RSM332 Exam

What is a stock?

A claim that represents ownership in a firm.

Why are stocks riskier than bonds?

Stockholders are paid after bond holders IF there is money left.

What are the two major differences between stocks and bonds?

- Stocks do not promise cash flows (i.e. dividends)

- Stocks have no maturity

What are the two models used to value stocks?

- Discounted cash flow models (dividend and free cash flows)

- Multiples valuation (estimates price by comparing to other asset prices)

What is the cost of equity used in the dividend discount model?

The rate of return investors require to hold equity in a firm.

What are the three assumptions of the DDM model?

- Dividends are like a perpetuity (constant)

- Growing perpetuity (constant growth)

- Estimate short-terms and then constant growth

What does the Gordon Growth Model state?

- Stock is a growing perpetuity

- P0 = D1 / r - g

What are the two components of the cost of equity (required return)?

- Dividend yield

- Growth rate

What are the two types of dividend yield?

- Trailing: past dividend over price

- Forward: expected dividend over price

How are the two types of dividends related?

Forward = trailing ( 1 + g )

What is the issue with the Gordon Growth Model and what is the solution?

- Growth is not constant

- Estimate dividends within 5 years, use GGM to estimate remainder (this is terminal value)

What is the issue with the DDM and what is the solution?

- Dividends are not always paid and stock prices are not based on dividends

- Use free cash flows

What are free cash flows?

The amount of cash left after deducting cash outflows.

How does the FCF method work?

Forecast FCFs for 4-5 years and then calculate terminal value using the constant growth equation for remaining perpetuity.

What are three reasons for which we model FCFs instead of earnings?

- Do not show impact of expenses

- Do not show money available to investors

- Not a cash flow

Why do we care about FCF to equity instead of FCF to firm?

FCF to equity is the amount left for dividends.

How do we find FCF to equity starting with FCF to firm?

FCF to firm - interest + net borrowing

How do we find FCF to firm starting with earnings?

Earnings - taxes - increases in working capital - expenditures

What is the advantage to the FCF vs DDM?

FCFs are not as smoothed out as dividends.

What do analysts do after performing a stock valuation?

Issue an opinion about the value of a stock (e.g. strong buy, sell).

What two amounts must be added to the equity value obtained by the FCF model?

- Cash and cash equivalents

- Marketable secruities

What is the idea behind multiples valuation?

A replicating portfolio can help us determine the value of a stock.

What are the three advantages of multiples valuation?

- Easy to understand and apply

- Does not require many inputs

- Reflects current market conditions

What are five disadvantages of multiples valuation?

- Problematic if there are no truly comparable peers

- Assumes that the peer group is correctly valued by the market

- Simplicity leaves out a lot of valuation-relevant information

- Some multiples depend on how much debt a firm has

- Hard to do counterfactual analysis

What should multiples valuation ideally be used for?

To complement standard DCF method of stock valuation.

What are the two types of multiples valuation?

- Equity multiples: compares market value of shareholder's equity

- Enterprise value multiples: compares the market value of shareholder's equity and debt

What is the advantage to enterprise value multiples?

Its is more robust to compare companies with different capital structures (debt to equity ratio).

What are the two ways to obtain the market price for a multiple?

- Comparable company analysis: collects accounting information and market price for traded companies to build the multiple

- Precedent M&A transactions: collects information on the price paid by acquirers on recent M&A deals

What are the three steps in multiples valuation?

1. Find a good comparison peer group (usually a competitor)

2. Reduce data noise using means / medians

3. Multiply by your firm's characteristics to get a price estimate

What is the implicit assumption of multiples valuation?

The multiple being used (e.g. PE ratio) is equal for the comparison and firm of interest.

What are the three ways to estimate the growth rate of earnings?

- Use historical growth rates

- Use analyst's forecast

- Estimate using financial statements

What is the sustainable growth rate equal to?

Return on equity * retention ratio

What are the two ideas of the NPVGO model?

Value of firm is sum of:

- Its value if it paid out 100% of its earnings as dividends (cash cow)

- NPV of growth opportunities

Why do dividends grow over time?

Firms retain earnings to reinvest in the firm's equity (e.g. invest in new product development).

How is the value of the cash cow found?

EPS / r

How is the value of growth opportunities found?

P0 - cash cow

What two things can be true for a firm with a high PE ratio?

- Low cost of capital

- Lots of growth opportunities

What two measures are used to measure the risk/return of an asset?

- Expected mean return

- Standard deviation of returns

What is the disadvantage of standard deviation?

Large gains and large loses both elevate the measure.

What do covariance and correlation measure?

How the returns of two assets are related.

What does the variance of a portfolio depend on?

Individual covariance terms.

When an asset is more risky the price is...

Lower

What two things must discount rates reflect?

