3. Investment Planning - All Exam Tips and Practitioner's Advice Flashcards
Lesson 1. Fixed Income Securities
Lesson 1. Fixed Income Securities
Course 3. Investing Planning
Describe Call and Put Provisions
Issuers may want the right to pay off their bonds at par before maturity. This ability provides management with flexibility because debt could be reduced or its maturity altered by refunding. Most importantly, expensive high-coupon debt that was issued during a time of high interest rates could be replaced with cheaper lower-coupon debt if rates decline.
Despite the cost of obtaining this sort of flexibility, many issuers include call provisions in their bond indentures. This gives the corporation the option to call (essentially refinance their debt at better rates or terms) some or all of the bonds from their holders at stated prices during specified periods before maturity. In a sense, the firm sells a bond and simultaneously buys an option from the holders. Thus, the net price of the bond is the difference between the value of the bond and the option. This is similar to what homeowners do when mortgage rates drop, they will typically look to refinance.
Put provisions give the holders an option, but this time it is to exchange their bonds for cash equal to the bond’s face value. This option generally can be exercised over a brief period of time after a stated number of years have elapsed since the bond’s issuance. Death puts, where the issuer allows the estate to exchange their bonds in the event of the death of the bond holder, are the most common puts available.
Practitioner Advice: It’s not always smart to go after a bond because of the amount of coupon that is being paid. Consider a callable bond that pays a 10% coupon versus a non-callable bond that pays an 8% coupon. If the 10% coupon bond is called, then the issuer will need to seek another fixed-income security that is likely to earn less than 10% annually. In the meantime, the person who bought the 8% coupon bond is still receiving 8% annually because the bond cannot be called. Therefore, it is important to make purchase decisions based on more than just the coupon rate.
Exam: Scenario ? ask when beneficial 4 bondholder to convert into stock
Describe Convertible Bonds
Exam Tip: Scenario-based questions may appear asking when it would be beneficial for a bondholder to convert bonds into stock.
Convertible bonds, a popular financial instrument, are securities that can be converted into a different security of the same firm under certain conditions. The typical case involves a bond convertible into shares of the firm’s common stock, with a stated number of shares received for each bond. Usually no cash is involved; the old security is simply traded in, and the appropriate number of new securities is issued in return. Convertible preferred stocks are issued from time to time, but tax effects make them, like other preferred stock, attractive primarily to corporate investors. For other investors, issues of convertible bonds are more attractive.
Example (Conversion Price Calculation)
If a convertible bond has a conversion ratio of 20 shares of stock per bond, then the conversion price would be equal to: $1000 ÷ 20 shares = $50/share. As a result, it would only be beneficial for the bondholder to convert if the stock price rises above $50.
Exam Tip: Scenario-based questions may appear asking when it would be beneficial for a bondholder to convert bonds into stock.
PA: time to buy bonds - when stock market peaking & bonds have been poor
Fixed-income securities are investments that range from conservative to very aggressive. Investors can use them for a number of reasons. Institutional investors use money market securities to facilitate business transactions while individual investors use them in money market mutual funds. Investors primarily invest in bonds for income. Some invest in speculative bonds for potential capital appreciation. Fixed-income securities vary depending on maturity and the issuer’s default risk. It is important to consider each investor’s tolerance for risk and the need for income.
The key concepts to remember are:
* Fixed-Income Attributes: Fixed-income securities are loans that have a finite maturity, principal amount, and stated interest (coupon) payments. They vary in default risk and maturity.
* Money Market Instruments are short-term debt securities that mature in less than one year. They are considered very conservative because of their short maturity.
* U.S. Government Securities: The U.S. Treasury and Federal Agencies issue these securities. U.S. Treasuries are considered the safest debt securities because they are backed by the full faith and power of the U.S. Government. Federal Agencies and federally sponsored agencies also offer fixed-income securities such as Mortgage Backed Securities (MBS).
* Municipal Bonds are issued by states and local governments. They are classified into general obligation bonds and revenue bonds. Municipal bonds are income tax-exempt on the federal level and on the state and local level if the investor purchases municipals from where they live. Investors in higher tax brackets benefit from investing in municipal fixed-income securities.
