Investments: Introduction to Equity Analysis
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Questions and Answers

What is the primary purpose of industry analysis?

  • To assess variations in economic performance across different industries (correct)
  • To standardize industry classifications globally
  • To evaluate government policies affecting market structures
  • To ensure all firms within an industry perform equally well
  • Which of the following methods is commonly used to define an industry?

  • Global Standard Industry Codes
  • North American Industry Classification System (NAICS) (correct)
  • Compendia of Economic Indicators
  • World International Trade Codes
  • In the context of business cycles, what does a peak represent?

  • The lowest point of economic decline
  • The midpoint of a sustained economic growth phase
  • The transition from expansion to contraction (correct)
  • The transition from recession to expansion
  • How is the dispersion in stock price performance across industries typically described?

    <p>It can be significantly diverse across different sectors</p> Signup and view all the answers

    What is indicated by a trough in business cycles?

    <p>The lowest point before economic recovery begins</p> Signup and view all the answers

    Which of the following industries is classified as a cyclical industry?

    <p>Durable goods producers</p> Signup and view all the answers

    What does higher operating leverage indicate about a firm's sensitivity to business cycles?

    <p>The firm is more sensitive to business cycles.</p> Signup and view all the answers

    Which factor is NOT one of the three affecting a firm's earnings sensitivity?

    <p>Marketing leverage</p> Signup and view all the answers

    Which of the following examples represents necessities, making them less sensitive to business cycles?

    <p>Groceries</p> Signup and view all the answers

    What is the impact of fixed costs on a firm's degree of operating leverage?

    <p>Higher fixed costs lead to higher DOL.</p> Signup and view all the answers

    If a firm has lower operating leverage, what is likely the impact on its profits during a recession?

    <p>Profits will be more stable.</p> Signup and view all the answers

    What is a characteristic of common stocks?

    <p>Shareholders have the last claim on a firm’s assets.</p> Signup and view all the answers

    Which metrics are used to calculate the Degree of Operating Leverage (DOL)?

    <p>Percentage change in profits and percentage change in sales</p> Signup and view all the answers

    What happens to unpaid dividends on preferred stocks?

    <p>They must be cleared before common stock dividends are paid.</p> Signup and view all the answers

    For firms A and B given their variable costs, how would a recession impact their profitability if both have the same sales volume?

    <p>Firm A will be less affected than Firm B.</p> Signup and view all the answers

    Which of the following statements about preferred stocks is true?

    <p>Preferred stocks have a higher claim than common stocks in liquidation.</p> Signup and view all the answers

    What does the intrinsic value of a stock refer to?

    <p>Expected future cash flows, including dividends.</p> Signup and view all the answers

    What does limited liability mean for shareholders of common stocks?

    <p>Their maximum financial loss is limited to their original investment.</p> Signup and view all the answers

    How are preferred stock payments treated for the issuing firm?

    <p>Payments are treated as dividends and are not tax-deductible.</p> Signup and view all the answers

    Which of the following is NOT a characteristic of common stocks?

    <p>Common stockholders are guaranteed a fixed dividend amount.</p> Signup and view all the answers

    In a liquidation scenario, who is paid first?

    <p>Secured creditors and bondholders</p> Signup and view all the answers

    Which statement correctly describes the relationship between Firm A and Firm B?

    <p>Firm A is less sensitive to business cycles than Firm B.</p> Signup and view all the answers

    What is the main impact of financial leverage on profits?

    <p>It increases profits sensitivity to the business cycle.</p> Signup and view all the answers

    Why might investors not always prefer industries with lower cycle sensitivity?

    <p>Higher sensitivity can mean high-beta stocks which may yield better returns.</p> Signup and view all the answers

    What is the primary goal of sector rotation?

    <p>To prioritize industries likely to perform well in current economic conditions.</p> Signup and view all the answers

    What challenge does sector rotation face in real-world applications?

    <p>The duration and intensity of economic cycles are unpredictable.</p> Signup and view all the answers

    During which stage of the industry life cycle is growth aligned with the general economy?

    <p>Maturity phase.</p> Signup and view all the answers

    What is a potential disadvantage of investing in high-growth industries?

    <p>Competition may erode potential profits.</p> Signup and view all the answers

    What occurs in the relative decline stage of an industry life cycle?

    <p>Growth slows down or contracts relative to the economy.</p> Signup and view all the answers

    Study Notes

    Course Information

    • Course code: MN-2066
    • Course title: Investments: Assets; Equities and Bonds
    • Lecture topic: Introduction to Equity and Industry Analysis
    • Lecturer: Rongxin Chen
    • Email: [email protected]

    Equity Securities

    • Common Stocks
    • Preferred Stocks
    • American Depositary Receipts (ADRs)

    Common Stocks

    • Represent partial ownership of a company
    • Each share typically gives the shareholder one vote
    • Holders may or may not receive dividends, depending on company profits

    Characteristics of Common Stocks

    • Residual claim: Stockholders have the last claim on a firm's assets and income. In liquidation, others (creditors, employees, authorities, suppliers, and bondholders) are paid before stockholders. In non-liquidation, shareholders claim after interest and taxes.
    • Limited liability: Maximum loss for shareholders is their original investment. Worst case is a worthless stock. Stockholders are not personally liable for firm obligations. General partners may risk personal assets (house, car, etc.).

