Unit 10

Current Yield (Dividend Yield)

A common stock's current yield, expresses the annual dividend payout as a percentage of the current stock price: CY = annual dividends per common share÷ market value per common share

Income Statement

A financial statement showing the revenue and expenses for a fiscal period. The primary source for the information necessary to construct a cash flow statement is the company's income statement.

Balance Sheet

A financial statement that reports assets, liabilities, and owner's equity on a specific date. Although the balance sheet shows cash on hand, that is only at that moment in time and doesn't indicate the "flow" in and out.

Gross Margin

Aka gross profit. The amount of money the retailer makes as a percentage of sales after the cost of goods sold is subtracted. Gross margin is computed by subtracting the cost of goods sold (COGS) from the net sales (or revenues) and dividing the remainder by the net sales.

Book Value Per Share

In the case of a corporation, it is basically the liquidation value of the enterprise. That is, let's assume we sold all of our assets, paid back everyone we owe, and then split what is left among the stockholders. (tangible assets - liabilities - par value of preferred) ÷ shares of common stock outstanding = book value per share *Book value reflects the liquidating value of the company, not its intrinsic value*

Mode

Mode measures the most common value in a distribution of numbers.

One of the best examples of a negatively correlated asset is an investment...

One of the best examples of a negatively correlated asset is an investment in gold stocks. Bonds frequently have a negative correlation as well which is one of the reasons for creating a balanced allocation.

Present Value Formula

PV = FV / (1 + r)^n This formula says that the present value of an investment equals the investment's FV discounted at (divided by) an interest rate over a time period specified by n. The factor (1 + r)^n is known as the discount factor.

Range

Range is the difference between the highest and lowest returns in the sample being viewed. When there are many values at either extreme of the range, the results tend to be skewed in that direction. Some look at the mid-range value which, as the name implies, is the number that is exactly in the middle of the range. To find mid-range, divide the range by 2 and then add it to the lower range.

When a company has a stock split, what happens to the P/E ratio?

Stays the same. Example: XYZ Corporation common stock has a market price of $45 per share and earnings per share of $3 when XYZ announces a 3-for-1 split. After the split, the price-to-earnings ratio of XYZ stock will be 15. Before the split, the stock had a P/E ratio of 15 ($45 per share ÷ $3). After the split, the price per share and the EPS drop in the same proportion, leaving the P/E ratio unchanged (new price = $15, new EPS = $1).

Actual Return over risk-free rate

The actual return of a stock or portfolio minus the risk-free rate. (Actual Return - RFR)

Exhausting the Principal

What happens when the client has a fixed sum and wants to know how long money can be withdrawn before it is exhausted? This is a simple computation when one has a financial calculator available, but all they give you at the test center is a simple four-function one, and that makes the task highly laborious.

Beta vs. Standard Deviation

Beta is a volatility measure of a security compared with the overall market, measuring only systematic (market) risk. Standard deviation is a volatility measure of a security compared with its expected performance and includes both systematic and unsystematic risk. Another way to put that is that standard deviation measures the total risk of a security or portfolio.

Current Assets

Cash, accounts receivable, and inventory.

Earnings Per Share After Dilution

EPS after dilution assumes that all convertible securities, such as warrants, convertible bonds, and preferred stock, have been converted into the common. In most cases, because there is now more common stock outstanding sharing in the earnings, EPS is reduced (diluted). Because of tax adjustments, the calculations for figuring EPS after dilution can be complicated and will not be tested.

Earnings Per Share (EPS)

EPS measures the value of a company's earnings for each common share: EPS = earnings available to common ÷ number of shares outstanding Earnings available to common are the remaining earnings after the preferred dividend has been paid. EPS relates to common stock only. Preferred stockholders have no claims to earnings beyond the stipulated preferred stock dividends.

Future Value Equation

FV = PV × (1 + r)^n *To find FV, you must already know the PV.*

Expected Return Equation

(Market Return - Risk-Free Rate) × (Beta) = Expected Return

Alpha Equation

(total portfolio return − risk-free rate) − (portfolio beta × [market return − risk-free rate])

Correlation coefficient ranges from...

-1 to +1 -1 is inverse correlation +1 is perfect correlation Risk elimination can be achieved if two securities with a perfect negative correlation are combined. That is, when one goes up, the other goes down by the same amount. In other words, one is the antipode of the other.

Generally speaking, correlation coefficients of ____ and up are considered to be a very high correlation.

0.80

Alpha (α)

1. Alpha compares the actual return in excess of the risk-free rate to the expected return If higher, positive alpha If lower, negative alpha If the same, zero alpha

Rule of 72

1. Approximate formula for doubling investment. 2. 72 / return percentage = years to double 3. 72 / number of years = percentage return needed to double For example, an investment of $2,000 earning 6% will double in 12 years (72 / 6 = 12).

