Portfolio Analysis Final

T/F Coincident indicators include economic time series that have peaks and troughs that roughly occur at the same time as the peaks and troughs of overall economic activity.

True

T/F Dividend growth is positively related to the return on equity.

True

T/F The coupon of a bond indicates the income that the bond investor will receive over the life of the bond.

True

T/F The dividend growth models are only meaningful for companies that have a required rate of return that exceeds their dividend growth rate.

True

What is the formula for the calculation of the Free Cash Flow to Equity (FCFE)?

Vi = ΣFCFE(t) / (1+k)^t FCFE = EPS x Payout Ratio

Economy analysis

- 1st step in the Fundamental Analysis process. - 2 components: the macro-analysis of the relationship between the aggregate securities market and aggregate economy, and the specific micro-valuation of the stock market employing the valuation approaches. - Economic growth leads to higher stock prices and using GDP Growth to predict stock prices. - Economic factors: govt budget and deficit, tax structure, balance of payments, foreign reserves, and exchange rate, infrastructures, demographic factors, and sentiments.

Industry analysis

- 2nd step in the Fundamental Analysis process. - Looks at a specific brand of manufacturing, service, or trade. - Used to understand a company's business and business environment, identifying active equity investment opportunities, and portfolio performance attribution: attribution address the sources of a portfolio's return.

Company analysis (Fundamental Analysis)

- 3rd step in the Fundamental Analysis process. - Looks at a specific company with their financial position, products and services offered, and its competitive strategy. - Last step because the analysist now has an understanding of the company's external environment.

Shiller P/E Ratio

- Also known as the cyclically adjusted price-earnings (CAPE) multiple. - Numerator is the value of the S&P 500. - Denominator is the inflated past earnings to the current year and averaging them - CAPE = Share Price / (10yr Avg inflation - adj. earnings)

CAPM

- Capital Asset Pricing Model - E(Ri) = RFR +(Beta)[E(Rm) - RFR] - indicates what should be the expected or required rates of return on risky assets. - Beta captures the non-diversifiable portion of that stock's risk relative to the market as a whole. - Evaluates whether a stock is fairly valued when its risk and the time value of money are compared to its expected return. (over, under, fairly valued)

Markowitz Portfolio Theory

- Developed by Harry Markowitz by deriving the expected rate of return for a portfolio of assets and an expected risk measure. - 4 Assumptions: 1) investors make decisions in a single time frame 2) investors prefer more money to less money 3) investors are risk avers: require extra return for extra risk 4) investors measure return by expected return and measure risk by standard deviation of returns - Main Arguments: 1) it is not good to have an investment funds in one asset 2) by investing in a portfolio you increase the possibility of improving return relative to risk 3) the risk of a portfolio is less than the weighted average risk of the individual constituent parts 4) risk can be reduced through diversification - Objective: minimize risk to investors

DDM

- P(i) = D(i)/(k-g) - Dividend Discount Model - Provides the present value of an asset. Helps predict the price of a company's stocks based on present day price and future dividends.

P/S Ratio

- P0 = [S0(1+g) x Profit Margin x Payout Ratio] / (k-g) - Typically used for new firms under 10 yrs old. -

FCFF

- PVj = ΣFCFF(t)/(1+WACC)^t - The amount of Cash Flow from operations, available for distribution after an accounting for depreciation, taxes, working capital, and investments.

SML

- Security Market Line - Shows trade-off between risk and expected return as a straight line intersecting the vertical axis at the RFR - When beta>1, stock has higher systematic risk than avg market - When beta<1, stock has lower systematic risk than avg market - If point is under the SML, it is overpriced. Point above the SML, it is underpriced. If it is on or close to the SML, it is fairly priced. - Equation: E(Ri) = RFR +(Beta)[E(Rm) - RFR], the RFR is the y-intercept, and the [E(Rm) - RFR] is the slope of the SML.

FCFE

- Vj = ΣFCFE(t)/(1+k)^t - Measure of how much Cash Flow is available to equity shareholders of a company after all expenses, reinvestments, and debts are paid.

P/B Ratio

- [BV0 x ROE x Payout Ratio] / (k-g) or market P per share / [Total Assets - Total Liabilities) / Number of shares outstanding] - used to compare a stock's market value to its book value. - Lower P/B could mean stock is undervalued or something is wrong with the company - Typically used by Financial Companies where the balance sheets are primarily of liquid assets.

trailing P/E ratio

- [Stock price / earnings from most recent fiscal year] or [Current Share Price / Trailing12month EPS] - looks at a company's share price in the market relative to its past year's earnings per share. - A useful indicator to standardize and compare relative share price between time periods and among companies. - Used because it creates an apples-to-apples evaluation of relative earnings.

What would the after-tax yield be on an investment that offers a 6% fully taxable yield? Assume a marginal tax rate of 31%.

4.144% 6% x (1-31%)

What would the equivalent taxable yield be on an investment that offers a 6% tax-exempt yield? Assume a marginal tax rate of 28%.