- Corporate Bonds are issued by companies both in the United States and Foreign Countries to finance their operations. Depending on the issuer, they may be backed by assets or by the full faith and power of the company. Corporate bonds may vary in risk from investment grade bonds issued by well-established companies to speculative bonds issued by small companies. Coupon rates increase as a bond issue’s inherent exposure to risk increases.
- Foreign Bonds enhance the level of diversification within a fixed income portfolio. However, there are special risks to be aware of in any type of foreign investing including exchange rate risk, political risk, and tax risk.
- Practitioner Advice:
- Bonds fall in and out of favor, but they do play an important role for investment planning decisions in a balanced portfolio.
- When rebalancing asset allocation near retirement age, your bond holdings should increase.
- Bond funds can lower risk through diversification.
- Having bonds in the portfolio also adds diversification to an otherwise equity-only portfolio.
- Be careful of falling into the trap of buying bonds when they’ve been doing well and then selling them when they are not.
- The time to consider buying bonds is typically when the stock market is peaking and bonds have been doing poorly.
Lesson 2. Equities
Lesson 2. Equities
Course 3. Investing Planning
PA: Many investors are mistaken theyre better off following stock split
Describe Stock Splits
Example (Stock Split)
If a $100 par value stock is split 2-for-1, the holder of 200 old shares will receive 400 new $50 par value shares, and none of the dollar figures in stockholders’ equity will change. If the shareholder’s total market value for the shares was $50,000, the total market value will remain the same. The only change is that the number of shares he or she owns has doubled.
Stock splits do not change anything for the company in terms of revenue or expenses. However, it can sometimes generate excitement around the stock. A stock split can signal that the firm’s management believes the stock to be undervalued in the market. It can also bring the share price to a more desirable trading range. Either way, these reasons can cause a short-term abnormal increase of activities around the stock.
Practitioner Advice: Many investors are mistakenly led to believe that they are somehow better off following a stock split. This misconception may stem from the fact that companies tend to split their stock if they are confident of future growth. It is not uncommon to see a run up in a stock price following a split, which may be somewhat of a self-fulfilling prophecy.
A company’s management may decide to alter the value of the stock by either a stock split or a reverse stock split. Splits and reverse splits only affect the price per share. A stock split adds shares based on a ratio; therefore the price per share declines. A reverse split would combine shares and therefore raise the price per share.
Example (Stock Split)
If a $100 par value stock is split 2-for-1, the holder of 200 old shares will receive 400 new $50 par value shares, and none of the dollar figures in stockholders’ equity will change. If the shareholder’s total market value for the shares was $50,000, the total market value will remain the same. The only change is that the number of shares he or she owns has doubled.
Stock splits do not change anything for the company in terms of revenue or expenses. However, it can sometimes generate excitement around the stock. A stock split can signal that the firm’s management believes the stock to be undervalued in the market. It can also bring the share price to a more desirable trading range. Either way, these reasons can cause a short-term abnormal increase of activities around the stock.
Practitioner Advice: Many investors are mistakenly led to believe that they are somehow better off following a stock split. This misconception may stem from the fact that companies tend to split their stock if they are confident of future growth. It is not uncommon to see a run up in a stock price following a split, which may be somewhat of a self-fulfilling prophecy.
Lesson 3. Pooled Investments
Lesson 3. Pooled Investments
Course 3. Investing Planning
Exam: Unit Investment Trusts passively managed. Prof at asset selection
Describe a Unit Investment Trust
Exam Tip: Unit Investment Trusts are passively managed. The professional management happens in the beginning for the asset selection. After that, no changes will be made to the portfolio except payment of interest and principal. Passive management results in lower management costs due to less turnover costs.
Some of the earliest pooled investments were unit investment trusts. A unit investment trust (UIT) is an investment company that owns a fixed set of securities for the life of the company. That is, the investment company rarely alters the composition of its portfolio during the life of the company.
Most unit investment trusts hold fixed-income securities that expire after the last security has matured. Life span for these companies can be as short as six months, for unit investment trusts of money market instruments, or as long as 20 years or more, for trusts of bond market instruments. Although UITs are less popular in the United States, they still draw European investors seeking to invest in fixed-income securities with a set maturity date.
Formation of a Unit Investment Trust
Purchase securities. A sponsor purchases a specific set of securities and deposits then with a trustee (such as a bank)
Sell shares to public. A number of shares known as redeemable trust certificates are sold to the public. These certificates provide their owners with proportional interests in the securities that were previously deposited with the trustee.
