Cost Of Capital
The required return necessary to make a capital budgeting project, such as building a new factory, worthwhile. Cost of capital includes the cost of debt and the cost of equity.
Deferred tax assets
Deferred tax assets represent taxes that have been paid (or often the carryforward of losses) but which have not yet flowed through the income statement. A deferred tax liability represents tax payments that have appeared on the income statement but not yet been paid. They usually arise when accounting standards and tax authorities recognize the timing of taxes due at different times. For example, when a company uses accelerated depreciation when reporting to the tax authority (to increase expense and lower tax payments in the early years) but uses the straight-line method on the financial statements. Since these differences will correct over the course of the asset’s depreciable life, they are called “temporary differences.
Under IAS 12 and US GAAP (SFAS 109), deferred taxes are accounted for under the liability method. Under this method, deferred tax assets and liabilities are recognized when there is a temporary difference between the stated value of an asset or liability for tax purposes and the value for financial reporting purposes. The deferred tax is also contingent upon the expectation that future revenue and income will be sufficient to offset the deferred tax.
To determine the deferred tax treatment under various circumstances:
- An asset whose carrying value exceeds its tax basis will result in a deferred tax liability.
- An asset whose carrying value is less than its tax basis will result in a deferred tax asset.
- A liability whose carrying value exceeds its tax basis will result in a deferred tax asset.
- A liability whose carrying value is less than its tax basis will result in a deferred tax liability.
Cash Flow Return on Investment (CFROI)
Cash Flow Return on Investment (CFROI) is an internal rate of return (IRR) type metric measuring the return expected to be generated by a firm’s existing assets throughout their useful lives. CFROI can be calculated in five steps:
- compute the average life of assets by dividing gross assets by depreciation expense
- compute gross cash flow by adjusting net income for non-cash charges, financing expenses, operating lease payments and equity reserve accounts
- compute the gross investment as gross plant and equipment adjusted for reserves, capitalized expenses, restructuring charges, amortization and the present value of operating leases
- compute the value of any assets that will not depreciate (which will represent the future value)
- solve for IRR (or CFROI)
Dividend Discount Model - DDM
A procedure for valuing the price of a stock by using predicted dividends and discounting them back to present value. The idea is that if the value obtained from the DDM is higher than what the shares are currently trading at, then the stock is undervalued.
explains 'Dividend Discount Model - DDM'
This procedure has many variations, and it doesn't work for companies that don't pay out dividends. For example one variation is the supernormal dividend growth model which takes into account a period of high growth followed by a lower, constant growth period. The principal behind the model is the net present value of the cash flows. To get a growth number, one option is to take the return on equity (ROE) and multiply it by the retention ratio (which is 1-the payout ratio).
Gordon Growth Model
A model for determining the intrinsic value of a stock, based on a future series of dividends that grow at a constant rate. Given a dividend per share that is payable in one year, and the assumption that the dividend grows at a constant rate in perpetuity, the model solves for the present value of the infinite series of future dividends.
Where:
D = Expected dividend per share one year from now
k = Required rate of return for equity investor
G = Growth rate in dividends (in perpetuity)
explains 'Gordon Growth Model'
The Gordon growth model is a type of dividend discount model used to value companies expected to grow at a constant rate forever. Most valuation models forecast growth for a certain time period before reverting to a Gordon growth model to estimate the ending value.
Because the model simplistically assumes a constant growth rate, it is generally only used for mature companies (or broad market indices) with low to moderate growth rates.
Strengths:
- Especially useful for valuing stable-growth dividend paying companies
- Useful for valuing broad-based equity indices
- Simplicity and clarity
- Helpful in understanding relationships between value, growth, required return and payout ratio
- Useful for estimating expected rate of return
- Output highly sensitive to assumptions for growth rate and required return
- Not practical for valuing non-dividend paying companies
- Not practical for valuing dividend paying stocks with unstable growth characteristics
Total Return
When measuring performance, the actual rate of return of an investment or a pool of investments over a given evaluation period. Total return includes interest, capital gains, dividends and distributions realized over a given period of time.
explains 'Total Return'
Total return accounts for two categories of return: income and capital appreciation. Income includes interest paid by fixed-income investments, distributions or dividends. Capital appreciation represents the change in the market price of an asset
Dividend Yield
A financial ratio that shows how much a company pays out in dividends each year relative to its share price. In the absence of any capital gains, the dividend yield is the return on investment for a stock. Dividend yield is calculated as follows:
explains 'Dividend Yield'
Dividend yield is a way to measure how much cash flow you are getting for each dollar invested in an equity position - in other words, how much "bang for your buck" you are getting from dividends. Investors who require a minimum stream of cash flow from their investment portfolio can secure this cash flow by investing in stocks paying relatively high, stable dividend yields.
