FSA Exam 1

What is public float?

The number of company’s shares that are available for the public to buy and sell on the stock market.

Public float = total shares outstanding – restricted shares held by insiders

What is the MD&A?

Management’s Discussion and Analysis. Management explains the company’s financial results, business performance, and future outlook.

What does it mean that markets are efficient?

Market prices immediately adjust to all available and relevant information

What are the assumptions behind the efficient market theory and the role of the “Superinvestor”? What “powers” does the Superinvestor have? Who are “noise traders”? How do they affect the market?

Efficient Market Theory assumptions:

• Rational investors exploit arbitrage opportunities

• These investors gain more resources/influence as they succeed

• Market prices adjust quickly to new information

Superinvestors

• Know true value of securities

• Have unlimited resources/time to influence market

Noice Traders

• Act irrationally or on incomplete information

• Can create short-term mispricing but are ultimately outperformed

What is fundamental analysis? What is technical analysis (see P2-4)? How effective is either one of these strategies (fundamental or technical analysis) if markets are efficient?

Fundamental analysis: Estimates a security’s intrinsic value by examining firm financials and industry/economic conditions.

Technical analysis: Uses patterns in past price/volume data to predict future movements.

If markets are efficient, both strategies are less effective, as prices already reflect all known information.

What are the three sources of value for an investment (see P1-3)? What have we learned so far about analyzing profitability, growth/size, and risk?

Profitability – assessed using ROE, margins, etc.

Growth/Size – impacts scale advantages and opportunity.

Risk – affects required return and valuation.

Know how to value a bond and the general formula for valuing any financial asset (including time value of money techniques).

Value = Present value of future expected cash flows

Use discounting techniques (PV of lump sum or annuity)

Know the valuation formula (discounted cash flows – see P1-3). What are the differences and similarities between valuing a bond and valuing a stock?

Both use DCF:

Bond: fixed payments + lump sum

Stock: dividends + future sale price (variable and uncertain)

Know that we can earn high returns by 1) the success of the underlying business (e.g., EPS) and/or 2) an increase in the underlying “multiple” that the market is willing to pay for the business (e.g., buying at a low P/E ratio and selling at a high P/E ratio). See P1-4.

Returns = EPS growth + multiple expansion (P/E)

What is a random walk? How does it relate to our problem examining the correlation of daily stock returns (P2-3)?

A “random walk” means past price changes do not predict future price changes.

Consistent with weak-form market efficiency.

Know how to interpret the basic output from a regression (independent variable, dependent variable, intercept, predicted value, coefficients on the independent variables, t-statistics, p-values, and R-squared).

Independent variable (X): input/predictor

Dependent variable (Y): outcome

Coefficient: expected change in Y per unit of X

T-stat: statistical significance

P-value: probability result is due to chance (low = significant)

R-squared: % of variation in Y explained by X

What are the sources of information about companies? What information do companies provide? What is the difference between recognition and disclosure? What is in 10-Ks, 10-Qs, and 8-Ks? Where can you find these filings? What is EDGAR?

10-K (Annual Report): Provides a comprehensive overview of the company’s financial condition, including audited financial statements, Management’s Discussion and Analysis (MD&A), risk factors, and footnotes.

10-Q (Quarterly Report): Similar to a 10-K but filed quarterly. It contains unaudited financial statements and a less detailed MD&A.

8-K (Current Report): Filed to announce major events that shareholders should know about, such as earnings announcements, leadership changes, mergers/acquisitions, or legal proceedings.

Press Releases: Timely, high-level summaries of key events or financial results (often prior to the full filing).

Conference Calls: Audio/webcast presentations by executives (usually the CEO and CFO) discussing quarterly or annual results, often followed by Q&A with analysts.

MD&A (Management’s Discussion and Analysis): Included in both 10-Ks and 10-Qs. Management provides narrative explanations of financial results, trends, risks, and forward-looking insights.

What makes each report different?