Pay out income & principal repayment. All income received by the trustee on these securities is subsequently paid out to the certificate holders, as are any repayments of principal.
Exam Tip: Unit Investment Trusts are passively managed. The professional management happens in the beginning for the asset selection. After that, no changes will be made to the portfolio except payment of interest and principal. Passive management results in lower management costs due to less turnover costs.
PA: decision to buy load or no-load fund is decision to pay for advice
Describe No-Load vs. Load Funds
Practitioner Advice: The decision to buy a load or no-load fund is really a decision of whether to pay for advice. The quality of the fund cannot be determined solely by cost.
Open-end funds are sold either directly from the company or through a sales force involving brokers, financial planners, and employees of insurance companies and banks. The method used to sell open-end funds is based on whether there is an additional sales commission charged to the investor. A sales commission, called a load, is used to pay for the sales of a fund. Open-end funds that are sold without these commissions (at NAV) are called no-load funds. Those that are sold with a commission are called load funds.
There are no noticeable differences in performance between no-load versus load funds. The difference is in the services provided. No-load funds, which charge lower transaction costs and generally provide fewer services, are beneficial for investors who have some investment knowledge and an understanding of how mutual funds work. Load funds are beneficial for investors who are seeking advice or guidance from a broker or adviser and do not mind paying a sales charge.
Practitioner Advice: The decision to buy a load or no-load fund is really a decision of whether to pay for advice. The quality of the fund cannot be determined solely by cost.
Practitioner Advice: Which class is suitable for the investor
Practitioner Advice: Which class is suitable for the investor?
* It all depends on the holding period.
* Anyone with large investment amounts should take advantage of breakpoints available for Class A (front load) shares. The longer you plan on holding the shares, the more beneficial it is to hold Class A shares. You are better off paying your entire load as a percentage of the initial investment amount than over time as a percent of your account each year.
* If your account grows each year, the percentage becomes a larger actual amount paid.
* For Class B (CDSC) shares, although the load disappears over time, there is a higher 12b-1 fee that is paid annually as a percentage of the account.
* Class C (level load) shares have an annual fee, again based on the size of the account.
Share Class Fees and Loads
* Class A shares. Typically, Class A shares of a fund charge a front load which can be reduced through breakpoints for larger investments. Typically charge a lower 12b-1 fee.
* Class B shares. Typically, Class B shares of a fund are shares with CDSC charge plus a 12b-1 fee. After the CDSC’s term is up, the Class B share may convert to Class A shares.
* Class C shares. Typically, Class C shares charge an annual 12b-1 fee.
PA: Dont be drawn into abnml returns. Sector can pay great, higher risk
Describe Specialized Funds
Practitioner Advice: Do not be drawn into abnormal returns. People are always drawn into hot sectors (such as technology). Sectors can pay off a great return, but they also present higher risk. By the time the sector becomes “the buzz,” it has probably gained its return already.
A few specialized stock funds concentrate on the securities of firms in a particular industry or sector. These are known as sector funds. For example, there are:
* Chemical funds
* Aerospace funds
* Technology funds
* Gold funds
Other specialized stock funds deal in securities of a particular type. Examples include funds that:
* Hold restricted stock,
* Invest in over-the-counter stocks, or
* Invest in the stocks of small companies.
Still others provide a convenient means for holding the securities of firms in a particular country, such as India and Indonesia funds. These funds allow investors to diversify beyond domestic companies and gain access to countries in which investing would otherwise be difficult.
However, specialized funds limit the portfolio managers’ ability to diversify away all of the nonsystematic risks of the assets within their portfolios. For example, a fund that invests in only technology-related stocks is subjected to risks specific to the technology industry. Investors who believe that certain sectors or countries will outperform the broad market may want to invest in these funds.
Practitioner Advice: Do not be drawn into abnormal returns. People are always drawn into hot sectors (such as technology). Sectors can pay off a great return, but they also present higher risk. By the time the sector becomes “the buzz,” it has probably gained its return already.
