Making Level I Success a Step to Level II

If you’re a CFA level 1 candidate, your top priority right now is to pass that first hurdle and enjoy a well-earned six months of rest. The last thing you want to think about is putting in your time on the next two exams.

But if I told you that there was something you could do while studying for the CFA level 1 exam that would save you a lot of time next year, would you be interested?

You bet you would!

Remembering a few key points while studying for the first exam could help you pass the level 2 exam and even give you a head start on the third exam as well.

Relationships between the CFA exams

The secret is understanding the related material across the exams and what you need from one exam to the next. While the topic areas across all three exams are all related to an extent, there are a few in which your work on earlier exams is absolutely imperative to passing.

Ethics and Professional Standards is probably the most consistent across all three exams. You will see a couple of new sections in the level 2 and 3, but the core material is exactly the same. The topic area is worth more nearly 12% of your total score across all three exams so definitely points you can’t afford to miss.

Not only is the topic extremely important across the exams, it’s been my experience from candidate comments that it is the one they are most often disappointed by on the first exam. Candidates assume they are ethical people and will be able to pick the correct answer out of the three possibles. They neglect the section and then are surprised at how difficult it is on the exam. Spend a little extra time on this area, do the end of chapter problems and save yourself a ton of time and stress in the next two exams.

Quantitative methods is another topic where mastery of the CFA level 1 curriculum will pay off big time on the second exam. While it is not a high-point section, only 12% of your first exam and 5% – 10% of the second, understanding the material in the CFA level 1 is critical to do the work on the next exam. The level 2 curriculum usually even includes optional refresher material for those candidates that didn’t learn or forgot the prior material. Think of it as the difference between two mathematics courses, one teaching the basics of multiplication and the other moving on to algebra. You would be absolutely lost in the algebra class without mastering the prior course.

Financial Reporting and Analysis is one of two or three core topics to the entire curriculum and worth more than a fifth of your first two exams. The readings on the financials statements in the first exam must be mastered to be able to do the intense analysis work in the second exam. Talk to almost any level 2 candidate and they will tell you that one of the hardest parts of the exam is the FRA material, especially intercorporate investments, multi-national operations and pensions. To be able to understand these readings, you must understand the relationships between the financial statements which is Level 1 material. Save yourself the time of reviewing this by mastering it early.

Study session 14 in the Equity Investments topic area will also be a very important reading for progressing to the level 2 exam. In fact, it looks like a lot of the level 1 material is repeated in the level 2 curriculum. Equity Investments are a quarter of your total score at the second level so you want to be ready for the topic.

The usual disclaimer applies that you cannot afford to completely neglect any topic area. You will need around 70% on your exam to pass to the next level. These exams are extremely difficult on a mental and physical level so do not expect to get all the points in any one section. Spend enough time on the secondary topic areas so you can get at least 60% or more and then focus on the higher-point and higher-importance sections.

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


Do Not Let the CFA Level 2 Exam Surprise You

The pass rate for the CFA level 2 exam has only been lower than that of the first exam in three of the last 10 years. For many candidates, that is a welcome relief after a grueling introduction to the exams and it must mean that the second exam is easier. Right?

Wrong! And it catches a lot of candidates off guard.

While the CFA level 2 exam may indeed be easier for a few, most candidates find it incredibly difficult especially compared to the CFA level 1 exam. Which exam is the most difficult for you will obviously depend on your own abilities but you need to go into the second exam knowing exactly what you are facing.

Quantitative Monster

It is often said that the CFA level 1 curriculum is a mile wide and an inch deep because it covers a huge range of material but really only teaches to the basic ideas within each. The CFA level 2 material covers the same topics but seems to focus more on the detail within a few. While the range of material can still seem daunting, candidates usually agree that the level two curriculum is a mile deep and maybe a few feet wide (to paraphrase the saying).

This becomes a little clearer looking at the topic weights across the exams. While the first exam is more evenly spread out, the second exam is more focused in a couple of topics. In fact, Financial Reporting & Analysis and Equity Investments alone will account for between 35% to 55% of your entire score.

