Category Archives: CFA Exam Tips

Your two-week CFA Exam Rocky Balboa Montage!

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Remember the great training montages in the Rocky movies? Where the champ could come back from a defeat to overcome a stronger boxer by just going through three minutes of training set to some kick*#@ music.

Ah, if only studying for the CFA exams were like that. You could slide through the first four and a half months of the year with your mind decidedly not in the game and then crank out a hardcore two weeks to beat the exam! Epic!

While you can’t expect to pass the exam with just two weeks of studying, what would your montage training program look like?

Eye of the Tiger
Picking up on the montage scenes in the movies where Rocky turns everything he can find into an exercise, you really need a diversity of study resources. Rocky’s montage may only last three minutes but yours will be two weeks and only doing practice problems is going to get boring. You need to be using flash cards, condensed reviews, practice problems, and single-sheet summaries. Just as you can’t expect to get well-developed pectorals from just a bench press, you need to hit the CFA curriculum from different angles to assimilate it.

Do you see Rocky taking it easy during the montages? No, he’s sweatin’ and pushing the limit lifting a 500 pound cart with Paulie in it. You can’t take it easy in your montage either. By now you know which topic areas are your most difficult. While it wouldn’t make much sense to spend a lot of time on something worth less than 10% of your score, you can’t afford to neglect any one section. Be realistic here and divide your time between those topics that carry a lot of weight and those in which you need the most work.

The beginning few sequences in Rocky’s montage sometimes start with him attempting a really heavy lift or exercise and not quite being able to get it, only to succeed with the same lift later on. For your montage, this means looking deeper into those practice problems or mock questions which were missed so you can answer them correctly if they come up again. It does you no good to just take a mock exam and look at your score. You have to actively study the questions you missed and understand what material you need to work on.

If you haven’t already, you absolutely need to take a practice exam now. Better yet, take two exams to make sure that your score in any particular topic area in the first practice wasn’t just luck. This is going to give you a good idea of where you stand for your grasp on the material.

Once you know how well you are doing on the material, start your two week montage hitting those practice problems, flash cards and review sheets.

At the end of your montage, maybe Wednesday/Thursday of next week, take another couple of practice exams to see your new, improved score.

Then get ready for the big day!
If the exams were a Rocky opponent…
Level 1: Apollo? Many Level 1 candidates are surprised the first time and fail but then come back for the win

Level 2: Mr. T? For most, the hardest exam and many candidates get overconfident after a passing Level 1 score. I pity the fool that don’t take Level 2 seriously!

Level 3: Ivan Drago? Still a tough exam but at this point, we all know that you are going to beat the exam though it may feel like you’ve got brain damage afterwards.

Ah, if only Stallone could live forever, “Rocky XXV: Clone Wars”

‘til next time, happy studyin’
Joseph Hogue, CFA

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Are the actual exam questions easier or harder than mock exams or practice problems?

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Leading up to the exams, I always wondered if my success on practice problems and mock exams would carry through to the actual test. My strategy of taking at least five full-length exams, one that I have written about on the blog, helps to build a confidence interval around your possible exam score. You’ve all been through the quant material so we won’t repeat how to use a collection of scores to estimate an average and predicted score.

Unfortunately, this method of prep is only as good as the tests you use to make the estimate. If the questions within the mock exams or the practice problems are significantly easier than the actual test questions then you’ll get an inflated estimate and may be in for an unpleasant surprise come June 1st.

So how do you know if the practice problems, mock exams or question banks are easier or harder than the actual exam?

From my own experience, the practice problems in the curriculum were probably the closest to the actual test questions in terms of difficulty. The problem with these is that taking a few singular questions provides a poor estimate on how you will do across 120 questions and 18 study sessions. You really need to complete a handful of practice problems from each topic and all at once.

The CFAI mock exams seemed a little harder than the actual exam for the years I took the test (2009-2011). Taking the mock exams each year, I was always a little disappointed in my score but then had no problem on the actual exam. I don’t know if it is intentional, but the Institute did a good job of making me study a little harder in the last couple of weeks.