PA: index funds, depends efficient market hypothesis, few funds beat S&P
Describe Index Funds
Practitioner Advice: Why invest in index funds? It depends on your view of the efficient market hypothesis. The strong form of this hypothesis believes that all information is available to investors about investments. There is no additional advantage to researching to uncover hidden values and to exploit inefficient knowledge. Very few funds actually beat the S&P 500, the benchmark that many large cap funds are measured against. Investors buy Index Funds because they believe there is little value gained investing in large cap funds which on a load-adjusted basis may not exceed the index returns.
An index fund attempts to provide results similar to those computed for a specified market index. The fund manager does this by investing the portfolio in the same companies and in similar proportions as the market index the fund is trying to mimic. The portfolio is then passively managed to remain consistent with that market index.
For example, the Vanguard Index 500 Trust, a no-load open-end investment company, provides a vehicle for small investors who wish to obtain results matching those of the Standard & Poor’s 500 stock index, less operating expenses.
Since index funds do not have much active trading or active management, both operating and management expenses are lower than actively managed funds.
Index funds are ideal for those who are willing to accept the return and risk similar to the market.
Practitioner Advice: Why invest in index funds? It depends on your view of the efficient market hypothesis. The strong form of this hypothesis believes that all information is available to investors about investments. There is no additional advantage to researching to uncover hidden values and to exploit inefficient knowledge. Very few funds actually beat the S&P 500, the benchmark that many large cap funds are measured against. Investors buy Index Funds because they believe there is little value gained investing in large cap funds which on a load-adjusted basis may not exceed the index returns.
PA: prob w/ choosing funds based on ratings is purchase high, sells low
Describe Ratings
Practitioner Advice: Buyer Beware! Often companies focus their advertisements on only their top rated funds. Or they may try to tell their clients to unload funds with poor ratings and buy funds with good ratings. This may produce a short-term rise in the portfolio. However, it is important to remember that the performance that is evaluated and rated is historical. There is no guarantee for the future. The problem with choosing funds based on ratings alone is that the buyer typically purchases at a high price and ultimately sells at or near the low. The problem is then compounded when the client repeats the performance.
For example, when the economy is doing poorly, the Fed lowers interest rates and bond funds will do well. Their ratings could increase. However, interest rates are bound to go up when the Fed decides to curb inflation. So if someone purchases bond funds based on high ratings alone, they may be buying into lowering interest rates that already occurred only to face rising interest rates and a falling price.
Morningstar ranks mutual funds based on a risk-adjusted performance scale. The Morningstar Risk-Adjusted Rating is determined by subtracting the fund’s downside risk measure from its return measure. The fund’s return measure is a comparison of its average return compared to the other funds of the same category.
A fund’s downside risk is calculated by first subtracting the risk-free return of a T-Bill from the fund’s return. Only the negative excess returns are summed, and the absolute value is then divided by the number of months to provide a measure of the fund’s downside risk.
The fund’s risk-adjusted measure is compared against all the other funds in the same category; percentile ranks are determined and a rating is then assigned.
Morningstar’s rating system has five ranks, as follows:
Stars Percentile Return Category Risk Category
5 1 - 10 Highest or High Lowest or Low
4 11 - 32.5 Above Average Below Average
3 33.5 - 67.5 Average Average
2 68.5 - 90 Below Average Above Average
1 91 - 100 Lowest or Low Highest or High
Practitioner Advice: Buyer Beware! Often companies focus their advertisements on only their top rated funds. Or they may try to tell their clients to unload funds with poor ratings and buy funds with good ratings. This may produce a short-term rise in the portfolio. However, it is important to remember that the performance that is evaluated and rated is historical. There is no guarantee for the future. The problem with choosing funds based on ratings alone is that the buyer typically purchases at a high price and ultimately sells at or near the low. The problem is then compounded when the client repeats the performance.
For example, when the economy is doing poorly, the Fed lowers interest rates and bond funds will do well. Their ratings could increase. However, interest rates are bound to go up when the Fed decides to curb inflation. So if someone purchases bond funds based on high ratings alone, they may be buying into lowering interest rates that already occurred only to face rising interest rates and a falling price.
PA: rating past performance, diversifiy, asset allocation & rebalancing
What are some Caveats to keep in mind?
Practitioner Advice: It is most important to remember that a rating measures past performance. The management could have done well and continue to do so. However, cyclical effects could have been a factor to good ratings. The most important thing is to look beyond the ratings and focus on diversification, asset allocation and rebalancing based on objectives, risk tolerance and time horizon.
