practice problems AI flash cards

What is the "market approach" to valuation?

Using comparable firms and/or a valuation multiple (e.g., P/E ratio) to estimate price. Useful for firms that lack fundamental information.

What is the "income approach" to valuation?

Using fundamental analysis to estimate future financial statements, and ultimately, future income/cash flows.

What is the "cost approach" to valuation?

Valuing something based on how much it would cost to create today.

What is a momentum trading strategy?

"The trend is your friend." In other words, recent positive returns will predict future positive returns. This is generally a short-term strategy.

What is a mean reversion trading strategy?

"What goes up must come down (and vice versa)." In other words, on average firms performing very well will struggle in the future, and firms performing poorly will improve in the future. This is generally a longer-term strategy.

How is a momentum trading strategy different from a mean reversion trading strategy?

Momentum: "the trend is your friend," predicting recent positive returns lead to future positive returns, short-term. Mean reversion: "what goes up must come down," expecting strong performers to decline and weak performers to improve, longer-term.

What factors influence the estimation of a cost of equity capital (COEC) for a company?

Risk-free rate, equity-risk premium, beta, and size.

What effect do the factors have on the cost of equity capital (COEC)?

All else equal, (1) a higher risk-free rate results in a higher COEC, (2) a higher equity-risk premium results in a higher COEC, (3) higher beta results in a higher COEC, and (4) larger size results in a higher COEC.

What are value stocks?

Stocks with low P/E or M/B ratios (or a high B/M ratio), priced lower relative to fundamentals, potentially due to risk (e.g., financial distress), low growth expectations, or misvaluation.

What are glamour stocks?

Stocks with high P/E or M/B ratios (or a low B/M ratio), the opposite of value stocks.

What is the difference between "value stocks" and "glamour stocks"?

Value stocks have low P/E or M/B ratios (high B/M), priced low relative to fundamentals. Glamour stocks have high P/E or M/B ratios (low B/M), the opposite.

What should you consider when backtesting and/or validating a trading strategy?

[1] Choosing the right window for testing (not too long to avoid irrelevance, not too short for reliability), [2] Ensuring trades are feasible (traded/available shares, price impact, trading costs), [3] Avoiding survivorship and look-ahead bias, [4] Selecting an appropriate trading window (day-trading or long-term), [5] Measuring success with abnormal returns or control variables for risk, luck, etc.

What is survivorship bias in backtesting?

Dropping companies that leave the sample (e.g., due to delisting) without assuming a delisting return (e.g., 0% or market average).

What is look-ahead bias in backtesting?

Using a trading signal that wasn’t available when the trade was initiated.

Describe Piotroski's general approach to creating a trading signal.

Piotroski took a known strategy (investing in high B/M companies) and used nine financial indicators to score stocks, predicting which high B/M stocks would recover and revert to the mean with improved performance.

Why was Piotroski's trading signal effective?

Deciles with the highest scores performed best, while low scores performed worst (including hedge returns); it was an ideal signal predicting fundamentals and price, backed by theory and extensive backtesting.

What are valuation ratios?

Measures comparing a market valuation with a fundamental measure of value, e.g., P/E, M/B, PEG, P/Sales.

How are valuation ratios calculated?

They contain a market measure (e.g., price) divided by a fundamental accounting measure (e.g., earnings, book value, sales).

What is an implied cost of equity capital?

The cost of capital implied by the market's expectations for future cash flows and the current market price.

How is the implied cost of equity capital calculated?

In a valuation workbook, assume the market shares cash flow forecasts, then find the cost of equity capital that makes the intrinsic value equal the current market price.

What happens to the implied COEC if the market price increases?

All else equal, if the market price increases, the implied COEC goes down (holding cash flow forecasts constant).

What is an earnings response coefficient (ERC)?

The stock price reaction for every cent of surprise at the time of the earnings announcement.

How is an earnings response coefficient (ERC) interpreted?

A positive ERC indicates the market reacts in the same direction as the earnings surprise; a larger ERC means a larger price reaction per cent of EPS surprise.

What is a hedge return?

The return from buying stocks a signal suggests will have the highest return and selling those predicted to have the lowest return.

When should a hedge return be used?

Commonly used to test whether a trading signal/strategy is effective, e.g., Piotroski’s high vs. low B/M scores.

What is an abnormal return?

The return earned compared to a benchmark, such as average market returns or returns for similarly sized stocks.

How is an abnormal return calculated?

Subtract the benchmark return (e.g., market average) from the actual return of a stock/portfolio.

How is an abnormal return different from a raw return?

Raw returns are the actual return; abnormal returns are the excess return compared to a benchmark, showing the value of a trading strategy.

What is post-earnings announcement drift (PEAD)?

The relation where earnings surprise predicts future returns, with returns drifting in the same direction as the surprise for a period (up to 6 months).

How did we test for post-earnings announcement drift (PEAD) in class?

We checked if the earnings surprise on day "0" predicts the price response on day "+1"; in an efficient market, the price should fully react on day "0", but we found drift.

When would researchers use "signed returns" to test a research question?

To show the direction of the market's response, e.g., if the market reacts as expected given the signal, like with the ERC.

When would researchers use "unsigned (absolute value) returns" to test a research question?

To test if the market reacts to the release of information, i.e., if information has "information content."

What does the Sharpe ratio reveal about portfolio performance?

The average return per unit of risk (volatility), or "average risk-adjusted returns," with risk as the standard deviation of returns.

What does the Sortino ratio reveal about portfolio performance?

Similar to Sharpe, but risk is adjusted to remove "upside volatility," focusing only on downside risk by setting returns above the mean to the mean before recalculating standard deviation.

What are some factors investors should consider when identifying a "comparable firm" for valuation?

(1) Industry, (2) size, (3) growth, (4) profitability, (5) risk.

What is a "trailing P/E" valuation?

Uses historical EPS (often trailing 12 months, or TTM) compared to current price in the P/E ratio.

What is a "forward P/E" valuation?

Uses projected EPS (e.g., consensus analyst forecast for the current year) compared to current price in the P/E ratio.

What is the difference between a "trailing P/E" and a "forward P/E" valuation?

Trailing P/E uses historical EPS (e.g., TTM); forward P/E uses projected EPS (e.g., analyst forecasts) compared to current price.

What are the characteristics of an ideal trading signal?

Predicts both an accounting fundamental (e.g., earnings) and market returns, showing a theoretical basis and market inefficiency.

What is a margin of safety?

The difference between estimated intrinsic value and the current market price, indicating investment safety.

How is the margin of safety calculated?

Margin of Safety = 1 - (current stock price / intrinsic value), often expressed as a percentage.

Example of margin of safety calculation

If the current stock price is $40 and the intrinsic value is $50, the margin of safety = 1 - (40/50) = 20%.