To better explain the concept, refer to this dividend yield example: If two companies both pay annual dividends of $1 per share, but ABC company's stock is trading at $20 while XYZ company's stock is trading at $40, then ABC has a dividend yield of 5% while XYZ is only yielding 2.5%. Thus, assuming all other factors are equivalent, an investor looking to supplement his or her income would likely prefer ABC's stock over that of XYZ.
To better explain the concept, refer to this dividend yield example: If two companies both pay annual dividends of $1 per share, but ABC company's stock is trading at $20 while XYZ company's stock is trading at $40, then ABC has a dividend yield of 5% while XYZ is only yielding 2.5%. Thus, assuming all other factors are equivalent, an investor looking to supplement his or her income would likely prefer ABC's stock over that of XYZ.
Deferred Annuity
A type of annuity contract that delays payments of income, installments or a lump sum until the investor elects to receive them. This type of annuity has two main phases, the savings phase in which you invest money into the account, and the income phase in which the plan is converted into an annuity and payments are received.
A deferred annuity can be either variable or fixed.
For example, an investor may choose to defer annuity payments until she retires.
A deferred annuity can be either variable or fixed.
explains 'Deferred Annuity'
Earnings on a deferred annuity account are taxed only upon withdrawal, providing the annuity with a tax benefit. This type of annuity also provides a death benefit, so that the beneficiary of the annuity is guaranteed the principal and the investment earnings.For example, an investor may choose to defer annuity payments until she retires.
Annuity
A financial product sold by financial institutions that is designed to accept and grow funds from an individual and then, upon annuitization, pay out a stream of payments to the individual at a later point in time. Annuities are primarily used as a means of securing a steady cash flow for an individual during their retirement years.
explains 'Annuity'
Annuities can be structured according to a wide array of details and factors, such as the duration of time that payments from the annuity can be guaranteed to continue. Annuities can be created so that, upon annuitization, payments will continue so long as either the annuitant or their spouse is alive. Alternatively, annuities can be structured to pay out funds for a fixed amount of time, such as 20 years, regardless of how long the annuitant lives.
Annuities can be structured to provide fixed periodic payments to the annuitant or variable payments. The intent of variable annuities is to allow the annuitant to receive greater payments if investments of the annuity fund do well and smaller payments if its investments do poorly. This provides for a less stable cash flow than a fixed annuity, but allows the annuitant to reap the benefits of strong returns from their fund's investments.
The different ways in which annuities can be structured provide individuals seeking annuities the flexibility to construct an annuity contract that will best meet their needs.
Annuities can be structured to provide fixed periodic payments to the annuitant or variable payments. The intent of variable annuities is to allow the annuitant to receive greater payments if investments of the annuity fund do well and smaller payments if its investments do poorly. This provides for a less stable cash flow than a fixed annuity, but allows the annuitant to reap the benefits of strong returns from their fund's investments.
The different ways in which annuities can be structured provide individuals seeking annuities the flexibility to construct an annuity contract that will best meet their needs.
Terminal Value - TV
The value of an investment at the end of a period, taking into account a specified rate of interest.
explains 'Terminal Value - TV'
The formula to calculate terminal is the same as that for compound interest:
Where:
TV = the total amount
P = the principal amount
r = interest rate
t = period of time
Where:
TV = the total amount
P = the principal amount
r = interest rate
t = period of time
Unsystematic Risk or Nonsystematic Risk
Company or industry specific risk that is inherent in each investment. The amount of unsystematic risk can be reduced through appropriate diversification.
Also known as "specific risk", "diversifiable risk" or "residual risk".