Morningstar’s performance measures are useful in giving an investor a quick reading of how a mutual fund has performed in the past relative to other funds.
However, several things should be kept in mind.
Indices used for comparison may not be appropriate benchmarks for all types of funds.
Morningstar’s performance measures do not indicate which approach the fund is using in its quest for abnormal returns.
The use of peer group comparisons to evaluate performance has several serious conceptual and practical shortcomings. In an attempt to minimize this problem, Morningstar uses more narrowly defined categories for comparison purposes, but such categorization is still far from perfect.
Survivorship bias (tendency for poorly performing funds to go out of business and hence leave the peer group) skews comparisons with similar funds.
Practitioner Advice: It is most important to remember that a rating measures past performance. The management could have done well and continue to do so. However, cyclical effects could have been a factor to good ratings. The most important thing is to look beyond the ratings and focus on diversification, asset allocation and rebalancing based on objectives, risk tolerance and time horizon.
PA: purchase REIT now based on perf, would be :( lower demand realestate
Describe Real Estate Investment Trusts (REITs)
Real Estate Investment Trusts (REITs) are closed-end investment companies that invest in real estate instead of financial assets and serve as a conduit for earnings on investments in real estate or loans secured by real estate. REITs pass these on to their shareholders and, as long as 90% of their taxable income is distributed to shareholders annually, that income is free from taxation for the REIT. At least 75% of a REIT’s assets and income must be derived from real estate equity or mortgages.
Mortgage REITs, also referred to as Real Estate Mortgage Investment Conduits (REMICs), allow investors to receive a stream of income from the mortgage payments.
Equity REITs offer investors the potential growth of their investments through realized capital gains, as well as the pass-through from rental income.
Real estate investment trusts utilize a common financial intermediation process known as securitization. Returns to REIT investors come from rental income, which is passed on to shareholders, and from property value changes, which are reflected in REIT prices.
Like investment companies, REITs come in many different varieties. Some invest in real estate mortgages; others make equity investments. Most REITs own specific types of properties, such as apartments, malls, or golf courses, in specific geographic areas. Some are publicly traded, whereas others have their shares exchanged on a privately arranged basis. Investors seeking income may be interested in mortgage REITs. Investors seeking growth of principal value may be interested in equity REITs.
Practitioner Advice: Demand for REITs had increased in recent years because when the economy was doing well, there was a high demand for office space. Since demand outpaced supply, rent was high and there was a lot of building going on. However, once the economy headed into a contraction, supply exceeded demand. There is a lag in REIT performance reflecting lower rent and building leases. Therefore, if you were to purchase a REIT now based on its recent performance, you would likely be displeased with it once it begins to reflect the lower demand for real estate.
Lesson 4. Derivatives, Insurance Securities, and Other Investments
Lesson 4. Derivatives, Insurance Securities, and Other Investments
Course 3. Investing Planning
If annuity payments continue beyond the life expectancy noted on IRS Table V, all income generated from the annuity is considered __ ____??____ __.
There are two basic types of annuities:
* Fixed
* Variable
Exam Tip: If annuity payments continue beyond the life expectancy noted on IRS Table V, all income generated from the annuity is considered taxable income.
Lesson 5. Investment Risks
Lesson 5. Investment Risks
Course 3. Investing Planning
PA: The downside of business risk can be limited through diversification
Describe Business Risk
PRACTITIONER ADVICE: Business risk is the source for potential downside risk as well as upside return. The reason why some people buy specific stocks is because they believe something specific about that business will yield a profit for them. The downside of business risk can be limited through diversification. If an investor bought a portfolio of securities rather than holding only one company’s securities, the investor will limit the effects of the downside risk of one company to his or her entire investment.
Most stocks and corporate bonds are influenced by how well or poorly the company that issued them is performing. Business risk deals with fluctuations in investment value that are caused by good or bad management decisions, or how well or poorly the firm’s products are doing in the marketplace. Businesses can go bankrupt, and management can make poor decisions. A CEO’s decision to leave a company, or a company’s decision to lay off part of their staff, may cause the share price of the company’s stock to rise or fall depending on the impact of the decision on the company’s performance. Business risk is specific to the stock or bond that the business issues. Business risk is a type of unsystematic, or diversifiable risk.