This is obvious enough to anyone preparing for the exam. What is not so obvious is the quantitative difficulty you will see on the exam. Those problem sets are a monster!

Given that nearly half of the exam could be from just two topic areas, I hope I don’t have to tell you where you should be spending your time. You absolutely must know the FRA and Equity material, especially the formulas.

We covered some of the most important formulas on last year’s exam in three posts (First, Second, Third) and linked here. Almost all will still be applicable to this year’s exam so feel free to look through the posts for hints on each.

There’s two things you can do to help get through the formulas.

  • First, you need to understand what is conceptually happening in the formula. Trying to understand the myriad of symbols is crazy. If  WACC = (Vd/(Vd +Vce))rd (1-t) + (Vce/(Vd+Vce))rce) doesn’t make you go cross-eyed you are a stronger person than I am. Think about it intuitively and it makes sense. The overall cost of a firm’s funding capital is the cost and proportion of equity and debt. The percentage of each funding type relative to the total is multiplied by its cost. Debt is tax advantaged, so you need the after-tax cost.
  • Secondly, you have to work these formulas through practice and repetition. One of the most popular posts here shows that active learning (engaging the material through practice and conversation) allows you to remember much more than passive learning. The best way to approach tough formulas is to put them on flash cards. We covered the importance of flash cards and why you should make your own set in the previous post.

Just because a higher percentage of candidates usually pass the second exam than the first doesn’t necessarily mean it is easier. Think of it this way, candidates are fully aware of the immense challenge presented by the exams after the first test and still less than half typically pass the second exam. That should give you an idea of difficulty on the CFA Level 2 exam.

The good news is that tens of thousands of candidates pass the exam every year and you can too. Focus on those formulas, especially in the high-point topic areas, and you will do well. Less than two months ahead of the CFA exams. Be ready.

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


5 Things I Wish I Knew about the CFA Level II Exam

We’ve already covered the top five things you should know about the CFA Level I Exam and about the exams in general. The Level II Exam is, in mine and many other candidates, the most difficult level of the three CFA exams and it might be hard to narrow it down to just five things.

  • Don’t Underestimates the Exam

I was pleasantly surprised at the ease of the Level I exam. The exam was not necessarily easy but it was less detailed than I was expecting and I had studied more than I probably needed. While I am not sure that I consciously underestimated the Level II exam, I may not have studied as hard as I did for the first exam. The exam was harder than I anticipated and I was sweating bullets for the full six hours.

The CFA Level II Exam is arguably the most difficult of the three and also possibly the most important. It includes some of the most important valuation and analysis techniques that you will use as an analyst. Spend as much time as you can devote to learning the material.

  • It’s all about the Detail

While the first exam seemed a mile wide and an inch deep, the level II exam is a mile deep but covers less breadth. Sure there are still the 18 study sessions covering the same topic areas, but it seemed like only a fraction of the material in each topic was important but that fractional portion went into amazing detail.

Case in point, the financial reporting topic in the level I exam barely scratches the surface with a general description of the statements and how the relate to each other. In the level II exam, you will be looking at the accounting for individual line items within the statements and the calculations can get extremely lengthy. The CFA Level I exam was mostly questions on qualitative concepts, the Level II exam is much more quantitative.

  • Practice the vignette structure

The item-set structure of the CFA Level II exam throws some candidates. While the questions usually appear in the order that information appears in the vignette, it can still be a lot to read and remember.

There are two approaches to the structure. Some candidates prefer to read the questions quickly to get an idea for the information for which they are looking. Then they read through the vignette and underline relevant data. The second approach is to read through the vignette first, underlining data that looks important, and then go through the questions. After having gone through the curriculum and practice problems, you’ll have an idea of important information so it’s not entirely a guessing game.

  • Don’t buy your flashcards

Practice problems are even more important when studying for the Level II exam. The test is very quant-focused and there are quite a few accounting processes that you must remember within the FRA topic area.