I used Stalla and another prep provider (which I won’t name but it’s the most widely used) when I took the exams and before I knew about FinQuiz. The question bank problems did seem to be easier than the actual exam and much easier then the Institute’s mock exam. I was usually well into the 80% rate on practice exams through the software and was a little surprised when I took the actual exam.

Having helped prepare some of the questions for the FinQuiz mock exams, I think they are about the same level of difficulty as the actual exam. I have looked at samples across all three exams and there is a good range of easy to difficult problems, similar to the exam.

Your own experience may be different and there are other posts on the forums to help you with the question. One thing to remember when looking at your scores is that you will probably do better on an exam when relaxed in a study area with no consequence to your score compared to the 6-hour mental aerobics on June 1st. This is why I always liked to target a higher percentage score on the mock exams and practice problems than was necessary. If you are regularly making 75%-85% on these tests, you can be confident that you will do well on the actual exam.

As we’ve talked about previously, try not to worry during the exam even if the actual exam seems harder than your prep questions. You’ve done everything you can to prepare and getting nervous during the test will not help. I’ve talked to many candidates you came out of the exam feeling disappointed that it was much more difficult than they anticipated. They spend the next couple of months distraught because they think they failed, only to find out that they passed and put themselves through so much anxiety for nothing.

Spend the next two weeks finishing up your review. Keep to your plan and try to cover as much as possible, then don’t worry about it.

Good luck on the exam,
Joseph Hogue, CFA

 

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CFA Exam Day, What to Expect and How to Prepare

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Unfortunately, more than a few candidates have failed an exam not because they didn’t know the curriculum but because of a test day hurdle.

You’ll hear stories every year of the candidate that is refused admission because they don’t have the proper identification, arrived late or don’t have their admission ticket. On top of these problems, you also run the risk of being so distracted from test day jitters that you can’t focus on the exam.

Knowing how to prepare for exam day and what to expect can go a long way to having a successful June 1st.

Unless the testing center is within walking distance, don’t assume that you can get their without any planning. If you can, try to drive the route a few days before test day. You may be surprised to see detour signs or that construction will start over the weekend. Google maps or other GPS services are good but not infallible and they aren’t going to refund your hard work if you get lost and miss the exam.

Play it safe on the food. That big meal the night before might just keep you up all night with indigestion. Eat a good breakfast but nothing heavy on grease or sugar. If you drink coffee, have a cup to avoid caffeine withdrawal. You are allowed to use the restroom during the exam but it comes out of your allotted time.

Don’t forget to print out your admission ticket (available by clicking here). In fact, open a new internet window and do it now. Put it in a safe place and do not write on it. After you’ve done that, look for your passport. Go ahead, I’ll wait……

Ok, visually check to make sure your passport does not expire through the test day then put is with your admission ticket.

Some candidates bring ear plugs for the test. I never had a problem with noise distractions but it is a good idea just in case. I have heard horror stories of open windows and lawn mowers distracting candidates. If you are at all distracted by small noises, bring ear plugs.

On test day, you’ll all arrive and wait outside the exam room. There will be a table of exam admin to check people in. Just before the exam begins, you’ll all file into the room showing your admission ticket and identification. You’ll be given your seat assignment and put your materials in front of you on the table. Test procters will also check your calculator and any materials you have with you. There is usually a separate area outside the exam room to leave your personal items not allowed in test room but I’d recommend leaving your stuff in the car if you can.

The proctor will read off the test instructions just before the exam. From this point forward do not talked to anyone or look around for any reason. I know it may seem rude but you really cannot risk being flagged as a cheater. It does happen.

I wouldn’t get too anxious about what to do or not to do over lunch. Don’t be afraid to talk to other candidates, these are the best peers and connections you’ll have over your career. Obviously, don’t talk about the test or any specific questions but just use the opportunity to get to know people and what they do.

Just eat as you normally would for lunch. Stay as close to the test site as possible and don’t get in a rush.

