Investment securities are available in three classes: stocks, bonds, and cash equivalents. Each class has its own level of risk and potential return. Additionally, each security class has its own expected cash flows that may be used to determine the financial health of the bond, asset, or company. Financial statements are helpful for keeping track of the company's assets and liabilities and are useful for calculating a company's operating income and free cash flow. For stocks, there are two categories of stock valuation: absolute and relative valuation. Absolute valuation calculates the inherent value of a stock. Relative valuation calculates a stock's value compared to its competitors.
At A Glance
Risk is the probability a security will perform differently than its anticipated return. Overall risk comes from multiple sources, such as business risk, exchange rate risk, purchasing power risk, financial risk, and tax risk.
- The primary driver of investment decisions is the risk of suffering losses on an investment in contrast to the potential returns.
Cash flow provides an account of the financial health of a company.
- The comparison between future cash flow and present cash flow is a driver for investment analysis, as investors will compare these options and choose the one that yields a larger return.
- The future cash flow of a security is associated with risk, and it is the primary driver of the security's value.
Future cash flow can be calculated and used by investors to approximate how lucrative an investment may be.
- Financial statements can be used to calculate both operating and free cash flows.
- It is important to understand the difference between free cash flow to the firm and free cash flow to equity because investors base investment value on what is ultimately available for distribution to shareholders.
- The value of a bond can be calculated based on a bond's coupon rate and par value.
- The effects of interest rate risk and inflation can be both short and long term.
- The yield-to-maturity rate is an effective method for investors to determine a bond's potential value as well as how a bond should be appropriately priced.
- The value of a stock can be calculated using two methods: absolute valuation models and relative valuation models.