PRACTITIONER ADVICE: Business risk is the source for potential downside risk as well as upside return. The reason why some people buy specific stocks is because they believe something specific about that business will yield a profit for them. The downside of business risk can be limited through diversification. If an investor bought a portfolio of securities rather than holding only one company’s securities, the investor will limit the effects of the downside risk of one company to his or her entire investment.
Exam: provided mean return & std dev, solve probability, draw bell curve
Describe characteristics of Normal Distribution
Exam Tip: Write it out! When you encounter a problem in which you are provided with a mean return and standard deviation, then asked to solve for the probability of a certain return, draw a bell curve, split it down the middle, write the mean return at the midpoint, and work outward to identify the standard deviations. From there, apply the probabilities between the appropriate standard deviations to solve.
The symmetrical, bell-shaped distribution known as a normal distribution plays the center role in the mean-variance model of portfolio selection. The normal probability distribution is also used extensively in financial risk management. The normal distribution has the following characteristics:
* Its shape is perfectly symmetrical.
* Its mean and median are equal.
* It is completely described by two parameters - its mean and variance.
* The probability of a return greater than the mean is 50%.
* The probability of a return less than its mean is 50%.
* There is approximately a 68% probability that the actual return will lie within + / - one standard deviation from the mean.
* There is approximately a 95% probability that the actual return will lie within + / - two standard deviations from the mean.
* There is approximately a 99% probability that the actual return will lie within + / - three standard deviations from the mean.
Exam Tip: Write it out! When you encounter a problem in which you are provided with a mean return and standard deviation, then asked to solve for the probability of a certain return, draw a bell curve, split it down the middle, write the mean return at the midpoint, and work outward to identify the standard deviations. From there, apply the probabilities between the appropriate standard deviations to solve.
What is important to realize about the lognormal distribution?
PRACTITIONER ADVICE: You will not be responsible for the creation or formulation of a lognormal distribution.
* However, it is important to realize that the lognormal distribution has been found to be very accurate in the distribution of prices for many financial assets.
* In fact, the primary principal of the Black-Scholes-Merton Option Pricing Model is that the asset underlying the option is lognormally distributed.
Lesson 6. Measures of Investment Returns
Lesson 6. Measures of Investment Returns
Course 3. Investing Planning
- Practitioner Advice: Arithmetic mean is less telling because the standard deviation of the period can vary significantly — the price of the investment could have been very volatile during that period. If so, then the return is not reflective of the movement of the investment during that time.
Exam: This equation does not appear on the CFP Exam equation sheet
Formula for Holding Period Return
**TEST TIP: This equation does not appear on the CFP® Certification Examination equation sheet.
**
- Holding-Period Return
o A measure that can be used for any investment is its holding-period return.
o Holding period is defined as the length of time over which an investor is assumed to invest a given sum of money. The holding period return has a major weakness because it does not consider the time or how long it took to earn the return.
o When this procedure is applied, the performance of a security can be measured by comparing the value obtained in this manner at the end of the holding period with the value at the beginning.
o Please note that in the formula below, any coupon (from a bond), interest, dividend, or any other cash flow received from the investment does not assume reinvestment.
o Any reinvestment (like capital gains distributions and dividends from a mutual fund) would be imbedded in the ending value (P1) and the separate addition of theses payments would overstate the return.
o HPR=(PE+D−PB) / PB
o Where:
o PE = price in the end of the period
o PB = price at the beginning of the period
o D = any dividend, interest, or cash flow paid.
PRACTITIONER ADVICE
PRACTITIONER ADVICE
o A time-weighted return is a geometric return which often requires using the N key for the root calculation. In the example above, the two returns are semi-annual, which, when multiplied, produce the annual return.
o If the same example had used annual figures, a square root calculation would be necessary, as denoted in the Geometric Mean Return formula.
Lesson 7. Time Influence on Valuation
Lesson 7. Time Influence on Valuation
Course 3. Investing Planning
PRACTITIONER ADVICE
What is the alternative method for calculating the real interest rate?
An alternative method for calculating the real interest rate is to subtract the inflation rate from the nominal return (as a whole number), and then dividing that amount by 1 plus the inflation rate.
Using the same example above,
11 - 4 = 7. Then 7/1.04 = 6.73.
This is the real (or inflation adjusted) return, and is already expressed in the correct format for your calculator. The other method requires you to convert the decimal expression to a whole number.
