Answers

The 10 questions below are designed to test your basic knowledge of investments.  Answering these questions will help you decide if Why Stocks Go Up and Down, 4th Edition is worth the investment (pun intended).

ANSWERS – The answers to each question, along with the chapter references, are provided below.

Question 1 : EPS declines when a company raises its common dividend.

Answer : False – Paying a dividend to common stockholders is something the board of directors may choose to do with company earnings. It does not reduce earnings.

Question 2: Dividends paid in a given year can be greater than the net income generated that year.

Answer: True – As long as the company has the cash, it can pay what it wants (usually).

Question 3: Dilution occurs when outstanding shares of stock in a company become worth less as a result of the company issuing more shares.

Answer: True – Dilution is an important concept in understanding stock price movement, and is particularly useful evaluating the price and financing terms of an acquisition.

Question 4: The debt to total capitalization ratio (sometimes referred to simply as debt to cap) usually refers to total debt divided by total capitalization.

Answer: False – Debt to cap is calculated by dividing long-term debt (not total debt) by total capitalization.  What constitutes a “safe” ratio depends on the nature of the company and its industry.

Question 5: Investors wishing to minimize their risk of loss would be better off buying a company’s debentures than its bonds.

Answer: False – Bonds are safer because they are secured by specific assets as well as the company’s contractual commitment to pay interest and principal. Debentures are only backed by the latter.

Question 6: A bond selling at a discount from par will have a higher yield to maturity than current yield.

Answer:  True – The current yield is just the coupon (annual interest payment) divided by the current price of the bond. The yield-to-maturity also considers the coupon, but in addition, the yield-to-maturity adds the capital gain the bondholder will have if the bond is bought below par and held to maturity.

Question 7: The higher the price-to-earnings ratio, the greater the risk.

Answer: False – The price/earnings ratio is usually related to the company’s growth rate. A company whose earnings per share are growing at 20% per year is likely to have a much higher price/earnings ratio than a company that is only growing at only 5% per year. The slower growing company might be a lot riskier.

Question 8: For some companies, it is preferable to value their stock using a multiple of cash flow or EBITDA rather than earnings.

Answer:  True – Companies that have high depreciation and low earnings, for example, may be better valued using a multiple of cash flow.

Question 9: Determining if a stock’s P/E  multiple is attractive or not is better judged using future earnings than present earnings.

Answer: True – When companies have different earnings growth rates, the P/E multiple should be calculated using the current price relative to  expected earnings a few years out.

Question 10: Stocks go up and down in response to changes in investors’ perception of a company’s ability to generate earnings and pay dividends, both this year and in the future.

Answer: True – Changes in perception can arise from developments within the company, in the company’s competitive environment, or in the economy in general.  Note that this explanation only addresses why stocks go up and down.  It does not explain why a stock sells at a particular level.