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Invesment Analysis

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Stock Valuation

The value of a stock is equal to the stream of cash payments discounted at the rate of return that investors expect to receive on other securities with equivalent risks. Common stocks do not have a fixed maturity; their cash payments consist of an indefinite stream of dividends. This is a condition of market equilibrium. If it did not hold, the share would be overpriced or underpriced, and investors would rush to sell or buy it. The flood of sellers or buyers over time forces the price to adjust so that the fundamental valuation holds.

The ratio EPS is the capitalized value of the earnings per share that the firm generates. A growth stock is one for which earnings growth is large relative to the capitalized value of EPS. Most growth stocks are found in rapidly expanding firms, but expansion alone does not create a high value. What matters is the profitability of the new investments.

The same formulas used to value common shares can also be used to value entire businesses. In that case, you discount not dividends per share but the entire free cash flow generated. Usually a two-stage discounted cash flows model is deployed. Free cash flows are forecasted out to a horizon and discounted to present value. Then a horizon value is forecasted, discounted, and added to the value of the free cash flows. In valuing a business, forecasting reasonable horizon values is particularly difficult. The usual assumption is moderate long-run growth after the horizon, which allows use of the growing-perpetuity formula at the horizon. Horizon values can also be calculated by assuming “normal” price–earnings or market-to-book ratios at the horizon date.

Investment Criteria

Some firms look at the book rate of return on the project. In this case the company decides which cash payments are capital expenditures and picks the appropriate rate to depreciate these expenditures. It then calculates the ratio of book income to the book value of the investment. Few companies nowadays base their investment decision simply on the net present vale (NPV) rate of return, but shareholders pay attention to book measures of firm profitability and some managers therefore look with a jaundiced eye on projects that would damage the company's book rate of return.

Some companies use the payback method to make investment decisions. In other words, they accept only those projects that recover their initial investment within some specified period. Payback is an ad hoc rule. It ignores the timing of cash flows within the payback period, and it ignores subsequent cash flows entirely. However, this takes no account of the opportunity cost of capital.

The internal rate of return (IRR) is defined as the rate of discount at which a project would have zero net present value (NPV). The IRR rule states that companies should accept any investment offering an IRR in excess of the opportunity cost of capital. If capital is limited, then the firm should follow a simple rule: Calculate each project's profitability index, which is the project's net present value per dollar of investment. Then pick the projects with the highest profitability indexes until you run out of capital. Unfortunately, this procedure fails when capital is rationed in more than one period or when there are other constraints on project choice.

Investment Decisions

  1. Discount cash flows, not profits.
  2. Remember that depreciation is not a cash flow (though it may affect tax payments).
  3. Concentrate on cash flows after taxes. Stay alert for differences between tax depreciation and depreciation used in reports to shareholders.
  4. Exclude debt interest or the cost of repaying a loan from the project cash flows. This enables you to separate the investment from the financing decision.
  5. Remember the investment in working capital. As sales increase, the firm may need to make additional investments in working capital, and as the project comes to an end, it will recover those investments.
  6. Beware of allocated overhead charges.
  7. Estimate the project's incremental cash flows.
  8. Include all indirect effects of the project, such as its impact on the sales of the firm's other products.
  9. Dismiss sunk costs.
  10. Include opportunity costs, such as the value of land that you would otherwise sell.
  11. Take inflation into account.
  12. If cash flows are forecasted in nominal terms, use a nominal discount rate.
  13. Discount real cash flows.

Investment Risks

Suppose the project has the same market risk as the company's existing assets. In this case, the project cash flows can be discounted at the company cost of capital. The company cost of capital is the rate of return that investors require on a portfolio of all of the company's outstanding debt and equity. It is usually calculated as an after-tax weighted-average cost of capital, that is, as the weighted average of the after-tax cost of debt and the cost of equity.

Managers, therefore, need to understand why a particular project may have above or below-average risk. You can often identify the characteristics of a project even when the beta cannot be estimated directly. For example, you can figure out how much the project's cash flows are affected by the performance of the entire economy.Diversifiable risks do not affect asset betas or the cost of capital, but the possibility of bad outcomes should be incorporated in the cash-flow forecasts. Also be careful not to offset worries about a project's future performance by adding a fudge factor to the discount rate.

Most projects produce cash flows for several years. Firms generally use the same risk-adjusted rate to discount each of these cash flows. When they do this, they are implicitly assuming that cumulative risk increases at a constant rate as you look further into the future. That assumption is usually reasonable. It is precisely true when the project's future beta will be constant, that is, when risk per period is constant.

Call Options

There are two types of options. An American call is an option to buy an asset at a specified exercise price on or before a specified maturity date. Similarly, an American put is an option to sell the asset at a specified price on or before a specified date. European calls and puts are exactly the same except that they cannot be exercised before the specified maturity date. Calls and puts are the basic building blocks that can be combined to give any pattern of payoffs.

To exercise an option you have to pay the exercise price. Other things being equal, the less you are obliged to pay, the better. Therefore, the value of a call option increases with the ratio of the asset price to the exercise price. You do not have to pay the exercise price until you decide to exercise the option. Therefore, a call option gives you a free loan. The higher the rate of interest and the longer the time to maturity, the more this free loan is worth. So the value of a call option increases with the interest rate and time to maturity.

If the price of the asset falls short of the exercise price, you won't exercise the call option. You will, therefore, lose your investment in the option no matter how far the asset depreciates below the exercise price. On the other hand, the more the price rises above the exercise price, the more profit you will make. Therefore the option holder does not lose from increased volatility if things go wrong, but gains if they go right. The value of an option increases with the variance per period of the stock return multiplied by the number of periods to maturity. Always remember that an option written on a risky (high-variance) asset is worth more than an option on a safe asset. It's easy to forget, because in most other financial contexts increases in risk reduce present value.

Investing Basics

Many analytic jobs involve developing views, writing reports, and disseminating them to the public or clients. 'Quants,' on the other hand, work behind the scenes, developing mathematical models to assist analysts in their predictions. Computer programmers and math majors may find a rewarding career in finance. A quant can earn tremendous sums of money, if a talented individual is able to build software or mathematical models that outperform the market on a regular basis. These jobs consist of looking for patterns in data, watching for market trends based on underlying economic or psychological factors, then forecasting market movements.

Along more traditional lines, NASDAQ offers a wealth of securities' investing tutorials, and live streams of data from it's online network of websites, headquartered at Nasdaq.com. At a minimum, browse their stock screener and financial analysis pages. Below, find links directly to Nasdaq pages, offering updated interactive charts, volume trading, summary quotes, and IPO disclosures.

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Liquidity Ratios: Acid Test

Liquidity ratios are used to help assess whether a business has sufficient cash or equivalent current assets to be able to pay its debts as they fall due within the year. A business that finds that it does not have the cash to settle its debts becomes insolvent. The formula for the acid test ratio is Current Assets minus Inventory, divided by Liabilities. The reason is that not all assets can liquidated into cash at fair market value. Notably, raw materials and large inventories of product must first be sold, and then cash collected from debtor accounts.

The Acid Test Ratio, sometimes also called the Quick Ratio, adjusts the Current Ratio to eliminate those current assets that are not already in cash form. An acid test ratio of over 1.0 is good news; the business is well-placed to be able to pay its debts even if it cannot turn inventories into cash. Care has to be taken when interpreting the acid test ratio. The value of inventory that a business needs to hold will vary considerably. For example, you wouldn’t expect a law firm to carry inventory, but a major supermarket carries a large dollar value of inventory at any given time.

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