10-K is annual, audited, and the most comprehensive.

10-Q is quarterly, unaudited, and less detailed.

8-K is event-driven and filed as needed, not on a regular schedule.

Recognition vs. Disclosure:

Recognition: When an item is formally recorded in the financial statements (e.g., revenue, liabilities).

Disclosure: Supplementary information provided in footnotes or MD&A to give context to recognized items or explain non-recognized risks/events.

Where to find filings:

All public company filings can be found on the SEC’s EDGAR database:

What is an “earnings announcement”? What is a “conference call”? What are “management forecasts”? What is Reg FD?

Earnings announcement: Press release with key financial info

Conference call: CEO/CFO discuss performance and outlook with Q&A

Management forecasts: Forward-looking statements (e.g., CAPEX)

Reg FD: Ensures equal access to material information

Who are financial analysts? What is the difference between buy-side and sell-side analysts? Are sell-side analysts potentially biased? What are their incentives?

Buy-side: work for firms investing money (e.g., mutual funds)

Sell-side: work for brokerages, issue public reports

Bias: Yes—sell-side may face conflicts due to business relationships

What are the outputs of financial analysts? What items do they forecast? What are analyst recommendations, target prices, and earnings/revenue estimates? How does the market respond to earnings announcements and earnings surprises (think about expectations)? What is generally contained in an analyst report (see P2-1)? Understand how an analyst gets to a target price by multiplying a “multiple” (e.g., 26X, which is a forward P/E ratio) by the expected earnings (i.e., they use a market approach).

Analysts produce forecasts for:

- Earnings, revenues, cash flows, growth rates

- Stock recommendations (Buy, Hold, Sell)

- Target prices (future price expectations)

Analyst reports typically include:

- Company overview, valuation metrics, earnings model, strategic risks

Target price = Expected EPS × Valuation multiple (e.g., forward P/E)

The market reacts to earnings surprises (actual EPS vs expected EPS), not just raw results

You should be able to basically understand the information that we have talked about on a company’s “Summary” page and “Statistics” page on Yahoo Finance including: price information, market cap, dividend payout ratios, trailing P/E.

Price info: current price, day range, 52-week range

Market cap: share price × shares outstanding

Dividend payout ratio: dividends / net income

Trailing P/E: price-to-earnings ratio using past 12 months earnings

You should be able to understand the information given in a company’s “Analysis” page from Yahoo Finance.

Shows analyst estimates for EPS, revenue, long-term growth

Includes low/high/average forecast ranges

PEG ratio: P/E ÷ growth — helps identify value investments

What kind of information is contained in an industry report?

Market share and competitive positioning

Industry trends and forecasts

Key success factors

Regulatory environment

Financial benchmarks (margins, ROA, etc.)

What does a P/E ratio tell investors? Know how to calculate and interpret a P/E ratio. What is a “ttm” P/E ratio?

P/E = Price per share / Earnings per share

Measures how much investors are willing to pay for each $1 of earnings

ttm = trailing twelve months (uses past data) 

Know how to calculate market returns as a %: (current price – past price) / past price

(new – old)/old

What is a durable competitive advantage? Why do we want that as an investor? What gives Coke or Microsoft a durable competitive advantage? What gives successful firms the ability to sustain high returns (ROA and ROE)? How can we tell from past performance whether a company has a durable competitive advantage?

A durable competitive advantage enables a company to earn high returns over time.

Sources include:

• Brand recognition (e.g., Coke)

• Network effects (e.g., Microsoft)

• Customer loyalty, economies of scale, pricing power, high switching costs

Sustained high ROA and ROE over time indicate durability.

How would you analyze a company’s strategy and/or its competitive environment? Where would you go to get this information?

Read 10-K “Business” section and MD&A

Use Porter’s Five Forces, industry reports, and ratio trends

Compare margins, turnover, and leverage to peers

Know how to calculate ROA and ROE. How do we interpret these ratios? What do they tell investors?