    Quick Tests

    • Question 1: If you buy 100 shares of IBM stock, to what are you entitled?
    • Question 2: What is the most money you can make on this investment over the next year?
    • Question 3: If you pay $115 per share, what is the most money you could lose over the year?

    Preferred Stocks

    • Characteristics:
      • Promise to pay a fixed amount of income each year.
      • Not obligated to pay every year; dividends owed accumulate.
      • Have priority over common stocks.
      • Unpaid dividends accumulate and must be cleared before common stock dividends
      • In liquidation: Preferred stockholders have priority over common stockholders, but below debt holders.
      • No voting power in firm management
      • Payments are dividends, not interest; not deductible for the issuing firm. Note: firms may exclude a percentage of dividends from taxable income. Suitable as fixed income investments.

    Valuation of Stocks

    • Intrinsic value: Expected future cash flows (e.g., dividends).
    • Top-down analysis:
      • Global Economy
      • Domestic Macroeconomy
      • Demand and Supply Shocks
      • Federal Government Policy
      • Business Cycles
      • Industry Analysis

    Industry Analysis

    • Why important?
      • Firms in troubled industries might perform well.
      • Economic performance varies widely across industries.
    • Considerable dispersion in stock prices across different industries (e.g. +42% in retail; -34% in coal)
    • Defining an Industry: Determining industry boundaries is complex.
    • Common methods:
      • North American Industry Classification System (NAICS) codes (replace SIC codes)
      • Standard & Poor
      • Value Line Investment Survey

    Business Cycles

    • Definition: The recurring pattern of economic recession and recovery.
    • Transition points (peaks and troughs)
      • Peaks: Transition from an expansion to a contraction
      • Troughs: Point at the bottom of a recession where recovery begins

    Cyclical vs. Defensive Industries

    • Cyclical Industries: Above-average sensitivity to the economy's state
      • Examples: Durable goods producers (e.g., automobiles), capital goods
    • Defensive Industries: Little sensitivity to the business cycle
      • Examples: Food producers and processors, pharmaceutical firms, and public utilities

    Sensitivity to Business Cycles

    • Three factors affecting firm earnings sensitivity:
      • Sensitivity of Sales
      • Operating Leverage
      • Financial Leverage

    Sensitivity of Sales

    • Necessities vs. Non-essentials
      • Necessities: less sensitive (e.g. food, drugs, medical services).
      • Non-essentials: more sensitive (e.g. machine tools, steel, autos, transportation)

    Operating Leverage

    • Definition: Ratio of fixed to variable costs
      • Fixed Costs: Incurred regardless of production levels.
      • Variable Costs: Vary based on production volume.
    • Higher operating leverage: More sensitive to business cycles
    • Lower operating leverage: Less sensitive to business cycles

    Degree of Operating Leverage (DOL)

    • Measure of how profits react to sales changes
    • Formula(s):
      • DOL = (Percentage change in profits) / (Percentage change in sales)
      • DOL = 1 + (Fixed costs / Profits)

    Example

    • Comparing two firms (A & B) in the same industry.
    • Similarities: Identical sales, prices per unit, consistent across business cycle phases.
    • Differences: Fixed and variable costs per output unit

    Example: DOL Calculations

    • Using examples with data for the two firms (A and B) during Recession, Normal, and Expansion phases of the business cycle.
    • DOLs during different economic periods

    Financial Leverage

    • Definition: Employing borrowed funds through debt
    • Interest on debt: Obligatory, independent of sales
    • As a fixed cost: Interest increases profits sensitivity to the business cycle.

    Sensitivity to Business Cycles

    • Investor preferences for industries
    • High-beta stock riskier (firms in sensitive industries)
    • Expected return versus risk

    Sector Rotation

    • Definition: A strategy where analysts adjust portfolios based on the business cycle
    • Goal: Prioritize industries or sectors poised to outperform others
    • Decisions are grounded in one's evaluation of the business cycle's current phase.
    • Challenges: Duration and intensity of each cycle phase are unpredictable; success hinges on accurate anticipation of the next stage.

    Industry Life Cycles

    • Four stages:
      • Start-up: Extremely rapid growth
      • Consolidation: faster than general economy, but slowing
      • Maturity: Growth aligned with the general economy
      • Relative Decline: Growth slower than, or even contracting to the general economy.
    • When investments are most appealing: Consideration of high-growth industries versus the reflection of anticipated growth and competition already factored into the prices.

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    Description

    This quiz covers the basics of equity securities, including common stocks, preferred stocks, and American Depositary Receipts (ADRs). It explores the characteristics of common stocks such as residual claims and limited liability. Test your understanding of how equity functions within investments.

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