8.33% 6% / (1 - 28%)

T/F An increase in the required rate of return k will increase the P/E ratio.

False

T/F An investor is risk-neutral if she chooses the asset with lower risk given a choice of several assets with equal returns.

False

T/F Bond ratings are positively related to earnings and instability.

False

T/F Combining assets that are not perfectly correlated does affect both the expected return of the portfolio as well as the risk of the portfolio.

False

T/F For a two-stock portfolio containing Stocks i and j, the correlation coefficient of returns (rij) is equal to the square root of the covariance (Covij).

False

T/F High-yield bonds are considered "investment" grade.

False

T/F In constructing the portfolio, the manager should maximize the investor's risk level.

False

T/F It is important to analyze the economies and security markets before analyzing alternative industries or companies.

False

T/F Revenue bonds are essentially backed by the full faith and credit of the issuer and its entire taxing power.

False

T/F Stock prices move coincidentally with the economy.

False

T/F The expected return and standard deviation of a portfolio of risky assets is equal to the weighted average of the individual asset's expected returns and standard deviation.

False

T/F The growth rate of dividends and profit margin are the main determinants of the P/E ratio.

False

T/F The three-step valuation process consists of (1) analysis of alternative economies and markets, (2) analysis of alternative industries, and (3) analysis of industry influences.

False

T/F The yield to maturity is normally equal to the coupon rate.

False

P/E Ratio

P0 = Di/(k-g) --> P0 = [E0 x (1+g) x Payout Ratio] / (k-g) - Measures its current share price relative to its per-share earnings. - Indicates the dollar amount an investor can expect to invest in a company in order to receive one dollar of that company's earnings. - Three Functions: The firm's expected rate of growth of earnings per share, the stock's required rate of return, and the firm's dividend payout ratio. - A stock with a low P/E ratio relative to its expected growth rate is undervalued - A stock with a high P/E and a low expected growth rate is overvalued.

Identify the three most important determinants of the value of a bond. Describe the effect of each.

The three most important determinants of the value of a bond are Coupon, Maturity, and Yield to Maturity. Coupon: A coupon (payment) is the fixed interest received on the bond from the issuer to the issued person. The present value of the coupon payment received over the life of the bond is the main part of the bond valuation. Maturity: Maturity is the time period for which bonds are issued. The bond can be issued with call provision, which can be retired prematurely by the issuer, or with refunding provision, which can refund the bonds and be replaced with new lower coupon bonds. Yield to Maturity: YTM is a determinant of the price of the bond. The YTM shows how the investor anticipates being compensated for owning the security. The investor holds YTM until its maturity.

T/F A basic assumption of the Markowitz model is that investors base decisions solely on expected return and risk.

True

T/F An equity investor's required rate of return is influenced by the economy's real risk-free rate, the expected rate of inflation, and a risk premium.

True

T/F Earnings growth and dividend yield will be impacted by GDP growth.

True

T/F If the estimated value of an asset is greater than the market price, you would want to buy the investment.

True

T/F The annual interest paid on a bond relative to its prevailing market price is called its current yield.

True

T/F The average tax rate is defined as total tax payment divided by total income.

True

T/F Treasury Inflation-Protected Securities (TIPS) are inflation-indexed bonds in which the bond principal and interest payments are indexed to the consumer price index.

True

A bond that only pays a principal payment at the maturity date is known as a ____.

Zero-Coupon Bonds

The P/E ratio for BMI Corporation is 21, and the P/S ratio is 5.2. The industry P/E ratio is 35, and the industry P/S ratio is 7.5. Based on relative valuation, what type of stock is BMI? Interpret the results.

a. These are undervalued stocks. The P/E ratio shows the relation between the current price and the earnings per share. Because the company P/E is less than the Industry P/E, it shows its undervalued. The P/S shows the relation between the current price and the sales per share. Because the company BMI is less than the Industry, it shows that its undervalued. a. BMI P/E Ratio and P/S Ratio both are less than the industry's P/E Ratio and P/S Ratio. Due to the fact that BMI corporation's P/E and P/S ratios are both below the industry average, we would conclude that the stock could be currently undervalued compared to industry alternatives. The price of BMI corporation's stock is very low relative to the company's earnings (Low P/E ratio when compared to the industry). The price of BMI Corporation's stock is very low relative to the company's sales (Low P/S ratio when compared to the industry).

1. Define the variables included in the following model: i = f(RFR, I, RP)

i = the interest rate, the amount paid in % for the amount used in the form of loans, borrowings, or investments RFR = real risk-free rate of interest, the market rate where the investor expected from the investment which is absolutely risk free. I = Expected rate of Inflation, inflation rate expected by the investor for the future and current rate of inflation RP = Risk Premium, extra return over the RFR which is expected by the investor for every additional unit of risk.

The ___ the variance of returns, everything else remaining constant, the ___ the dispersion of expectations, and the ____ the risk.

larger, greater, higher