ROA = Net Income / Total Assets

• Profit per dollar of assets

ROE = Net Income / Equity

• Profitability for common shareholders

Higher ratios = stronger performance, but context (industry, strategy) matters

What is “mean reversion” in general? Why does ROE tend to revert to the mean (for both low and high ROEs)? Why is the mean reversion of ROE incomplete after 5 years? Why should investors care about mean reversion? See P3-5.

Mean reversion: Performance tends to return to historical averages over time

ROE reverts due to competitive forces, changes in economic conditions, and temporary advantages

After 5 years, reversion is incomplete, which means temporary differences can persist

Investors should factor this into forecasts (don’t expect extremes to last forever)

Understand the basic strategic tradeoff between profit margins and asset turnover. For example, what is the difference in strategy between Walmart and Target? How can we see that difference in those companies’ financial ratios?

Tradeoff: High margins often come with low asset turnover, and vice versa

Walmart: low margin, high turnover (low-cost leader)

Target: higher margin, lower turnover (differentiation strategy)

Know how to perform a basic ROE analysis. Be able to decompose ROE into its three multiplicative components: net profit margin, asset turnover, and leverage. Be able to explain the meaning of each of these ratios. Know also that ROE = ROA * Leverage and that ROA can be decomposed into net profit margin and asset turnover. P3-2 is a good problem to review.

ROE = Net Profit Margin × Asset Turnover × Leverage

Net Profit Margin = Net Income / Sales

Asset Turnover = Sales / Assets

Leverage = Assets / Equity

Know how to perform an advanced ROE analysis. Know how to separate net income available to common shareholders into 1) net operating profit after-tax (NOPAT) and 2) net non-operating expense (NNE). Know how to separate common equity or book value into 1) net operating assets (NOA) and 2) net non-operating obligations (NNO). Be able to calculate RNOA and understand its decomposition into net operating profit margin and net operating asset turnover. Be able to calculate a firm’s financial leverage ratio (NNO/common equity), the net borrowing cost (NNE/NNO) and the “spread” for a given company. Know how to discuss all decompositions in terms of company strategy. P3-3 is a very good problem to review.

RNOA = NOPAT / NOA

• NOPM = NOPAT / Sales

• NOAT = Sales / NOA

Financial Leverage = NNO / Equity

Net Borrowing Cost (NBC) = NNE / NNO

Spread = RNOA – NBC

• Positive spread = financing adds value

Have a good intuitive feel for the advanced ROE analysis model. Understand how it divides ROE into an operations component and a financing component. Understand intuitively what RNOA, financial leverage, and the spread mean.

ROE = RNOA + (Spread × Financial Leverage)

Operations: how well assets are used to generate profit

Financing: whether debt usage improves or hurts returns

What is the main advantage of the advanced ROE analysis versus the basic ROE analysis?

Separates operating performance from financing

Helps better assess strategy and sustainability

Be familiar with the WMT vs. TGT comparison in P3-4.

Walmart: Low margins, high turnover, low leverage

Target: Higher margins, lower turnover, higher leverage

Shows how strategies reflect in ROE components

What is the limitation of just considering profitability, without also considering growth/size?

Profitability alone ignores whether the company can scale

A small, profitable firm may not create much value without growth

Sustainable value = Profitability × Growth Potential – Risk

What are the costs and benefits of being a very large firm? How can growth add value to a firm? Be specific about the possible benefits (we discussed scale, networks, and scope). Can growth destroy value?

Benefits of size:

• Market power, brand recognition

• Economies of scale, scope, and network effects

• Access to cheaper capital

Costs:

• Bureaucracy, slower decision-making

• Regulatory scrutiny

Growth adds value if profitability and risk stay constant.

But growth can destroy value if it lowers returns or increases risk.

