Equity Investments Flashcards

An analyst uses a residual income model to value a stock. Residual income is defined as:

Answer: Net income minus the equity charge (required return × book value of equity)

Residual income = Net income – (required return on equity × beginning book value of equity); it measures value created above the cost of equity.

Which industry structure, under Porter's Five Forces, would MOST support high profitability for existing firms?

Answer: Few rivals, high barriers to entry, few substitutes

High barriers to entry, few competitors, and limited substitutes reduce competitive pressure, allowing existing firms to maintain pricing power and high margins.

A company repurchases shares in the open market. All else equal, this will MOST likely:

Answer: Increase earnings per share (EPS)

Share buybacks reduce the share count; if net income is unchanged, EPS rises because the same earnings are divided among fewer shares.

The price-to-book (P/B) ratio is LEAST informative when analyzing a company in which sector?

Answer: Technology or software

Technology and software firms have significant intangible assets (IP, brand, human capital) not fully captured on the balance sheet, making P/B less meaningful.

In the two-stage dividend discount model, the second stage typically assumes:

Answer: A stable, sustainable long-run growth rate

The two-stage DDM uses a high near-term growth rate followed by a terminal stage with a stable, long-run sustainable growth rate applied in perpetuity.

Which of the following is an example of a top-down approach to equity analysis?

Answer: Starting with macroeconomic conditions, then narrowing to sector and finally individual stock selection

A top-down approach begins with macroeconomic analysis (GDP, interest rates), then identifies attractive sectors, and finally selects individual stocks within those sectors.