Teach Your Self Finance And Investment Basics

accounts payable The amount owed to suppliers for goods and services

purchased on credit; payment obligations usually range between

30 and 90 days.

accounts receivable The amount due from customers for goods and

service sold on credit; discounts are often given for timely payment

(e.g., within 10 days).

alpha The rate of return on an investment in excess of the expected

rate of return as forecast by a pricing model (e.g., CAPM).

after-tax cost of debt The tax-adjusted cost of debt; the nominal interest

rate adjusted for tax benefits of interest payments. The

equation is (1 _ tax rate) * (nominal interest rate).

arbitrage pricing model (APM) An asset pricing model that predicts

expected returns on a security on the basis of a correlation between

the security and multiple input variables.

average-risk stock A stock with a beta equal to 1; an issue that moves

with the market.

bear market A long-term downward trend in security prices. Recently,

this has been defined as a decline of 20 percent or more

over an extended time period. The worst bear market in the last

50 years occurred between 2000 and 2002.

beta The measure of systematic risk of a security. The beta of the market

is defined as 1. If a security’s beta is greater than 1, it is expected

to exceed market changes (e.g., when the market increases

by 5 percent, the security increases by 10 percent). If a

security’s beta is less than 1, it is expected to lag behind market

changes (e.g., when the market increases by 10 percent, the security

increases by 5 percent).

bonds A security issued by a borrower that establishes a contractual

obligation to repay a specified amount at a future date, usually

with periodic interest payment.

book value The accounting value of a corporate security.

book value per share (BVPS) Common stockholder equity divided by

the number of shares outstanding. This is an estimate of the equity

stake in an organization that each share represents.

bottom-line growth A company’s growth in net income.

bull market An extended period of increasing security prices.

capital asset pricing model (CAPM) An asset pricing model that determines

the required rate of return on securities on the basis of

a market risk premium and a risk-free rate.

cash flow An exchange of cash, either inflow or outflow, as a result

of a transaction.

cash inflow The net cash amount flowing into a firm (e.g., revenues)

as a result of the ongoing operations of a business.

cash outflow The net cash amount flowing out of a firm (e.g., expenses)

from the ongoing operations of a business.

clientele effect The tendency of investors to purchase stock of a company

based on its dividend policy. Investors who desire predictable

current income buy stocks with higher dividends (e.g.,

ConEd), while those who desire growth buy stocks that pay little

or no dividends (e.g., Intel).

common stock Equity ownership in a corporation. Two important

characteristics of common stock are that its owners have a residual

claim on corporate assets (behind bondholders and preferred

stockholders) and are subject to limited liability.

common stock equivalents Common stock plus securities convertible

into common stock of a company.

compound The process of accumulating the time value of money

over time. For example, compounding interest payments means

that an investor who earns interest in one period will earn additional

interest in the following period because of the reinvestment

of interest in each period.

compound annual growth rate (CAGR) A rate that assumes annual

compounding of growth.

contingent claim A claim whose value is based on the value of another

asset or the outcome of a specific event.

corporate value The estimated total dollar value of an enterprise, usually

determined by models and appraisals.

current stock price The most recent price level at which an equity investment

traded, as determined by the financial market where

that security trades.

cyclical stocks Companies or industries whose financial performance

(revenues and earnings) is tied to business cycle fluctuations. The

automotive, steel, and cement industries are examples.

debt/equity ratio The total amount of debt financing that the firm has

in its capital structure, divided by the dollar amount invested by

shareholders.

defensive stocks Stocks that provide necessary services, such as electric

utilities and gas; essentials, such as food; or staples, such as

soft drinks. Because of the nature of these products, the stocks

provide a degree of stability during periods of economic decline.

depreciation The periodic allocation of the cost of property, plant,

and equipment over the useful revenue-generating life of the asset.

Depreciation is a noncash expense and is not a cash outflow.

depreciation rate Annual depreciation divided by annual revenues.

diluted earnings per share Earnings per share adjusted for all potential

equity claims on earnings. Diluted EPS is lower than basic

EPS because it accounts for potential dilutive common shares

from complex securities like convertible bonds and stock options.

discount The process of calculating the present value of expected

cash flows. To discount means to multiply a number by less than

1.0.

discount factor The multiplier used to convert an expected future

cash flow into current dollars.

discount rate The rate of return used to measure the time value of

money. The discount rate varies with risk of the cash flows being

discounted.

discounted cash flow approach A valuation model based on the present

value of expected cash flows.

dividend A payment of cash or stock by the company to its stockholders.

diversification Spreading investment holdings across multiple industries,

strategies, or firms to reduce the company-specific risk

associated with an investment portfolio.