Also known as "specific risk", "diversifiable risk" or "residual risk".
explains 'Unsystematic Risk'
For example, news that is specific to a small number of stocks, such as a sudden strike by the employees of a company you have shares in, is considered to be unsystematic risk.Systematic Risk
The risk inherent to the entire market or entire market segment.
Also known as "un-diversifiable risk" or "market risk."
Also known as "un-diversifiable risk" or "market risk."
explains 'Systematic Risk'
Interest rates, recession and wars all represent sources of systematic risk because they affect the entire market and cannot be avoided through diversification. Whereas this type of risk affects a broad range of securities, unsystematic risk affects a very specific group of securities or an individual security. Systematic risk can be mitigated only by being hedged.
Even a portfolio of well-diversified assets cannot escape all risk.
Even a portfolio of well-diversified assets cannot escape all risk.
Diversification
A risk management technique that mixes a wide variety of investments within a portfolio. The rationale behind this technique contends that a portfolio of different kinds of investments will, on average, yield higher returns and pose a lower risk than any individual investment found within the portfolio.
Diversification strives to smooth out unsystematic risk events in a portfolio so that the positive performance of some investments will neutralize the negative performance of others. Therefore, the benefits of diversification will hold only if the securities in the portfolio are not perfectly correlated.
Further diversification benefits can be gained by investing in foreign securities because they tend be less closely correlated with domestic investments. For example, an economic downturn in the U.S. economy may not affect Japan's economy in the same way; therefore, having Japanese investments would allow an investor to have a small cushion of protection against losses due to an American economic downturn.
Most non-institutional investors have a limited investment budget, and may find it difficult to create an adequately diversified portfolio. This fact alone can explain why mutual funds have been increasing in popularity. Buying shares in a mutual fund can provide investors with an inexpensive source of diversification.
Diversification strives to smooth out unsystematic risk events in a portfolio so that the positive performance of some investments will neutralize the negative performance of others. Therefore, the benefits of diversification will hold only if the securities in the portfolio are not perfectly correlated.
explains 'Diversification'
Studies and mathematical models have shown that maintaining a well-diversified portfolio of 25 to 30 stocks will yield the most cost-effective level of risk reduction. Investing in more securities will still yield further diversification benefits, albeit at a drastically smaller rate.Further diversification benefits can be gained by investing in foreign securities because they tend be less closely correlated with domestic investments. For example, an economic downturn in the U.S. economy may not affect Japan's economy in the same way; therefore, having Japanese investments would allow an investor to have a small cushion of protection against losses due to an American economic downturn.
Most non-institutional investors have a limited investment budget, and may find it difficult to create an adequately diversified portfolio. This fact alone can explain why mutual funds have been increasing in popularity. Buying shares in a mutual fund can provide investors with an inexpensive source of diversification.
Covariance
A measure of the degree to which returns on two risky assets move in tandem. A positive covariance means that asset returns move together. A negative covariance means returns move inversely.
One method of calculating covariance is by looking at return surprises (deviations from expected return) in each scenario. Another method is to multiply the correlation between the two variables by the standard deviation of each variable.
One method of calculating covariance is by looking at return surprises (deviations from expected return) in each scenario. Another method is to multiply the correlation between the two variables by the standard deviation of each variable.
explains 'Covariance'
Possessing financial assets that provide returns and have a high covariance with each other will not provide very much diversification.
For example, if stock A's return is high whenever stock B's return is high and the same can be said for low returns, then these stocks are said to have a positive covariance. If an investor wants a portfolio whose assets have diversified earnings, he or she should pick financial assets that have low covariance to each other
For example, if stock A's return is high whenever stock B's return is high and the same can be said for low returns, then these stocks are said to have a positive covariance. If an investor wants a portfolio whose assets have diversified earnings, he or she should pick financial assets that have low covariance to each other
Efficient Market Hypothesis - EMH
An investment theory that states it is impossible to "beat the market" because stock market efficiency causes existing share prices to always incorporate and reflect all relevant information. According to the EMH, stocks always trade at their fair value on stock exchanges, making it impossible for investors to either purchase undervalued stocks or sell stocks for inflated prices. As such, it should be impossible to outperform the overall market through expert stock selection or market timing, and that the only way an investor can possibly obtain higher returns is by purchasing riskier investments.
explains 'Efficient Market Hypothesis - EMH'
Although it is a cornerstone of modern financial theory, the EMH is highly controversial and often disputed. Believers argue it is pointless to search for undervalued stocks or to try to predict trends in the market through either fundamental or technical analysis.