- Time value of money

- Risk

What are the two assumptions of the mean-variance framework?

- Higher expected return increases utility

- Higher standard deviation of returns decreases utility

What is the equation of the mean-variance framework?

U = E[r] - A * o^2

(A = risk aversion)

What is an indifference curve?

A curve along which an investor has the same utility.

What is portfolio theory?

The branch of Finance that deals with the questions of how to best form portfolios to achieve certain ends (e.g. maximization of future wealth).

What are the only two things investors should care about involving portfolios?

- Expected return

- Variance

What are the three inputs needed to compute the mean and variance of a portfolio?

- Expected return of each asset

- Standard deviation of returns of each asset

- Correlation for each pair of assets

What is the minimum variance portfolio?

The lowest possible risk, and therefore, the minimum expected return we should be willing to accept.

What does an optimal portfolio do?

Maximizes an investor's utility.

When may a "bad" asset be an attractive part of a portfolio?

If its correlation with other assets is low, it acts as an insurance in the portfolio (moves in opposite direction).

What does the Sharpe Ratio measure?

Reward per unit of risk (higher Sharpe is better).

Why is the optimal portfolio called the tangency portfolio?

It just touches the efficient frontier.

What are the two components of the optimal portfolio for any investor?

- Risk free asset

- Risky assets

What are the six assumptions of modern portfolio theory?

- Investors only care about mean and variance of returns

- Returns follow a normal distribution

- Correlations between returns of different assets are predictable

- Investors are rational and have same expectations

- There are no transaction costs

- Assets are infinitely divisible

What is the result of diversification on firm vs market risk?

- Can eliminate firm risk

- Cannot get rid of market risk

What three things does the capital asset pricing model (CAPM) allow us to do?

- Measure the performance of investment strategies

- Identify undervalued securities

- Decide whether or not to proceed with a project

What is the idea behind CAPM?

If everyone demands the same assets to build their portfolios (MPT), it will impact the equilibrium prices of these individual assets.

What is true in equilibrium?

Demand for assets (from MPT) = supply of assets (from the market)

What characteristic of an asset allows for risk reduction?

Low correlation with the overall portfolio.

What does the beta of a security measure?

The risk of the security relative to the risk of the market.

What does CAPM state?

Expected return = risk free rate + beta * market risk premium

What else does beta measure?

How the return on a security moves when the market return moves (i.e. sensitivity to the market).

What are the three properties of CAPM?

- Price of asset is based on beta

- Total risk = market risk + firm-specific risk

- The variance of individual return is not a good proxy for risk

Why is the beta of firm-specific risk zero?

There is no excuse for it since it can be diversified away.

What is a higher beta associated with?

Higher expected return.

What is the Security Market Line?

A line that graphs individual asset's expected returns as a function of asset's risk.

What is true if a portfolio is above or below the SML?

- Above = attractive

- Below = unattractive

What is alpha?

The difference between the actual (expected) and the CAPM-implied expected return.

What are the three steps in beta estimation?

1. Get the stock and market returns for 50+ periods

2. Get the risk-free rate and market excess return

3. Regress stock excess returns on market excess returns to get the regression coefficient

What time horizon should you use for the beta regression?

Convention is to use five years.

What return frequency should you use?

Convention is to use monthly.

What should you use as the market return?

S&P 500 / TSX

What should you use as the risk-free return?

Convention is to use short-maturity T-bills.

What are the seven assumptions of CAPM?

- Investors have identical expectations about asset returns

- Investors are risk averse and maximize expected utility that depends only on mean and variance of returns

- Investors cannot influence prices (they are price-takers)

- Investors plan for one identical holding period (e.g., 3 years)

- Investors can borrow or lend an unlimited amount at the risk-free rate

- There are no market imperfections (e.g., taxes, transaction costs, short-selling restrictions, etc.)

- All assets are infinitely divisible

Why is CAPM not always ideal?

It relies on many assumptions that do not always hold.

What are the two reasons for which arbitrage pricing theory if better than CAPM?

- Requires less restrictives assumptions

- More realistic assumptions

What are the five assumptions of arbitrage pricing theory?

- Investors are risk averse and have wealth and knowledge to take advantage of arbitrage opportunities

- Markets are perfectly competitive and frictionless

- All investors have the same view of the future

- Return on a security is a linear function of risk factors

- The number of assets is much larger than the number of factors

What are the two methods for determining lambda and beta?

- Statistical approach

- Economic approach

What two things did Fama French find that CAMP misses?

- Risk related to firm size

- Risk related to B/M (book equity to market equity)

What did Mark Carhart notice about CAMP?

Winners continue to win and losers continue to lose.

What is the disadvantage to multi factor models?

Harder to interpret and justify theoretically.

What is the most common application of multi factor models?

Evaluating the performance of investments.