Module Summary
Time is an element that influences the valuation of securities. Cash flows from the future can be discounted back to arrive at a present value. The future value of an investment can also be determined through compounding of current cash flows. One practical way to look at the time influence on valuation is to analyze two different mortgages. Click here to read a case study on how to choose between a 15-year versus a 30-year mortgage based on time value calculations. The effects of changing interest rates on bond prices can be determined through a bond’s duration, which is based on its maturity. The higher the duration the greater the effect of changing interest rates on price.
The following are key concepts to remember:
* Present Value and Future Value: Time value of money concepts can be used to determine the value of an investment by discounting for a current price or compounding for a future price.
* Convexity and Duration: Convexity is the relationship between bond prices and yields. Duration is a measure of the “average maturity” of the stream of payments associated with a bond.
PRACTITIONER ADVICE:
Time horizon helps to determine the amount of risk an investor should take. For example, if an investor has three years left until reaching their financial goal, they should consider moving their investments to a more conservative holding. Let’s say in the three years that remain, the investor could earn a 6%/yr return in a bond investment versus an 11%/yr return in a stock investment. Most people at first glance would want the 11% from the stock. However, the stock investment is much more volatile than the bond investment.
Let’s assume the standard deviation of the stock market is 15%. You know from your readings of module 196 (Investment Risks) the probability of the expected return (in this case 11%) plus or minus two standard deviations is approximately 95%. This means that in any particular year, even though the expected return is 11%, there is a 95% probability that the actual return for the upcoming year will range anywhere from -19% to 41%. The Investment Risk module also discussed the influence of time on the standard deviation. Over a three year holding period, the effective standard deviation of the investment would be 8.66% [ 15% / square root of 3 ]. Over the time horizon of three years, there is a 95% probability that the return would be in the range of -6.32% to 28.32%. The correct financial planning perspective is to avoid equity investments with such a short time horizon.
Lesson 8. Valuation of Bonds and Stocks
Lesson 8. Valuation of Bonds and Stocks
Course 3. Investing Planning
Section 2 - Capitalization of Income (Stock)
When you purchase a share of common stock, you receive dividend payments whenever they are declared, and then at some point in the future you generally sell the stock. Where does that price you are going to get when you sell your common stock come from? Well, it’s based on the future dividend payments the buyer expects while the stock is held plus some capital gains. Therefore, the value of a share of stock should be the present value of its future dividends. The difference between using the Capitalization of Income for stocks versus bonds is that the cash flows for a stock are unknown and there is no maturity date where the principal (par value) is returned to the investor. Companies can pay out dividends forever, because common stock has no termination date.
To ensure that you have a solid understanding of capitalization of income (stock), the following topics will be covered in this lesson:
* Net present value
* Internal rate of return
* Application to common stocks
Upon completion of this lesson, you should be able to:
* Calculate net present value,
* Compute internal rate of return, and
* Determine the value of common stocks.
PRACTITIONER ADVICE
Please note that different financial authors may use different terms for the same concept. While the author from the original textbook uses stock valuation terms of Net Present Value and Internal Rate of Return for the dividend discount models, the current textbook’s author uses contemporary terms of intrinsic value and expected return.
Describe the Multiple Growth Model
A more general DDM for valuing common stocks is the multiple-growth model. With this model, the focus is on a time in the future (denoted by T), after which dividends are expected to grow at a constant rate (g).
Valuing a share of common stock with the multiple-growth model requires that the present value of the forecast stream of dividends be determined. This process can be facilitated by dividing the expected dividend stream into two parts:
* finding the present value of each part, and
* adding these two present values together.
The first part consists of finding the present value of all the forecast dividends that will be paid up to and including time T, and denoting this present value by VT. The second part consists of finding the present value of all the forecast dividends that will be paid after time T and involves the application of the constant-growth model.
The value of the stock = V = VT- + VT+
V=∑Tt=1Dt(1+k)t+Dt+1(k−g)(1+k)T
The two-stage model assumes that a constant growth rate (g1) exists only until some time (T), when a different growth rate (g2) is assumed to begin and continue thereafter.
Practitioner Advice: Economic conditions and company forecasts are constantly changing. As a result, valuation methods that offer flexibility in company growth projections are especially valuable. The most useful of the dividend discount models, therefore, is the two-stage model because it is the only one that allows for a fast growth phase where g > k, followed by a “normal” phase where k > g.