Writing down the problems and processes is a much more effective learning technique than simply reading pre-made cards (remember active learning?). After working through the curriculum once, make flashcards for the more difficult and important LOS on your second run. Instead of simply writing the calculation and variables, try to make the cards as much like word problems as possible to simulate the exam. After several runs through your flashcards, you may even try re-writing the ones that are most difficult.

  • You are not alone

Despite being a self-study course, understand that you do not have to go it alone. There are really two tips here. First, you are in the middle of one of the most difficult professional curricula out there. You passed the first exam but it may be hard to see the light at the end of the tunnel. Most candidates approach their breaking point studying for the Level II and you need a support system to get you through. Friends and family are the obvious choice but seek out a couple of candidates as well. Take 15 minutes a week to talk about your studying and motivate each other.

You may also need help getting through some of the intense calculations and accounting within the Level II curriculum. No matter how hard I tried, I could not seem to get through the derivatives material. Whether it’s another candidate or someone with professional knowledge in the topic, it may be helpful to have someone explain it from another perspective.

Half of passing the exams is studying more effectively and not being surprised on that first Saturday in June. Knowing and avoiding some of the biggest mistakes candidates make will put you well ahead and help to get you through to the next exam. We will cover the five most important tips for the CFA Level III exam next week.

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


Help! I passed all three exams but the Institute denied my charter!

“I got that email that every candidate waits for saying that I passed the Level 3 exam and was able to submit my application for membership to the CFA Institute and receive my charter. I was so happy I spent the next hour calling and emailing friends and family. My happiness was quickly turned to pain and disappointment a couple of months later when my application was denied!”

This is an excerpt from an email I received last year in December and is pretty typical of ones I get each year. The problem is almost always the same, lack of approved work experience.

Before you receive your charter and are approved for Institute membership, you must:

  • Pass all three exams
  • Have two sponsors fill out the Institute’s      sponsorship application, one supervisor and one member of the local CFA      society
  • Meet the requirements for 48 months of ‘qualifying’      work experience
  • Pay member dues and sign the Professional Conduct      Statement

The requirement for 48 months of ‘qualifying’ work experience catches more candidates than you would think. The Institute fairly narrowly defines ‘qualified’ and will deny your application if your experience does not fit the mold.

‘Qualifying’ Work Experience
Below is the guidance from the Institute on what is considered ‘qualifying’ work experience.

  • Evaluating or applying financial, economic, and/or statistical data as part of the investment decision-making process involving securities or similar investments (e.g., publicly traded and privately placed stocks, bonds, and mortgages and their derivatives; commodity-based derivatives and mutual funds; and other investment assets, such as real estate and commodities, if these are held as part of a diversified, securities-oriented investment portfolio).
  • Engaged in responsibilities and/or producing work or work product that informs or adds value to those decisions.
  • Supervising, directly or indirectly, persons who practice these activities.
  • Teaching such activities.

The problem is that the definition provided is fairly broad while the actual criteria used in judging applications is more narrow.

In fact, my first application for membership in 2011 was denied for lack of experience. I was denied credit for my three years of work as a financial analyst since my role in the investment decision-making process was not clear.

Follow the Learning Outcome Statements
First, if you are a level one or level two candidate then you’re in luck and still have a few years to get the experience you need. If you are working in a front-office position and you’re job is directly involved in the decision-making process, you’re also in luck and shouldn’t have a problem.

If you do receive that disappointing letter, you can always provide more detail on your job duties. Focus on the learning outcome statements, especially those in the level 3 exam, and how they fit with your job duties. Every company makes investments of resources in projects and most personnel help in the decision-making process in some way. You just have to find your place in the process. After providing more detail on my work experience, including a rewrite of duties more closely related to the exam LOS, I was approved for membership and received my charter.

If you are not approved for membership even after re-applying, it’s not the end of the world. You will be given affiliate member status and will enjoy all the benefits of Institute membership but will not be able to vote. Leverage your ‘charter pending’ status into a job where your duties directly affect the decision-making process and reapply when you meet the 48 months requirement.