Above all, do not second guess any answers you worked on in the morning session! It’s over, don’t worry about it. If you prepared, you did fine. Worrying about the morning session will only lose you points in the afternoon.

I usually studied flash cards for about 20 minutes during lunch. It helped refresh some of the more detailed formulas, but at this point don’t worry too much about learning new material.

The CFA Institute is always the last word on exam day do’s and don’ts. Linked here is the Main Exam Page, where you will find links to print your exam ticket and other useful information. Linked here is the main page for policies on identification, calculators, materials, personal belongings and the candidate pledge. Lastly, the link here is to the Institute’s FAQ page for the exams.

We’ve still got a couple of weeks to the exam. We’ll spend them reviewing and talking about how to squeeze out those last points. Stick with it and get your study time in and you’ll go into the exam confident and ready to pass.

‘til next week, happy studyin’
Joseph Hogue, CFA

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Finding the Motivation the Second Time Around

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We’ve had a lot of emails about finding the motivation to review the same material after you’ve failed the exam. This is a tough one because you’ve already spent a ton of time and the material doesn’t really change much from year-to-year. If it wasn’t interesting enough to stick the first time around, what’s a candidate to do the second time?

As for motivation, I wish I could tell you that repeat testers have a higher pass rate than first-timers. You’ve got to think it’s probable but there isn’t much data to go on. I recently conducted a poll on the LinkedIn group asking candidates on which subsequent try did they pass. Of the 17 votes, 55% of the retesters passed on the second attempt with another 11% on the third attempt.

The best advice I can offer, for anyone studying those arduous 300 hours per exam, is not to think of it as an exam. Going into this as an exam, where you rationalize the hard work just to get through the next test, is a sure recipe for boredom. You’re not really enjoying the material, just muddling along thinking of it as a job.

I’ve talked on the blog a few times about the reward to your professional ability that comes with the CFA curriculum and I think that’s really the way you need to approach the exams. Looking for the quick payday or job opportunity from achieving the CFA designation is going to leave you surprised when you realize that even us charterholders have to work for it. Yeah, you will have more opportunities and will probably see a higher income but the charter isn’t something that is going to set you on easy street.

When you accept that the time you spent studying becomes ‘research’ after you pass the exams, the idea of covering the curriculum becomes a little easier and a lot more interesting. Embrace the fact that time spent learning about asset classes, risk management and portfolio management is just a part of your career. Time spent covering topic areas outside the narrow view of your current job or the job you think you want will make you a stronger professional and open up tons of opportunities in the future.

As for the practical side of studying the material, the best way to avoid boredom and frustration from covering the same material multiple times is to focus on practice problems and question banks.

Coming up to the final month of studying, this is also the method I’d recommend everyone wrap up their study plans. Time is critical at this point and no one can afford to keep covering material that they already understand. Complete at least 30-60 problems at a time to give yourself a good idea of how you are doing within a specific topic area.  By keeping track of your score within the individual topic areas and even down to the reading level, you can focus your reviews where you need it most.

Five weeks left. Stay strong and push through to the end. You’re almost there!

‘til next week, happy studyin’
Joseph Hogue, CFA

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CFA Level 1 Review, Fixed Income Overview

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Study session 15 in the CFA Level 1 curriculum begins the fixed income topic area with four readings (52-55) covering the basic concepts in debt securities. The topic is worth 12% of your Level 1 score but you really need these core concepts to understand the later material the other two exams. The topic will be worth about 10% and 15% of your Level 2 and Level 3 exams.

Looking back on the Level 1 curriculum for these posts, it strikes me how effectively the Institute manages to work candidates into a topic with basic concepts and ideas. I’ve heard the Level 1 exam described as a mile wide and an inch deep because of the breadth of information involved but the difficulty is offset by not requiring too much detail.

This is a key point you need to remember when studying for the first exam. Get the key concepts and vocabulary first. Not getting caught up in too much detail is going to help you cover the curriculum as many times as possible. Going over the material multiple times helps to commit it to memory and helps you pick out the correct answer out of three choices. You’ll still need a fair amount of detail, but the first exam is definitely a bird’s eye view of the material.

