share is useful to compare to the firm's stock price -if the stock price is significantly higher than the firm's book value, it may indicate that the firm is overvalued -if the book value per share is equal to or higher than the firm's stock price, it may indicate the firm is undervalued

DCA Dollar Cost Averaging

-allows an investor to invest the same dollar amount each month on a periodic basis, typically monthly -by investing the *same dollar amount* each month, and investor buys *fewer* shares when the price *increases* and *more* shares when the price *decreases*

Tactical Asset Allocation

-an *active* allocation strategy whereby the investor determines expected returns for asset classes, then rebalances the portfolio to take advantage of the expected returns -tactical asset allocation is performed frequently (shorter-term, move in/out certain areas)

Strong-Form EMH

-asserts that historical, public and private info will not help investors achieve above-average market returns -suggests that stock prices reflect all available info and react immediately to any new info -holds that even with inside info the market cannot be outperformed on a consistent basis

Breadth of the market

-breadth of the market measures the *number* of stocks that increase in value versus the number of stocks that decline in value

market volume

-gives technicians an insight into investor sentiment -if market volume is *high* and the market goes *up* = *positive* indicator regarding investor sentiment -if market volume is *high* and the market goes *down* = *negative* indicator regarding investor sentiment -if market volume is *low* and the market goes *up* = *negative* indicator regarding investor sentiment -if market volume is *low* and the market goes *down* = *positive* indicator regarding investor sentiment *if market volume and market go in same direction, positive sign*

Weak Form EMH

-historical information will not help investors achieve above-average market returns -rejects technical analysis and asserts that fundamental analysis will help an investor achieve above-average returns -holds that security prices reflect all price and volumed data -is in direct contradiction with technical analysis, which attempts to predict future pricing based on the study of past pricing and volume patterns

Active Investment Strategy

-investors believe that the markets are inefficient -investors can achieve above-average market returns through active investing and market timing

Passive Investment Strategy

-investors believe the markets are efficient, and it's difficult to achieve above-average market returns -a passive buy-and-hold investment strategy is best -passive investment strategies are buy-and-hold strategies such as laddered bonds, ETFs. barbell bond strategy, UITs, and index investing

fundamental analysis assumes

-investors can determine reliable estimates of a stock's future price behavior -some securities may be misplaced, and through fundamental analysis, it can be determined which securities are mispriced

Efficient Market Hypothesis (EMH)

-investors cannot consistently achieve above-average market returns -prices reflect all information that is available and change very quickly to new information -stock prices follow a "random walk" -investors who believe in the efficient market hypothesis believe a passive investment strategy is appropriate, such as buy and hold an index

Small firm effect

small caps tend to outperform large caps -it's easier for them to grow revenues and earnings fast than a large cap

tools of technicians charting

-involves the plotting of historical stock prices to determine a trading pattern -also involves plotting a 50-, 100- or 200-day moving average along with the historical stock prices

technical analysis Support

-may develop when a stock goes down to a lower level of trading because investors may choose to act on a purchase opportunity that they previously passed -a signal that new demand is coming into the market demand predicted to rise

Return on Equity (ROE)

-measures the overall profitability of a company -there is a direct relationship between ROE, earnings and dividend growth

PE Ratio Price-to-earnings Ratio

-represents how much an investor is willing to pay for each dollar of earnings -it is a measure of the relationship between a stock's price and its earnings -PE ratios are a useful tool to value a stock if a firm pays no dividends -the relationship of price to earnings is known as PE multiplier

technical analysis Resistance

-resistance may develop when investors who bought on an earlier high may not view this as a chance to get even -some might see this as an opportunity to take a profit demand predicted to drop

Dow Theory

-signals an end to a bull or bear market -does not indicate when it happens, just confirms that it has ended

Dividend yield formula

-states the annual dividend as a percentage of the stock price

Value line effect

-stocks that receive Value Line's highest ranking (1) outperform stocks that receive the lowest ranking (5)