‘til next time, countin’ the days to start the 2014 study season
Joseph Hogue, CFA


2014 Level 2 CFA Exam Changes

The changes to the 2014 CFA Level 2 exam are not as extensive as we’ve seen in the past but there are a few important differences. There are seven new readings and a few ones that have been dropped. All the new readings will have new LOS, though they may be similar to past LOS.

If you’re new to the exam, I wouldn’t change my study schedule too much for the curriculum changes but make sure you have a good grasp of the material. Those repeating the exam will want to focus on the new material since most of the old material will be relatively fresh in your mind.

The Standards and ethics material is the same next year as it has been in the past.

The material in quantitative methods (Study Session 3) and economics (Study Session 4) are basically the same, though some of the LOS have been split or combined but this won’t change the ideas or formulas that you need to know.

Study Session 6, Financial Reporting and Analysis, includes the same three readings (19-21) but they have been updated from last year. LOS 21b and 21h-j have been added and require a more detailed understanding of currency transaction exposure and multinational accounting.

Study Session 8, corporate finance, has not changed though some of the LOS have been split, combined or have slightly different wording. Again, these changes really do not affect what you need to study or understand. Focus on the bigger changes.

The Lessons we Learn, reading 22; Study Session 7 has also been updated

Study Session 11, Equity Valuation (Industry and Company Analysis) has seen the most changes with the addition of two new readings; Reading 33, “Your Strategy Needs a Strategy,” and Reading 34, “Industry and Company Analysis.”

The two new readings strike me as very similar to the Five Forces reading, more management-related than the rest of the curriculum. As an analyst, you need to be able to understand business models and management perspective but a lot of this stuff always seemed too theoretical to me. Easy to remember though.

Reading 44, “A Primer on Commodity Investing,” has been added to Study Session 13, Alternative Investments. The material is fairly close to that in the commodities reading that was dropped from the Level 1 curriculum this year. This happens often where the Institute moves the focus of material from one year to another. The LOS in the new reading look fairly basic and it shouldn’t be a problem for candidates.

Fundamentals of Credit Analysis (Reading 42, 2013) in the Fixed Income material has been replaced by Reading 45, Credit Analysis Models in Study Session 14. While the LOS have changed, they appear to cover mostly the same ideas and concepts. If anything, the new LOS are a bit more quantitatively focused.

Credit Derivatives: An Overview (Reading 53, 2013) has been replaced by Reading 56, Credit Default Swaps in Study Session 15. The new material actually looks a little easier because it is more narrowly focused on Swaps rather than all credit derivatives.

Study Session 18, Portfolio Management has also seen some pretty big changes. The Theory of Active Portfolio Management (Reading 55, 2013) has been dropped and two new readings have been added; Reading 58, “Residual Risk and Return: The Information Ratio” and Reading 59, “The Fundamental Law of Active Management.” Both of these new readings turn the focus to a quantitative approach to active management from last year’s focus on theory.

That concludes our review of the changes to the three exams for the 2014 season. We’ve still got a while before you need to start worrying about a study schedule so we’ll probably cover some miscellaneous topics or answer some questions in the coming weeks. Let me know if there’s anything you want covered.

‘til next time, take a break!
Joseph Hogue, CFA


Must Know CFA Level 2 Formulas, part 3

This is the last of three posts covering the must know formulas for the Level 2 CFA exam. In this post we’ll cover study sessions 13 through 18. The other two posts can be found here: part 1 and part 2.

SS13- Alternative Investments

The Learning outcome statements say you need to be able to calculate the value of real estate over all three approaches; income, cost and sales but the focus of the curriculum is clearly on the income approach and understanding net operating income (NOI). The cost and sales approach to valuation are fairly simple. Cost is just the total expense of creating a similar property while the sales approach looks at the square foot value of similar properties that have sold on the open market.

Of the three valuation methods using income, the direct capitalization is the most important though you also need to understand the DCF and multiplier methods. The discounted cash flows method is just like any other DCF where you take the cash flows over the life of the investment along with a terminal value and discount them to a present value. The multiplier method involves multiplying the gross income from a property by a multiple derived from sales data on similar properties.