Features of Debt Securities
Understand the basic types of affirmative and negative covenants like paying interest & taxes, meeting financial ratios, limitations on additional debt, and restrictions on asset sales.

Definitions and just knowing the lingo is always important. Know what a coupon is and understand what happens to the price if the coupon rate is higher or lower than current market rates. Think about it intuitively. If a bond offers a higher coupon rate than you can find in the market, you are going to be willing to pay a premium on the price, and the opposite is true for a coupon rate below the current market yield.

Understand the basic idea behind call and put provisions, sinking funds, repurchase agreements and prepayment. Remember, the full or dirty price is the agreed price plus all accrued interest.

Risks Associated with Investing in Bonds
There are 11 basic risks listed with bonds: interest rate, call and prepayment, yield curve, reinvestment, credit, liquidity, exchange-rate, volatility, inflation, event, and sovereign risk. Some (interest rate, prepayment, yield curve) are extremely important and you will be seeing a lot of the curriculum focus on detail but you need to have an understanding of the basic factors within each.

The inverse relationship between rates and price underlies interest rate risk. As rates increase, the price of a bond decreases because investors can get a better rate in other products. Understand how maturity of the bond affects the change in price, i.e. longer time left means bigger price swings because you could be earning more/less for a longer time. Duration is the measure of rate risk and you need to remember the formula for the exam = (Price at lower rate – Price at higher rate)/ (2*initial price* change in yield)

Prepayment risk is when the bond issuer (or mortgage holder) has the option to buy back the product. Remember, all options have value and the value of this call feature will be more valuable as rates decrease.

Reinvestment risk is associated with the need to reinvest payments of interest and principal at lower rates than the bond offers. Zero coupon bonds have no reinvestment risk because they have no payments until maturity while amortizing securities have more risk because they pay off principal and interest.

Understand the three types of credit risk: default, credit spread, and downgrade risk.

Understand the threat that inflation poses to bonds as fixed-income products. This means that even as the value of the currency depreciates, the investor only receives the set coupons and principal so the bond is worth less in real terms.

Overview of Bond Sectors and Instruments
This reading is of secondary importance and you really only need a basic idea of the seven sectors of the bond market and an overview of their characteristics.

Sovereign bonds: Government issued and relatively lower risk. They can be issued in local or foreign currencies. Understand the basic differences of the U.S. debt like T-notes, T-bonds, Strips and TIPS.

Semi-government: These are issued by a quasi-government agency and often carry an implicit guarantee. The focus is on agency mortgage debt and the types of CMO and MBS, think Fannie Mae and Freddie Mac a few years ago.

Municipal or province: Like sovereign bonds but issued by smaller authorities like towns and cities. Understand the difference between tax-backed and revenue bonds and the effect on risk. The interest is often tax-advantaged for taxes owed to the issuing municipality or state.

Corporate Bonds: Understand the four factors used by credit rating agencies (character, capacity, collateral, and covenants). This section has a few formulas and is probably one of the more testable in the reading.

Mortgage backed securities: Understanding structure and prepayment risk is the important material here and will be used for more detail in the Level 2 exam.

Asset backed securities: Understand the types of internal and external credit enhancements as well as the role of special purpose vehicles.

Collateralized debt obligations: These are basically the same as asset-backed debt but the backing for the bond is a diversified pool of different debts, i.e. domestic/foreign bonds, bank loans, distressed debt, ABS, and MBS.

Understanding Yield Spreads
An extremely important reading and the setup for many formulas in the Level 2 exam. Understand the effect of monetary policy (open market operations, discount rate, reserve requirements, and verbal notes) on rates.

Understand the theory behind the four shapes to the yield curve and what they say about the outlook for rates and the economy: positively-sloped (normal), flat, inverted (downward-sloping), and humped.

Understand the three theories of term structure: pure expectations, liquidity preference, and market segmentation.

