Investments Study Guide - Ch. 11, 13, 14, 18, 19 (Bodie, Kane & Marcus)

Holding Period Return (HPR)

The total return earned on a stock over one holding period: dividend income plus capital gain or loss, both relative to the beginning price. HPR = Dividend Yield + Capital Gains Yield.

Preferred Stock Intrinsic Value

V = D / k. D = the fixed annual preferred dividend, k = required rate of return. Preferred stock is valued as a perpetuity because its dividend is fixed and never grows.

Intrinsic Value (Common Stock)

The present value of a firm's expected future cash flows to shareholders, discounted at the required rate of return (market capitalization rate, k). If intrinsic value exceeds market price, the stock is undervalued.

Market Capitalization Rate (k)

The market-consensus estimate of the appropriate discount rate for a firm's expected cash flows; the required rate of return used to find intrinsic value.

Dividend Discount Model (DDM)

Values a stock as the present value of all expected future dividends.

Constant-Growth DDM

A version of the DDM that assumes dividends grow forever at one constant rate. P0 = D1 / (k - g).

Two-Stage DDM

Assumes dividends grow at one, often higher, rate for a set number of years, then drop to a stable, permanent growth rate afterward.

Multistage Growth Model

Allows dividends to grow at several different rates as a firm matures through multiple phases, rather than just two.

Present Value of Growth Opportunities (PVGO)

The part of a stock's price attributable to expected future investments earning above-normal returns. P0 = No-Growth Value per Share + PVGO.

Free Cash Flow to the Firm (FCFF)

Cash flow available to all security holders, debt and equity, after operating expenses and investments. Discounted at the WACC to value the whole firm.

Free Cash Flow to Equity (FCFE)

Cash flow available specifically to equity holders after debt payments. Discounted at the cost of equity to value equity directly.

Purchased Goodwill

Goodwill = Purchase Price minus Fair Value of Net Identifiable Assets. The premium an acquirer pays above the fair value of a target's net assets, recorded as an intangible fixed asset.

DuPont System

Breaks Return on Equity (ROE) into components (tax burden, interest burden, margin, turnover, leverage) to reveal what's driving profitability.

Tax Burden (DuPont)

Net Profit divided by Pretax Profit. The share of pretax profit that survives taxes.

Interest Burden (DuPont)

Pretax Profit divided by EBIT. The share of operating income that survives interest expense.

Profit Margin (DuPont)

EBIT divided by Sales. Operating profitability earned per dollar of sales.

Asset Turnover (DuPont)

Sales divided by Assets. How efficiently a firm's assets generate sales.

Leverage / Compound Leverage Factor (DuPont)

Assets divided by Equity. How much a firm amplifies its ROE through debt financing.

P/E Ratio (Sustainable Growth)

P/E = (1 - b) / (k - g), where b = plowback ratio, k = required return, g = ROE times b. Example: k=12%, ROE=14%, b=0.75 gives g=10.5% and P/E = 0.25/0.015 = 16.67.

PEG Ratio

P/E Ratio divided by the expected earnings growth rate, in percent. Used to judge whether a P/E multiple is justified by growth.

Quality of Earnings

The realism and sustainability of a firm's reported earnings, how closely accounting earnings track true, repeatable economic earnings.

Earnings Management

Using flexibility within accounting rules to make reported profitability look better than economic reality.

Allowance for Bad Debt (Quality of Earnings factor)

A discretionary estimate of uncollectible receivables. Overly optimistic assumptions can inflate reported earnings quality.

Nonrecurring Items

One-time gains or losses that get folded into operating results, distorting the sustainability of reported earnings.

Earnings Smoothing

Managing the timing of income or expenses to reduce the reported volatility of earnings across periods.

Off-Balance-Sheet Assets and Liabilities

Obligations or resources not reflected on a firm's balance sheet, which can obscure its true financial position.

International Diversification Benefit

Adding foreign stocks reduces total portfolio risk because country market returns are not perfectly correlated, though this benefit has shrunk as global correlations have risen.

Exchange Rate Risk

Uncertainty in an investment's return caused by movements in the exchange rate between the investor's home currency and the foreign currency.

Country-Specific / Political Risk

Risk from local government actions such as expropriation of assets, changes in tax policy, or restrictions on currency exchange.

Interest Rate Sensitivity (Bond Prices)

Bond prices and yields move inversely. The relationship is convex, so a yield increase causes a smaller price change than an equal-sized yield decrease.