Beta (β)

1. Beta is the measure of a stock's co-movement relative to a benchmark 2. Beta measures systematic risk - the risk associated with the market in general, not the total risk that pertains to a specific security. β = 1 (average risk investment) β > 1 (above average risk investment) β < 1 (below average risk investment)

4 types of Correlation

1. Positive correlation: two securities' prices moves in a similar direction. - Little or no diversification. 2. Negative correlation: prices of two securities move in opposite direction. - Adds diversification to portfolio. - Lowers volatility of a portfolio. 3. Perfect correlation: parallel movement (index funds) 4. Zero correlation: no discernible pattern - No linear correlation.

Standard deviation (σ)

1. Standard deviation is a measure of the volatility of an investment's projected returns, computed by using historical performance data (past events). 2. Standard deviation measures a security's dispersion of returns versus its historical performance (mean). 3. The larger this dispersion or variability is, the higher the standard deviation. 4. The higher the standard deviation, the larger the security's returns are expected to deviate from its average return, and, hence, the greater the risk. 5. Standard deviation is expressed in terms of percentage. 6. Standard Deviation measures total risk (systematic and unsystematic). 7. Securities will vary within one standard deviation about two-thirds of the time and within two standard deviations about 95% of the time.

A review of a corporation's financial statements reveals the following information: Net assets—$50 million Net revenues—$20 million Cost of goods sold—$14 million Depreciation—$1 million Interest—$1 million Long-term debt—$20 million Using the information, the gross margin for the year was

30% The gross margin, or margin of profit, is usually expressed as a percentage. It is the operating profit remaining after subtracting the cost of goods sold from the revenues (sales), divided by those revenues. In this question, the cost of goods sold is $14 million, and that number includes the depreciation. Subtracting $14 million from $20 million results in an operating profit of $6 million, which is 30% of the $20 million in revenues. You might also see this referred to as pre-tax margin. Please note that, as with so many questions on the exam, there are extra numbers that have no relevance to the question. U9LO1

Sharpe Ratio

A measure that indicates the average return minus the risk-free return divided by the standard deviation of return on an investment.

Negative Beta

A negative beta means that the investment will move in the opposite direction from the overall market. For example, if the beta is −1.2, a 10% up move in the market's return will cause the stock return to decline by 12%. On the other hand, if the general market were to suffer a decline, a stock with a negative beta would generally show positive returns. Assets with a negative beta can be an important component when diversifying a portfolio.

Standard Deviation Example

A security has an expected return of 12% and a standard deviation of 5%. Investing in a security with an expected 12% return, an investor can expect returns to range within 7% to 17% about 67% of the time and within 2% to 22% about 95% of the time. If an investor had a choice between an investment that historically returned 12% with a standard deviation of 6% and another investment that also returned 12% but had a standard deviation of 10%, the investor would probably choose the first one. In effect, he would expect to receive an equal return in the future return with less risk.

Mean

Arithmetic mean — simple average Geometric mean — always lower (unless all returns are equal) The geometric mean of any given set of numbers (n) is obtained by multiplying all of them together and then taking the nth root of them. (will not be tested)

Income in Perpetuity

As an investment adviser representative, a client may approach you about a method for providing an annual income "forever" for a relative or perhaps a charity. This is known as income in perpetuity. If you know the average expected rate of return and the desired annual income, divide that income by the rate of return and you will arrive at the lump sum required to throw off that income perpetually.

A quick rundown of the most testable points about ratios.

Book value is the company's 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; it assumes preferred dividends were paid.

Central Tendency

Central tendency is usually defined as the center or middle of a distribution. There are many measures of central tendency. Mean, median, mode

What beta is good for conservative investors.

Conservative clients need securities with low positive betas, whereas aggressive clients will find betas in excess of 1.00 to be quite suitable.

Current Ratio

Current assets ÷ current liabilities 1. The current ratio is the current assets divided by the current liabilities. 2. The higher the ratio, the more liquid the company. 3. Therefore, a 4 to 1 ratio is the strongest and a .5 to 1 ratio is the weakest.

If a stock's market price and P/E ratio are known, the EPS can be calculated as follows:

Current market value of common stock÷ P/E ratio

Factors that decrease working capital

Factors that decrease working capital include increasing current liabilities such as: - declaring cash dividends; - paying off long-term debt whether at maturity or, if called, earlier; and - net operating losses.

Factors that increase working capital

Factors that increase working capital include increases in cash from: - issuing securities (long-term debt or equity); - profits from the business operations; and - the sale of non-current assets, such as equipment no longer in use.

Future Value (FV)

Future value (FV) is the formal term that indicates what an amount 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: 1. rate of return it earns (r); and 2. number of years over which it is invested (n).

When computing present value (or future value), we are using an estimated rate of return. What happens if the actual return is different from the estimated?