Dow Jones Industrial Average (DJIA) A price-weighted equity index of

30 blue-chip New York Stock exchange companies.

earnings Net income.

earnings before interest and taxes (EBIT) Income generated by the

company before the payment of interest on debt and income

taxes.

earnings before interest but after taxes (EBIAT) Same as EBIT minus

the payment of income taxes.

earnings per share (EPS) Corporate earnings divided by shares outstanding.

efficient capital market A market in which information asymmetries

do not provide profit opportunities, and new information is

quickly interpreted and reflected in the value of shares.

excess marketable securities Marketable securities held by the firm for

investment purposes. Marketable securities do not include treasury

stock of the issuing firm.

excess return period The number of years that a company is expected

to earn a return on incremental investment in excess of its

weighted average cost of capital.

expected return The return an investor expects to earn at a specific

level of risk.

expected return of the market (Rm) The expected return on a market

benchmark index (e.g., S&P 500) for a specific period. Historic

data are often used to estimate this variable.

fairly valued stock A stock’s price that is equal to its intrinsic stock

value.

Financial Accounting Standards Board (FASB) The primary rulemaking

body that establishes, interprets, and publishes financial

accounting principles for public and private firms.

fiscal year (FY) The accounting year consistent with the operating cycle

for which a firm reports its periodic financial statements.

free cash flow (FCF) Equal to cash inflows minus cash outflows.

free cash flow to equity (FCFE) Equal to free cash flow minus interest

expense.

free cash flow to firm (FCFF) The free cash flow available to all shareholders

and stakeholders after capital expenditure obligations

are fulfilled.

fully valued stock A stock with a price that is generally considered to

be at the high end of its intrinsic value. High-growth firms eventually

become fully valued when all future growth expectations

and opportunities are priced into the shares and there is a limited

additional upside.

fundamental analysis Security analysis that incorporates all available

public information relating to a particular company,

including historic prices, industry data, and overall market

performance.

greater fool theory A theory based on the belief that anyone who

makes an investment will be able to sell it to a less informed investor

for a profit in the future.

growth stocks Stocks of companies in expanding industries where the

growth in earnings on revenues is expected to be significantly

greater (e.g., 15 percent or more)

hedge fund A hedge fund is a sophisticated investment partnership

that borrows money, purchases financial assets, and simultaneously

hedges the risks associated with owning the assets by selling

offsetting hedge liabilities.

incremental working capital expenditure The change in working

capital from period to period.

initial public offering (IPO) The first publicly traded issue of a corporation’s

common stock.

intrinsic stock value The firm’s raw material, work in process, and

finished goods surplus that has not been used or sold in the normal

operating process.

investment rate Investment in property, plant, and equipment, divided

by annual revenues.

leverage The use of debt financing in a firm’s capital structure.

leveraged buyout (LBO) The purchase that is financed with a large

percentage of debt and is secured by the firm’s assets.

long Treasury rate The yield on long-term U.S. Treasury securities—

typically the benchmark 10-year Treasury Bond.

market capitalization The total market value of the outstanding debt

and equity of a firm.

market risk premium The difference between the expected return on

the market portfolio (usually the historic return on the S&P 500)

and the risk-free rate of return.

merger A combination of two firms in which one firm absorbs the assets

and liabilities of the other firm in their entirety.

momentum trading strategy A technical trading technique that involves

buying a stock because the trend in a stock’s price has

been up, and selling a stock because its stock price trend has

been down.

net change in working capital The difference in working capital from

one period to another.

net investment New investment minus depreciation.

net operating income (NOI) Earnings from continuing operations before

paying interest on debt or income taxes.

net operating profit (NOP) See net operating income.

net operating profit after taxes (NOPAT) Operating income before interest

payments on debt and income taxes. Used to calculate

cash flows to the firm, the measurement seeks to exclude the tax

benefits of debt financing in the profit measurement.

net operating profit margin (NOPM) Net operating profit per dollar

of sales (NOP divided by revenues).

net present value (NPV) The present value of future cash flows, minus

the initial cost of the venture or project.

operating income Income from continuing operations before paying

income tax and interest expense.

overvalued stock A stock whose price is greater than its intrinsic value.

par value The nominal dollar amount assigned to a security by the

issuing firm. Par value for stock is generally 1 cent or $1 and has

nothing to do with the ultimate market price or book value of the

issue. Par value for bonds is generally $1000.

period of competitive advantage See excess return period.

pretax cost of debt The nominal rate of interest on a debt issue; the

figure does not incorporate the tax benefits of debt interest expense.

preferred stock An ownership claim on corporate assets senior to that

of common stock but junior to debt. It is technically an equity

security, but has features similar to both debt and equity. Preferred

stock pays shareholders a periodic dividend payment.