Generally, sales growth is accompanied by similar growth in assets, expenses, earnings, and EPS. What does it tell you when earnings are growing faster than sales (see P4-1(d))? What does it tell you when EPS is growing faster than earnings (see P4-1(e))? Are stock repurchases always a good idea by management? When do stock repurchases increase value for the remaining shareholders?

Earnings > Sales growth: implies improved margins or cost control

EPS > Earnings growth: likely due to stock repurchases

Repurchases create value only if the stock is undervalued or they enhance per-share metrics without hurting long-term performance

Know how to calculate the “sustainable growth rate” given a firm’s ROE and dividend payout ratio. What does this rate tell an investor? What is the value in comparing the sustainable growth rate to analyst estimates of long-term growth? See P4-1.

SGR = ROE × (1 – Dividend Payout Ratio)

Tells us how fast a firm can grow without new equity

Comparing SGR to analyst forecasts reveals if growth is realistic or will require new capital

What are common size financial statements? Why are they useful? Note that changes in margins is just comparing the growth in expenses vs. the growth in sales. Note that changes in turnovers is just comparing the growth in assets or liabilities vs. the growth in sales. Common size income statement: items as % of sales

Common size income statement: items as % of sales

Common size balance sheet: items as % of total assets

Useful for comparison across time or peers

Helps highlight changes in cost structure and asset efficiency

What does margin analysis tell investors (gross margin, operating margin, net profit margin)? Why is gross margin of interest to investors? Why would an investor want to use the operating margin vs. the net profit margin?

Gross margin: pricing strategy and cost of goods control

Operating margin: how well the company controls operating expenses

Net margin: bottom-line profitability after all costs

Gross margin is key in retail/inventory-heavy firms

Operating margin focuses on core operations (vs. taxes, interest)

What are “economies of scale”? Know how to identify economies of scale using ratios such as COGS/Sales and SG&A/Sales (see P4-2).

Cost advantages from increased production

Ratios like COGS/Sales and SG&A/Sales fall as sales grow, signaling scale benefits

What do turnover ratios in general tell investors? Why should net operating assets generally grow at the same level as sales? What is the implication if net operating assets are growing faster than sales? You should be able to calculate and interpret the total asset turnover (from the basic ROE analysis), NOA turnover (from the advanced ROE analysis), A/R turnover (including average days to collect receivables), inventory turnover (including average days to sell inventory), and PP&E turnover.

Turnover = sales efficiency

NOA growth > sales = possible inefficiency or upcoming revenue boost

Key ratios:

Total Asset Turnover = Sales / Total Assets

NOA Turnover = Sales / Net Operating Assets

A/R Turnover = Sales / Accounts Receivable

Days to collect = 365 / A/R Turnover

Inventory Turnover = COGS / Inventory

Days to sell = 365 / Inventory Turnover

PP&E Turnover = Sales / PP&E

What happens when a firm tries to increase its leverage ratio (see P4-4)? What are the benefits? What is the downside to increased leverage?

Benefits:

• Amplifies returns (if RNOA > NBC)

• Enables growth without issuing equity

Downsides:

• Higher risk of default

• More volatile earnings

• Restrictive debt covenants

What is credit risk? How does high credit risk affect the value of a company’s common stock? How do we evaluate a company’s credit risk?

Credit risk = risk of declining solvency or default

High credit risk increases the firm’s cost of capital and depresses stock value

Evaluate using:

- Leverage ratios, interest coverage, credit ratings

What are credit ratings? Where do these come from?

Issued by agencies (e.g., S&P, Moody’s, Fitch)

Reflect a company’s default risk

Available through sources like S&P NetAdvantage

Know the leverage ratios from the basic and advanced ROE analysis models. Also know the interest coverage ratio. Have some intuition for what these ratios tell investors about credit risk.

Basic leverage = Assets / Equity

Advanced leverage = Net Non-operating Obligations / Equity

Interest Coverage = EBIT / Interest Expense

Lower coverage signals higher risk

Higher leverage + lower coverage = higher credit risk