Exam Tip: Here’s the typical fact pattern for Multi-Stage Dividend Discount Model questions:
A client owns a stock paying a certain dividend rate, which changes to another (constant) dividend rate in the future. A time frame and the client’s required rate of return will be provided. From there, you will be asked to calculate the valuation of the stock based on the dividend payments and, possibly, use a valuation result to determine whether a stock is overvalued or undervalued in the market.
As the name of the calculation states, there are many steps to conduct as you work toward a solution. Know that breaking the problem into three, smaller problems, makes the calculation more manageable and easier to understand.
Section 4 – Price/Earnings Models
A stock’s earnings per share over the forthcoming year (E1) are estimated, and then the security analyst specifies a “normal” price/earnings ratio for the stock. Analysts determine whether a stock is undervalued or overvalued by comparing the stock’s actual price/earnings ratio (P/E0) with its “normal” price/earnings ratio (V/E0). Price/earnings ratio is simply the price per share of the asset divided by the earnings per share.
V/E0 > P/E0 = Underpriced
V/E0 < P/E0 = Overpriced
Earnings per share (Et) are related to dividends per share Dt by the firm’s payout ratio (Pt),
Dt=(Pt)(Et)
If an analyst has forecasted earnings per share and payout ratios, then he or she has implicitly forecasted dividends.
Various DDMs can be restated where the focus is on estimating what the stock’s price/earnings ratio should be instead of on estimating the intrinsic value of the stock. In the restatement, Pt Et is substituted for Dt, resulting in a general formula for determining a stock’s intrinsic value that involves discounting earnings:
V=p1E1(1+k)1+p2E2(1+k)2+p3E3(1+k)3+…=∑∞t=1ptEt(1+k)t
therefore,
VEt=p1(1+k)1+p2(1+k)2+p3(1+k)3+…=∑∞t=1pt(1+k)t
PRACTITIONER ADVICE:
The problem with looking at a company’s P/E is that you cannot be sure how they are forecasted. For example, published earnings figures are based on the previous four quarters, while other publications may use the current quarter and project it out for the next four quarters. If the company had an exceptionally good or exceptionally bad quarter, it is amplified by being used as the predictor of the next three quarters. A problem arises when aberrations from the norm are explained away as being warranted, when in fact they are the result of greedy investors.
TEST TIP:
TEST TIP:
Sustainable Growth Rate is a product of some real data. It uses ROE x Retention Rate. On the CFP exam, instead of asking for a calculation of sustainable growth rate, there may be a question that asks you to choose the fastest growing company from a list of ROE figures and retention rates.
The one with the highest ROE and retention rate would be the one that has the greatest sustainable growth.
PRACTITIONER ADVICE:
What do the words “margin” and “turnover” usually tell you about ratio?
PRACTITIONER ADVICE:
Most of the ratios will not need to be memorized because the name of the formula usually guides your calculation.
* The word “margin” usually means sales in the denominator
* The word “turnover” usually means sales in the numerator.
Lesson 9. Portfolio Management and Measurements
Lesson 9. Portfolio Management and Measurements
Course 3. Investing Planning
Describe Initial and Terminal Wealth
When investing in different securities, the percentage of change in an investor’s wealth from the beginning to the end of the year can be calculated in terms of the rate of return as:
HPR = ((P1 - P0 )+D)/P0, or Holding Period Return = ((End-of-Period Wealth - Beginning-of-Period Wealth) + Income)/Beginning-of-Period Wealth
The above formula is used to calculate the one-period rate of return on a security, where beginning-of-period wealth is the purchase price of one unit of the security at t = 0. The end-of-period wealth is the market value of the unit at t = 1, along with the value of any cash (and cash equivalents) paid to the owner of the security between t = 0 and t = 1.
One must also remember that in the calculation of the return on a security, it is assumed that a hypothetical investor purchased one unit of the security at the beginning of the period.
TEST TIP
Since the formulas on the distributed formula sheet for the CFP Certification Exam are not labeled, it is as important to recognize a formula by its components. Most questions that offer a beginning wealth (or price) and an ending wealth (or price) will have something to do with the Holding Period Return equation. The equation could also be manipulated where the return is given and you must solve for the ending or beginning wealth (price).