Meanwhile, while academics point to a large body of evidence in support of EMH, an equal amount of dissension also exists. For example, investors, such as Warren Buffett have consistently beaten the market over long periods of time, which by definition is impossible according to the EMH. Detractors of the EMH also point to events, such as the 1987 stock market crash when the Dow Jones Industrial Average (DJIA) fell by over 20% in a single day, as evidence that stock prices can seriously deviate from their fair values.
Meanwhile, while academics point to a large body of evidence in support of EMH, an equal amount of dissension also exists. For example, investors, such as Warren Buffett have consistently beaten the market over long periods of time, which by definition is impossible according to the EMH. Detractors of the EMH also point to events, such as the 1987 stock market crash when the Dow Jones Industrial Average (DJIA) fell by over 20% in a single day, as evidence that stock prices can seriously deviate from their fair values.
Arbitrage Efficiency
Arbitrage Efficiency is a process through which one person buys a share in one market at lower prices and sell it in another market at higher prices and in this way earns a risk less profit.
Dividend
1. A distribution of a portion of a company's earnings, decided by the board of directors, to a class of its shareholders. The dividend is most often quoted in terms of the dollar amount each share receives (dividends per share). It can also be quoted in terms of a percent of the current market price, referred to as dividend yield.
Also referred to as "Dividend Per Share (DPS)."
2. Mandatory distributions of income and realized capital gains made to mutual fund investors.
Also referred to as "Dividend Per Share (DPS)."
2. Mandatory distributions of income and realized capital gains made to mutual fund investors.
explains 'Dividend'
1. Dividends may be in the form of cash, stock or property. Most secure and stable companies offer dividends to their stockholders. Their share prices might not move much, but the dividend attempts to make up for this.
High-growth companies rarely offer dividends because all of their profits are reinvested to help sustain higher-than-average growth.
2. Mutual funds pay out interest and dividend income received from their portfolio holdings as dividends to fund shareholders. In addition, realized capital gains from the portfolio's trading activities are generally paid out (capital gains distribution) as a year-end dividend.
High-growth companies rarely offer dividends because all of their profits are reinvested to help sustain higher-than-average growth.
2. Mutual funds pay out interest and dividend income received from their portfolio holdings as dividends to fund shareholders. In addition, realized capital gains from the portfolio's trading activities are generally paid out (capital gains distribution) as a year-end dividend.
Dividend Payout Ratio
The percentage of earnings paid to shareholders in dividends.
Calculated as:
In the U.K. there is a similar ratio, which is known as dividend cover. It is calculated as earnings per share divided by dividends per share.
Calculated as:
explains 'Dividend Payout Ratio'
The payout ratio provides an idea of how well earnings support the dividend payments. More mature companies tend to have a higher payout ratio.In the U.K. there is a similar ratio, which is known as dividend cover. It is calculated as earnings per share divided by dividends per share.
Retention Ratio
The percent of earnings credited to retained earnings. In other words, the proportion of net income that is not paid out as dividends.
Calculated as:
Calculated as:
explains 'Retention Ratio'
The retention ratio is the opposite of the dividend payout ratio. In fact, it can also be calculated as one minus the dividend payout ratio.Return On Equity - ROE
The amount of net income returned as a percentage of shareholders equity. Return on equity measures a corporation's profitability by revealing how much profit a company generates with the money shareholders have invested.
ROE is expressed as a percentage and calculated as:
Return on Equity = Net Income/Shareholder's Equity
Net income is for the full fiscal year (before dividends paid to common stock holders but after dividends to preferred stock.) Shareholder's equity does not include preferred shares.
Also known as "return on net worth" (RONW).
ROE is expressed as a percentage and calculated as:
Return on Equity = Net Income/Shareholder's Equity
Net income is for the full fiscal year (before dividends paid to common stock holders but after dividends to preferred stock.) Shareholder's equity does not include preferred shares.
Also known as "return on net worth" (RONW).
