4-6 slides

Question 1

Explain 2 methods used to value a firms shares

Answer 1

Owning a share means you receive dividends. Value of the share is the expected PV of these dividends Dividend Discount Model (DDM)

Shareholder owns a share of the firm. Value of the share is the expected PV of all future earnings less all incurred liabilities, i.e. debt financing costs Discounted Cash Flow (DCF)

Question 2

Weaknesses of methods of comparables

Answer 2

When valuing a firm using multiples, there is no clear guidance how to adjust for differences in growth rates, risk, or differences in accounting policies.
Comparables only provide information regarding the value of a firm relative to other firms in the comparison set (Relative Valuation).
Using multiples will not help us determine if an entire industry is overvalued.

Question 3

Whats the most commonly used multiple?

Answer 3

The Price-Earnings Ratio
P/E Ratio -> Share price divided by earnings per share

Two varieties: 
Trailing P/E ratio 
Use earnings over the last 12 months
12 month Forward P/E ratio
Use expected earnings over the next 12 months

Question 4

What is a multiple?

Answer 4

A multiple is nothing more than an expression of market value relative to a key statistic which is assumed to relate to that value e.g (Price per Share/Earnings Per Share)

A stock’s multiple simply reflects the markets interpretation of value

Question 5

What is nominal return?

Answer 5

Nominal return is the percentage increase in money value, the real return is the percentage increase in purchasing power (takes inflation into account)

Question 6

Over which time periods should you use geometric average and which time periods arithmetic average?

Answer 6

The arithmetic average is overly optimistic for long horizons and the geometric average is overly pessimistic for short horizons

So:

15 – 20 years or less: use arithmetic
20 – 40 years or so: split the difference between them
40 + years: use the geometric

Question 7

What does efficient capital market mean?

Answer 7

Stock prices are in equilibrium or are fairly priced

If this is true, then you should not be able to earn abnormal or excessive returns, i.e. returns disproportionate to the level of risk taken.

Efficient markets DO NOT imply that investors cannot earn a positive return in the stock market

Question 8

What is strong form market efficiency?

Answer 8

Prices reflect all public and private information.
No investor can earn excess returns.
No empirical evidence.

Question 9

What is semi-strong form market efficiency?

Answer 9

Prices reflect all public information.
Fundamental analysis cant earn excess returns
‘Some’ empirical support

Question 10

What is weak form market efficiency?

Answer 10

Prices reflect all information in market prices.
Technical analysis cant earn excess returns
Good empirical support

Question 11

What is portfolio diversification?

Answer 11

Portfolio diversification is the investment in several different asset classes or sectors (the less correlated the assets are the greater the risk reduction)
However, there is a minimum level of risk that cannot be diversified away and that is the systematic portion (at around 30 assets in the portfolio(?*))
Non-diversifiable risk equals around 20% SD

Question 12

List some things that effect market risk

Answer 12

changes in GDP, inflation, interest rates, etc.

Question 13

What is unsystematic/diversifiable risk?

Answer 13

These are risk factors that affect only a limited number of assets. Includes such things as labor strikes, part shortages, management changes etc.

The is the risk that can be eliminated by combining assets into a portfolio

Also known as unique, asset-specific or idiosyncratic risk

Question 14

What is a stocks beta?

Answer 14

A stock beta is the sensitivity of a stock’s return to the market’s return (= 1 for the market)

*Know what different values mean…

Question 15

what does the risk premium equal?

Answer 15

risk premium = expected return – risk-free rate