1)      Pure expectations says that forward rates represent expected future spot rates and are not based on other systematic factors. It predicts that the expected spot rate in one year is equal to the implied 1-year forward, implying that expectations are unbiased and the shape of the yield curve depends on expectations.

2)      Liquidity preference states that long-term rates not only reflect expectations but also include a premium for investing in the long-term bonds, a liquidity premium. Rates are biased as holding long-term maturity requires the premium and that a yield curve may have any shape because the size of the liquidity premium is positively related to investor risk aversion.

3)      Market segmentation states that the slope of the curve depends on supply and demand conditions in the long and short-term markets. An upward-sloping curve indicates that there is less demand for short-term relative to long-term while a downward sloping curve would imply the opposite.

Study session 15 in the CFA Level 1 curriculum concludes the topic area with four more readings in fixed income.

‘til next time, happy studyin’
Joseph Hogue, CFA

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The Best Vacation You Ever Had

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With a little over a month left to the tests, I started to get nostalgic for the bygone days of last-minute cramming for the CFA exams. I always took the last week before the exam off from work to dedicate my time to studying. A 40-hour plus week of mock exams, flash cards and review sheets may not sound like a vacation, but it beats the normal 9-5 routine and the curriculum can be pretty interesting if you let it. My full schedule is described in a prior post and linked here.

Instead of rehashing my own schedule for the last week, I thought I would pass along an idea from a friend in Chicago on how he spent his last week before the exams. I’ve talked to others about their last-week plans, but his yearly ritual wins hands-down.

Instead of staying in Chicago and locking himself away at the library for the six days before the exam, my usual approach, he would hop a flight to San Diego for a real vacation. He still put in the 8-10 hours of studying but spent it relaxing in the park or at the beach. Mornings would start early with a run on the beach at 6am followed by breakfast and studying by 8am. He would study through the day to about 4-5pm, stopping an hour for lunch. After relaxing for a few hours, he would put in another hour or two studying before bed.

Talking through his daily routine, it struck me that it really wasn’t that different from others. Mock exams every other day help to fine-tune the review and focus on those topics where you need the most work. Flash cards and condensed summary sheets help to break up the monotony of practice problems and reading. There are a lot of advantages to going away on a trip though.

First, all your meals are prepared for you so that’s one less thing to worry about or on which to spend time. Your friends and family know you are away so they don’t expect you to go out and party (I had more than a few friends that couldn’t understand why I wouldn’t want to stay out later during a week off from work when I was studying). Finally, you’ve spent the last five months (more or less) studying in the same place. Spending that last week studying at home as well can be extremely boring.

Of course there are risks to the vacation plan. My friend said he did enjoy a drink or two at night but never gave in to temptation and drank too much. A couple of drinks isn’t going to kill too many brain cells but be careful not to stay out too late. Don’t spend too much time worrying about where you are going to study or what you want to see. Pay a little extra for a nice hotel that is well-centered on the places you want to go. One caveat is to plan on coming back home Thursday to make sure flight cancellations do not keep you from getting home on time.  

The idea is to relax and have as much fun as possible over that last week while still hitting the curriculum hard for those last points to put you over. Going into the test with burnout and just ready to get it over with isn’t going to help you pass.

‘til next week, happy studyin’
Joseph Hogue, CFA

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How to Pass the CFA Exam in Six Weeks

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With just six weeks left to the exam, candidates are asking themselves if they have studied enough and what their chances are at passing the exam. For those that have followed our 21-week study plan, you should be starting the last few study sessions and tracking your progress through practice problems.

There are many candidates who have just recently started working through the curriculum and are wondering if six weeks is enough time. The short answer is probably not unless you are able to completely devote yourself to the exam over that period. Remember, the average candidate spends about 300 hours studying for each exam. Even if you are particularly bright, and not just overconfident and can get by on 250 hours, that is still more than 40 hours a week.