The direct capitalization approach revolves around finding the net operating income (NOI) and a cap rate which is the rate of return required by investors.

Gross rental income minus vacancy or collection losses is the effective gross income. The effective gross minus (utilities, taxes, insurance, maintenance, management and advertising) equals the NOI.

* Remember –financing costs and federal income taxes are not subtracted for NOI because the value is independent of financing and is a before-tax, unleveraged measure of income. Depreciation is also not removed.

The cap rate will usually be given or you will need to calculate it from sales and NOI data from similar properties. Otherwise, the cap rate can be found by (discount rate minus growth rate) as well.

The property value is then NOI/cap rate.

Understand how to arrive at the NAV of a REIT and calculate the NAV per share as well as the concept of Funds from Operation (FFO) and REIT price multiples. Understand the difference between FFO and bottom-line earnings and why FFO is a better metric for REITs.

NAV per share = (market value of real estate company’s assets – market value of company’s liabilities)/number of shares outstanding.

The private equity section is testable as well with formulas for distributed to paid in (DPI), residual value to paid in (RVPI), and total value to paid in (TVPI). You also need to know the pre-money and post-money valuation as well as the ownership fraction and price per share in venture capital financing.

DPI= sum of distributions/ cumulative capital called down
RVPI = NAV after distributions/ cumulative capital called down
TVPI (also called the investment multiple) is = DPI + RVPI

SS14- Fixed Income Valuation Concepts

Be sure to understand all the financial ratios in credit analysis like: operating profit margin, debt/EBITDA, EBIT or EBITDA to interest expense, and debt/capital.

Understand that the impact on return may be different for small and large yield changes. The impact on return for small, instantaneous changes is (-modified duration)* the change in the spread, while the impact for a large change in yield is (-modified duration*spread change) plus ½ convexity * (change in spread squared).

You may also need to value a callable or putable bond using an interest rate tree.
constructing a binomial interest rate tree.
1)      Given the coupon rate and maturity, use the yield on the current 1-year on-the-run issue for today’s rate.
2)      Assume the level of rate volatility
3)      Given the coupon rate and market value of the 2-year on-the-run issue, select a value of the lower rate and compute the upper rate. R1,u= r1,l * e2volatility

Where:
R1,u is the upper rate (1 reflects the interest rate starting in year 1 and u reflects the higher of the two rates in year 1)
Volatility is the assumed volatility of the 1-period rate

e is the natural antilogarithm, 2.71828
4)      Compute the bond’s value one year from now using the interest rate tree
5)      If the value calculated using the model is greater than the market price, use the higher rate of r1,l and recomputed r1,u and then calculate the new value of the on-the-run issue using new rates. If the value is too low, decrease the interest rates in the tree.
6)      The five steps are repeated with a different value for the lower rate until the value estimated by the model is equal to the market price.

SS15- Structured Securities

Be able to calculate the prepayment amount on a passthrough security given a monthly mortality rate. Remember, the single monthly mortality (SMM) is the prepayment/(beginning mortgage balance – scheduled principal payment)

The annualized SMM is the conditional prepayment rate (CPR) and is 1-(1-SMM)12

SS16- Derivatives: Forwards and Futures

The two study sessions covering derivatives are where the formulas get especially intense. You can’t afford to neglect the material because it is worth between 5% and 15% of your total exam score. Start by understanding the basic concepts behind the formulas to give yourself a chance at an educated guess if you forget the formula itself.

Be able to price equity or fixed-income forward as well as find the value of the contract over its life. Remember, the price of a forward is based on an arbitrage relationship between the contract and the underlying determined by how much it would cost to buy and hold the asset using borrowed funds. Knowing this means that you need the current price, interest rate, any cash flows in or out, and the contract length to be able to calculate the forward contract.  

Forward = (S0 – PV(CF))(1+r)t
You should be able to work through an arbitrage scenario given these data points and the price of a forward contract, first understanding if an arbitrage profit is available then calculating the profit.

Forward rate agreements are also very testable so be able to value a contract. FRA are agreements to pay (or receive) a set interest rate and receive (or pay) a floating rate that is determined at contract expiration.