P/E Effect

-stocks with a low PE ratio tend to outperform stocks with a high PE ratio

PEG Ratio

-the Price/Earnings to Growth Ratio compares a stock's PE ratio to the company's 3-to-5 year growth rate in earnings -the 3-to-5 year growth rate in earnings is the historical earnings growth ate -PEG ratio is used to determine if the stock's PE ratio is keeping pace with the firm's growth rate in earnings -PEG ratio = 1 suggests that the stock is fairly valued because PE is in line with the earnings growth rate -PEG > 1 suggests that the stock price is fully valued (or even overvalued) because an expanding PE is contributing to the stock price appreciating more than the growth rate of earnings

Dividend Discount Model

-the constant growth dividend discount model values a company's stock but discounting the future stream of cash flows -also known as intrinsic value model -D1 is next expected dividend. Calculated using the current dividend and dividend growth rate D1 = D0(1+g) -model may be used for simplistic perpetual dividend growth rate questions or for more complicated variable dividend growth rates -the set up for variable dividend growth rates is the same as for as single growth rate except you must start with the last rate and work backward

disadvantages of the dividend discount model

-the model requires a constant perpetual growth rate of dividends -many stocks do not pay dividends so the security value may not be estimated with this model -the growth rate of dividends cannot be greater than the expected return and the security price becomes very sensitive to the expected return when nearing the growth rate

technical analysis

-the process of charting and plotting a stock's trading volume and price movements -analysis of the trading volume and price movements will predict the future direction of stock prices long before fundamental analysis will -does not involve ratio analysis or analysis of financial statements like fundamental analysis -technical analysts *believe supply and demand drive a stock price*

Fundamental Analysis

-the process of conducting ratio analysis on the balance sheet and income statement to determine future financial performance and a forecasted stock price based upon that future financial performance -ratio analysis includes calculating liquidity, activity, profitability, and common stock measurements -fundamental analysis also includes a look at economic data to determine how the economy will impact various industries (economic data includes: inflation, interest rates, GDP and unemployment)

Dividend payout ratio

-the relationship between the amount of earnings paid to shareholders in the form of a dividend, relative to earnings per share -typically, the higher the dividend payout ratio, the more mature the company -a high dividend payout ratio may indicate the possibility of the dividend being reduced -a low dividend payout ratio may indicate that the dividend may increase, thereby increasing the stock price

Semi-Strong Form EMH

-this theory asserts that both historical and public information will not help investors achieve above-average market returns -rejects both technical and fundamental analysis but inside info will lead to above-average market returns

Expected Rate of Return

-through a restructuring of the formula used to calculate value, you can calculate an expected rate of return (r) -this formula uses price (P) meaning market price in place of value (V) on formula sheet

odd lot trading

-trades less than 100 shares -most is done by small investors -this is a contrarian indicator that asserts small investors are most likely wrong regarding their trades, so do the opposite of individual investors

to determine the average cost per share

1) take the Total Cost / Per Share Price to determine the number of shares purchased 2) Add the number of shares and total dollar amount invested 3) Take the total cost / total number of shares

fundamental analysts believe:

a stock price performance is largely driven by the financial performance of the firm

Market Anomalies

exceptions to the rule that markets are truly efficient, some examples: -January Effect -Small Firm effect -value line effect -P/E Effect -market anomalies do not support the EMH in any of the 3 forms

relationship between -required rate of return -stock price -dividend

if req'd rate of return decreases, stock price increases if dividend is expected to increase, stock price will increase if required rate of return increases, stock price will decrease if dividend is expected to decrease, stock price will decrease

january effect

january tends to be a better month because of tax loss selling in November and December followed by investors getting back into the market in January

PE ratio formula

price per share / EPS price per share = PE * EPS

Random Walk Theory

states that: -the behavior of stock prices closely resembles a random walk -prices of stocks are unpredictable but *not* arbitrary -it's impossible to consistently achieve above-average market returns -at any given moment, prices that exist on securities are the best incorporation of all available info and a true reflection of the value of that security -prices are in equilibrium -changes in price and volume of trading are generated by changing needs of investors

Advance Decline line

the advance decline line is the *difference* between the number of stocks that closed up versus the number of stocks that decreased in value

short interest

the number of shares sold short gives insight into the future demand for stock -stock that was sold short eventually needs to be purchased -a high short interest rate indicates "pent-up" demand

3 forms of EMH

weak form, semi-strong form, strong form