Even candidates that have been studying over the last several months may want to re-evaluate their progress. Our study plan has covered to study sessions 14 in the exams but this is still just the first time through the material. Candidates retesting material seen in the first couple of study sessions may find that they have forgotten some of the important concepts.

This is why you may want to change things up for this last six weeks and incorporate a few other resources. You’ll still need to finish the curriculum to the last study session, but you need to revisit the concepts in earlier study sessions through practice problems, flash cards and study notes.

 The resources below are some of my favorite for quick review and being able to get the most important parts of the curriculum in the most condensed form:

  • Study guides are still going to be your ‘core’ resource. Hopefully, you don’t need to re-read all the material but you should try to get through your problem areas again.
  • Flash cards! I’ve covered these in a previous post. This is one of the most useful resources at this point because you can carry them around easily and focus on specific questions/formulas.
  • Topic area summaries are worth the cost for their portability. Not quite as useful for formulas (practice is best) but you can easily review a summary page a few times a day and get core concepts down.
  • I would be spending the majority of time on practice problems and mock exams. Don’t just grade your answers but study the guideline answer for those you got wrong. I cannot think of a better way of focusing in on the stuff you don’t know yet.

For the most efficient use of your study time, I would start doing at least one mock exam or practice test each week. Sit down with a question bank of practice problems in the approximate weights from the exam and complete two, three-hour sessions. For each topic area, you need to be aiming for at least 70% but you’ll want to score higher in the core areas like ethics, financial statements, and equity analysis. Knowing approximately how well you are doing in each topic area will help you to allocate your study time over the next week.

Of course, the last week before the exam is still the ‘superman’ week. You might want to consider taking the entire week off from work and planning an intensive review of the material. We’ll cover how to plan the last week in a coming post. Let me know if you have any questions or comments.

‘til next week, happy studyin’
Joseph Hogue, CFA

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The CFA Exams and Questions that aren’t Really Questions

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Right about this time of year, about eight weeks until the June CFA exams, a group of questions pop up on the exam forums. Questions like, “which is better, the CFA or MBA?” and “Is the CFA designation even worth it?” Of course, these are relevant questions and should be asked but it strikes me how much more frequently they come up half-way through the study season. The fact that I’ve seen them asked by many that have already started studying for the exams, or are even passed the first exam, confirms that they may not be questions at all.

What? When is a question not really a question?

When it’s an excuse or a plea for motivation.

Believe me, I’ve been there. You are putting in your 40+ at work, your family wants more quality time and you’re starting to feel a bit like a hermit. You still have another nine weeks of study just for this test and another 300 hours for each of the other exams.

So, the questions start coming. Is it worth it? Will I ever use it? And the possibility that the answer is no becomes easier to imagine.

In the past, I’ve looked for answers to give candidates. The statistical evidence that charterholders make more, on average, than their peers. The fact that many job requirements call for the charter or progress towards attainment signaling that it is valued in the industry. Even anecdotal evidence from my own experience where I have gained consulting work based on the designation.

This time, we’re going to put aside the data and facts (not an easy task for an analytical nerd like myself).

At this point, presumably well into your study plan this year, you need to keep going just to see if you are up to the challenge. Because over 400,000 candidates have passed one of the exams and you are just as good as any one of them. Understand that those questions you’re asking is just your doubt trying to get the better of you. Push through it and be a more confident person for having beat it.

Two months is nothing. Two months is less than two-tenths of a percent of your life but I guarantee that if you quit now, you will wonder about what could have been for the rest of your life.

We’ll be starting week 13 of our 21-week study plan next week. Stay strong and keep studying.  

‘til next week, hang in there.
Joseph Hogue, CFA

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CFA Level 3 Review Equity Portfolio Management

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Study session 11 begins the level 3 material on equity portfolio management which is worth 5-15% of your total exam score.  There is only one reading (27) and much of the material is more conceptual than quantitative.

Equity Portfolio Management
As with the fixed income portion of the Level 3 exam, a big part here is remembering the differences between active and passive management. The advantages/disadvantages lie on a continuum for tax efficiency, fees and expected return.