Duration

A weighted average of the times until a bond's cash flows are received, with weights equal to each payment's share of the bond's total present value. Measures effective maturity and interest rate sensitivity.

Duration of a Zero-Coupon Bond

Always equals its time to maturity, the maximum possible duration for that maturity.

Duration and Coupon Rate

Holding maturity and yield constant, duration is higher when the coupon rate is lower.

Duration and Maturity

Holding coupon rate constant, duration generally increases with time to maturity and always increases for bonds priced at or above par.

Duration and Yield to Maturity

Holding other factors constant, duration is higher when yield to maturity is lower.

Duration of a Perpetuity

Equals (1 + y)/y, a finite value even though the perpetuity itself never matures.

Immunization

A bond portfolio strategy that matches asset and liability duration to shield net worth from interest rate movements.

Rebalancing

Realigning the proportions of assets in a portfolio as needed to maintain a desired strategy, such as an immunized position.

M-Squared (M2) Measure

Adjusts a managed portfolio's risk, by mixing with the risk-free asset, to match a benchmark index's volatility, then compares that risk-matched return to the index's actual return.

Comparison Universe

A peer group of portfolio managers with similar investment styles, used to assess a manager's relative performance.

Survivorship Bias

An upward bias in average fund performance caused by excluding failed funds from a historical sample.

Substitution Swap

Exchanging one bond for a nearly identical bond that is priced more attractively.

Intermarket Swap

Switching a bond position from one segment of the bond market to another.

Rate Anticipation Swap

Adjusting a bond portfolio in response to a forecast of interest rate changes.

Pure Yield Pickup Swap

Moving into higher-yielding bonds, usually with longer maturities, purely to raise portfolio yield.

Tax Swap

Swapping two similar bonds to capture a tax benefit, such as harvesting a loss.

Horizon Analysis

Forecasting bond returns based largely on a predicted yield curve at the end of the investment horizon.

Sharpe Ratio

Excess portfolio return, over the risk-free rate, divided by total standard deviation. Use when the portfolio represents an investor's entire risky holding.

Treynor Measure

Excess portfolio return divided by beta. Use when the portfolio is just one piece of a larger, multi-manager portfolio, since only systematic risk matters there.

Jensen's Alpha

The average return a portfolio earned above or below what CAPM predicts, given its beta and actual market performance. Positive alpha means the manager added value beyond systematic risk exposure.

Information Ratio

Alpha divided by the standard deviation of a portfolio's diversifiable (residual) risk. Measures abnormal return earned per unit of uncompensated risk taken.

International CAPM

Applies CAPM at the global level using a benchmark like the MSCI World Index as the market portfolio. Expected return = risk-free rate + (beta against the global index times the global market risk premium).

Covered Interest Rate Parity (Forward Rate)

F0 = S0 times [(1 + r-domestic) / (1 + r-foreign)]. Sets the no-arbitrage forward exchange rate; if the quoted forward rate differs, a riskless covered interest arbitrage profit is available.

Market Timing

Adjusting the split between risky assets (stocks) and safer assets (money market or bonds) based on a forecast of overall market direction.

Perfect Market Timing as a Call Option

Perfect market timing is mathematically equivalent to holding a call option on the equity portfolio, guaranteeing the better of two outcomes each period.

Current Price of a Share (Constant-Growth DDM)

P0 = D1 / (k - g). D1 = next year's expected dividend, k = required return, g = constant growth rate. Requires k greater than g.

Two-Stage DDM Valuation (Worked Example)

D0=$1.00, g=20% for 3 years then 5% forever, k=12%: D1=$1.20, D2=$1.44, D3=$1.728, terminal value P3=D4/(k-gs)=$25.92, giving P0 = 1.20/1.12 + 1.44/1.12^2 + (1.728+25.92)/1.12^3 = $21.90.

Macaulay Duration (Formula)

D = sum of [t times CFt /(1+y)^t] / Bond Price. The weighted-average time until a bond's cash flows are received.

Modified Duration (Formula)

D = D / (1+y). Approximates the percentage change in a bond's price for a 1% change in yield: % price change is about equal to -D times change in yield.

Current Ratio

Current Ratio = Current Assets / Current Liabilities. A liquidity ratio measuring a firm's ability to cover short-term obligations with short-term assets. Example: Target's 2022 balance sheet gives 21,573/21,747 = 0.99.