If our actual return is less, we don't make out as well. That means that the PV (the required initial deposit) is going to be higher than we computed. On the other hand, if the actual return was higher than the PV (we did better than we thought), the PV (the amount we would have had to deposit), is less. The same logic holds true for FV. If the actual return is higher than projected, the FV will be higher (we made more on our money than we thought we would). Logically, if the actual return is lower, our FV winds up lower.

What is more important, NPV or IRR?

NPV is generally considered more important than IRR. — When an investment's IRR is equal to the discount rate (sometimes call the required rate of return), the NPV = zero. In an efficient market (Unit 20) bonds should be priced so that their NPV is zero. — The quickest way, to identify IRR versus NPV is that IRR is always expressed as a percentage, NPV never is. It is usually shown as a dollar amount. So, one is a rate (%), the other is a value ($).

Net Present Value (NPV)

Net present value (NPV) is the difference between an investment's present value and its cost. 1. Subtract the cost of the investment from the present value of the future returns (DCF) 2. A positive NPV is desirable. Example: If the cost of a bind is $940 and the present value of the bond is $900 than the NPV is -$40 which is not desirable. Note: NPV is expressed in dollar amounts and not as a rate of return. 3. A negative net present value of a series of discounted cash flows means the investment outlay exceeds the discounted cash flows.

Present Value (PV)

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.

Debt-to-Equity Ratio

The best way to measure the amount of financial leverage being used by the company is by calculating the debt-to-equity ratio. It is really a misnomer—it should be called the debt-to-total capitalization ratio because that is what it is. Long-term debt ÷ total capitalization

Dividend Payout Ratio

The dividend payout ratio measures the proportion of earnings paid to stockholders as dividends: dividend payout ratio = annual dividend per common share÷ earnings per share (EPS) In general, older companies pay out larger percentages of earnings as dividends. Utilities as a group have an especially high payout ratio. Growth companies normally have the lowest ratios because they reinvest their earnings in the businesses. Companies on the way up hope to reward stockholders with gains in the stock value rather than with high dividend income.

Internal Rate of Return (IRR)

The internal rate of return (IRR) is the discount rate (r) that makes the NPV of an investment equal to zero for a series of future cash flows. IRR is the method of computing long-term returns that takes into consideration time value of money. Although IRR may be used for almost any investment, its practical use for common stock is limited to those companies paying stable dividends. The yield to maturity of a bond reflects its IRR.

Median

The median is a midpoint of a distribution. That is, there are as many variables below as there are above. If the number of variables is even, then take the average of the middle two. The median is often more appropriate than the mean in skewed distributions or in situations with variables that fall far outside the normal range, (outliers).

Price-to-Book Ratio

The price-to-book ratio reflects the market price of the common stock relative to its book value per share. Book value is the theoretical value of a company (stated in dollars per share) in the event of liquidation and bears little or no relationship to the stock's current trading price. Market price of common stock÷ Book value per share

Quick Asset Ratio (Acid Test Ratio)

The quick asset ratio uses the company's quick assets instead of all of the current assets. Quick assets are current assets minus the inventory. Then divide these quick assets by the current liabilities to arrive at the quick ratio. (Current assets - inventory) ÷ current liabilities *Remember, cash is already apart of current assets. Don't let a question fool you.*

Risk-free rate used on the exam

The risk-free rate used on the exam will always be the 91-day (or 13-week) U.S. Treasury bill. Because their price movements are not generally related to the stock market, those T bills are said to have a beta of zero. It is possible on the exam that you will have an alpha computation where the RF (risk-free return) is not given. In that case, the computation is the same, but without the RF being subtracted from both the actual return and the market return.

Price-to-Earnings Ratio (P/E)

The widely used price-to-earnings (P/E) ratio 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: P/E = Current market value of common stock÷ earnings per share Growth companies usually have higher P/E ratios than do cyclical companies. Investors are willing to pay more per dollar of current earnings if a company's future earnings are expected to be dramatically higher than earnings for stocks that rise and fall with business cycles. Companies subject to cyclical fluctuations generally sell at lower PEs; declining industries sell at still lower PEs. Investors should beware of extremely high or extremely low PEs. Speculative stocks often sell at one extreme or the other.

Beta vs the beta coefficient

They are the same thing. In the securities industry, coefficient is ordinarily dropped for purposes of convenience.

Working Capital

Working capital is the amount of liquid capital or cash a company has available. Working capital is a measure of a firm's liquidity, which is its ability to quickly turn assets into cash to meet its short-term obligations. current assets − current liabilities = working capital

Suppose an investment of $1,000 was worth $4,000 in 16 years. Under the rule of 72, what is the compounded earnings rate?

You figure this by realizing that the account has quadrupled. That means it has doubled twice. So, if it took 16 years to double twice, it takes 8 years to double one time. Dividing 72 by 8 tells us that our account must be earning 9%.

Total Capitalization

long term debt + net worth (equity capital)