However, unlike bond payments, preferred dividend payments

are not legally binding, and the board of directors can withhold

dividends during the hard times.

premium The amount by which a security sells above its par value.

present value (PV) The value of future payments discounted to today’s

value to incorporate risk and the time value of money.

price/book value (P/BV) ratio The market price per share of stock, divided

by the book value per share.

price/cash flow (P/CF) ratio The market price of stock per share, divided

by the cash flow per share. Cash flow per share is roughly

estimated by using earnings before interest, taxes, depreciation,

and amortization on a per-share basis.

price/earnings (P/E) ratio The relationship between earnings per

share and the market price of common stock. Generally speaking,

a high P/E multiple relative to other companies in the same

industry implies that investors have confidence in a company’s

ability to generate higher future profits.

price/earnings/growth (PEG) ratio The P/E ratio divided by the projected

earnings growth rate. It measures the price that one pays

for expected future growth. This measurement was popularized

by the Motley Fool.

price/sales (P/S) ratio The market value of a firm divided by its annual

revenues. Companies with high profit margins usually have

higher P/S ratios.

price volatility The relative rate at which the price of a security moves

up or down, as determined by the annualized standard deviation

of daily changes in price.

pro forma Projections of what a company’s financial performance

will be in the future.

random walk hypothesis The theory that investment price movements

do not follow any pattern or trend over time, and that past

price movements have no impact on future price movements.

relative value approach Valuing a firm relative to other firms in the

industry on the basis of size, earnings, and similar characteris-

tics. Common relative value measurements include market/

book, price/earnings, price/cash flow, and price/sales.

residual value The terminal value of a company beyond the excess return

period. Calculated by dividing NOPAT by WACC.

return to stockholder A shareholder-realized return in the form of

capital appreciation and dividends over the holding period.

revenues Net sales generated by firm operations.

revenue growth rate An annualized growth rate of sales over a specified

time period, usually 5–10 years.

risk Unanticipated change in investment returns over an extended

period of time, as measured by the volatility of returns.

risk-free rate of return (Rf) The rate of return on the 30-year U.S. Treasury

bond.

secondary market The markets in which securities are traded after

their initial issuance. The NYSE, AMEX, and NASDAQ are secondary

markets.

senior claims The highest level of financial claims issued by a company.

The level of seniority is used to determine claims on assets

upon liquidation. Senior debt claims are paid prior to any payments

of junior claims. Debt and preferred stock have claims that

are senior to common stock.

share repurchase program A program under which a firm purchases

shares of its own stock via the secondary market.

shares outstanding The total number of shares issued by a firm that

has not been retired or repurchased.

short sale Borrowing a security from a broker and selling it at the current

market price, with the understanding that it must later be

bought back (hopefully at a lower price) and returned to the lending

agent.

short squeeze A situation where a rise in stock prices forces investors

who sold stock short to purchase shares to cover their short position

and cut their losses. As the price of the shares continues

to rise, more short sellers feel compelled to cover their positions.

spread to Treasuries The difference between security yields and the

yield on 30-year Treasury Bonds. High yield, emerging debt, corporate

debt, and dividend yield are often measured as a spread

to Treasury bonds.

standard deviation A statistical measurement equal to the square

root of the variance; a measurement of dispersion of a data sample

around the average. A security with a high standard deviation

of returns is risky because of the large range of potential returns

that the investor can expect.

Standard & Poor’s 500 A market value weighted index of 500 stocks

that represents more than $8 trillion in market capitalization in

the U.S. equity markets.

systematic risk Risk that cannot be diversified away by holding a portfolio

of securities. Measured by a stock’s beta.

takeover The act of acquiring control of an organization through a

cash or stock bid.

tax rate The ratio equal to the corporation’s provision for income

taxes divided by income before taxes.

technical analysis Analysis of market data (stock prices, volume, correlations,

etc.) in an attempt to predict future price movements

of a security on the basis of historic market trends. Technical

analysis includes chart analysis, moving averages, support and

resistance measurement, and numerous other measures of historic

relationships.

top-line growth Revenue growth of a company.

undervalued stock A stock whose market price is below its intrinsic

value.

unsystematic risk Any risk attached to a security that can be diversified

away by holding a portfolio of securities.

value to common equity Equal to total corporate value minus senior

claims. The current market value of all common stock.

ValuePro 2002 Easy-to-use stock valuation software that applies the

discounted cash flow approach.

volatility The relative rate at which the price of a security or index

moves up or down, as determined by the annualized standard

deviation of daily change in price.

weighted average cost of capital (WACC) The weighted average cost

of financing for a firm.

working capital Accounts receivable, plus the inventories minus accounts

payable. Working capital is required to support the revenue-

generating activities of a firm.

yield The annual percentage rate earned on a particular security of

investment asset.