Know the advantages/differences between ETFs and mutual funds. ETFs trade throughout the day, do not require shareholder recordkeeping, are more tax efficient because of in-kind redemptions, and do not have high exit costs. The one advantage of mutual funds is lower licensing fees.

Know the three main categories of investment style: value, growth and market oriented. Be able to determine the style from performance or fundamental data on the portfolio like price multiples, volatility, dividend yield, etc. Value styles will usually have lower price multiples, higher dividend yields, lower volatility.

The holding-based and returns-based style analysis is extremely testable and often shows up in the morning section. Understand the advantages and disadvantages of each.  Make sure you can use the output from the analysis to identify the management style as small-cap, large-cap, mid-cap and be able to determine style fit and drift.

The information ratio is easily testable and worth the small amount of time to memorize. It is fairly intuitive once you think about it. An investor’s (value) is a function of his depth of knowledge (IC) and breadth of knowledge (IB).

Be able to calculate the components of active return including misfit active risk, true active risk and total active risk.

I have the 2009 morning section of the Level 3 exam along with the guideline answers, originally released by the Institute but no longer available on the website. The exam includes a good practice question on equity portfolio management. Leave your email in the comments below or email me at info@efficientalpha.com and I will send you a copy.

Study session 12 concludes the material on equity investments with three readings on governance and international investments.

‘til next time, happy studyin’
Joseph Hogue, CFA

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CFA Level 2 Review Equity Investments

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Study session 11 in the CFA Level 2 curriculum continues the material on equity investments with two readings (32-33).

Five Competitive Forces
Porter’s five forces is an extremely popular industry analysis tool. If you ever go for your MBA, and many of you will without realizing it yet, you will see this material again. At the CFA curriculum level, it is pretty basic and your really only need to remember the underlying concept behind each force.

  • Threat of entry- barriers to entry on the supply and demand side, customer switching costs, access to distribution channels, government regulation, and capital requirements
  • Bargaining power suppliers- number of suppliers and switching costs, and differentiation among supplied materials
  • Bargaining power buyers – number of buyers and switching costs, and whether one buyer accounts for a significant share of revenue
  • Threat of substitutes- relative value of substitutes and buyer switching costs
  • Rivalry among competitiors- product cycle and introductions, marketing, price discounting

Understand the difference between factors affecting the industry structure (growth rate, tech innovation, government, complementary products) and the five forces that shape strategy.

Discounted Dividend Valuation
While the five forces is pretty basic and can be some easy points, this is the more important reading by far. You absolutely must know all the different iterations of dividend discount models.

Besides being able to plug data and calculate valuation, you are expected to understand the differences between the models and decide which model to use given different scenarios. As with many of the formulas in the CFA curriculum, you should start with the concept behind the calculation and understand what it means. This will help you get the conceptual points on the exams, which I would say are easily more than half of total points, and will help you memorize the formula.

We covered the free cash flow formulas and residual income model as inputs to dividend discount models in a prior post here.

Remember, FCFF is pre-debt cash flow while FCFE is post-debt so FCFF is preferable when the company has a volatile capital structure, is highly leveraged, or has negative FCFE.

The residual income model is only valid under Clean Surplus Accounting and is preferable when the company is not paying dividends and when expected free cash flows are negative.

Understand and be able to calculate the Gordon Growth Model and the different iterations of the dividend discount models.

The H-Model is an intimidating formula and many candidates neglect it and ‘hope’ that it doesn’t show up on the exam (but it often does). It is easier if you reason through the pieces. The formula is really just the Gordon growth with a “compromise” estimate of growth based on the two periods. The estimate for growth is just the long-term rate plus half of the difference between the supernormal period and the long-term rate.

Study session 12 in the CFA Level 2 curriculum could be the most important across the three exams for an equity analyst. The four readings cover four different methods of valuation: FCF, Relative Valuation, Residual Income, and Private Company Valuation.

‘til next time, happy studyin’
Joseph Hogue, CFA

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