The payoff on a FRA is = Notational times ( underlying rate at expiration – forward contract rate)(days in underlying rate/360) divided by (1+underlying rate at expiration (days in underlying/360))

It may seem like an intimidating formula but it is really just the difference in rates at expiration multiplied by a time factor relative to the contract length. Make sure you use 360 for the days in a year.

SS17- Derivatives: Options, Swaps, and Rate Derivatives

Being able to calculate synthetic positions using options is a matter of knowing the put-call parity formula.  The relationship says that the value of a call plus the (strike price divided by (1+risk free rate)t) should be equal to the value of a put and the underlying asset.

C0 + (x/(1+Rf)T) = P0 + S0

Rearranging this formula, you can find the price for synthetic positions by putting C0, P0, or S0 alone on one side of the equation.

Be able to calculate the payment to a cap or floor holder.

Payment to cap is the max of either zero or notational*(index rate – cap strike rate)*(days in settlement period/360)

While the payment to the floor holder is the max of either zero or notational*(floor strike rate – index rate)*(days in settlement period/360)

The swaps material can be lengthy and complicated with formulas for the fixed payment, floating payment and for the pricing. Remember that currency swaps involve two different currencies and the notational principal is usually exchanged at initiation.

SS18- Portfolio Management
Portfolio management becomes the focus on the Level 3 exam, so it really pays to learn the material on the second exam to save time next year. The expected return and standard deviation on a two-asset portfolio is a common question and fairly easy. Remember that the return is just the weighted returns of the assets while you’ll need the variance and correlation coefficient for the standard deviation.

Varianceportfolio = w2121+w22 σ22+ 2w1w2(correlation) σ1 σ2
*Remember to take the square root of the variance to get the standard deviation.

Also be able to calculate the expected return on an asset given factor sensitivities and factor risk premiums, which is basically just a regression-type formula.

The formulas in these three posts should get you started on the list of most likely to show up on the exam. While you cannot take a formula sheet into the test with you, it’s a good idea to write one up just to practice the formulas and commit them to memory.

A little over a week left to the exam. 
‘til next week, happy studyin’
Joseph Hogue, CFA


Must Know CFA Level 2 Formulas, part 2

We covered the first five study sessions worth of formulas in last week’s post and will continue with study sessions 6-12 this week. Again, this is not a complete list of every calculation you will need on the Level 2 exam but the formulas in the curriculum that stand out to me as particularly important. At a minimum, you should know these and the conceptual material surrounding their assumptions and strengths/limitations.

SS6- FRA Intercorporate Investments, Post-Employment and Share-based Compensation, and Multinational Operations

Most of the FRA material is more knowing the accounting and procedures rather than complex formulas. Once you know what adjustments or expenses to be made to a beginning entry then the calculations are really little more than addition/subtraction.

The pension material is important here and you’ll see the same accounting in the next exam as well. Be able to calculate the defined benefit pension obligation and the net pension liability or asset. For the ending DBO = Beginning + Service Cost + Interest Cost +/- Past service cost from current amendments +/- actuarial gains or losses in the current period – benefits paid

Be able to calculate the pension expense and economic pension expense as well.

The translation effects on the balance sheet and income statement through the temporal and current rate methods is something that has been in the curriculum for a while and often appears on the exam. Remember, the gains and losses from the use of the temporal method go directly to the income statement whereas the gains/losses from the current rate method go to the CTA in the stockholders’ equity section of the balance sheet. The balancing ‘plug’ number for the current rate method is the cumulative translation adjustment while the plug number for the temporal method is retained earnings and the gain from translation on the income statement.

SS7  – FRA Earnings Quality Issues and Ratio Analysis
This is mostly a conceptual reading with some basic ratios and no real formula work

SS8- Corporate Finance

Economic profit is a fairly important formula here with the other formulas (i.e. market value added, residual income) also easily testable and seen in other sections of the exam. Economic profit is the excess earned over the dollar cost of capital invested.

  • EP = NOPAT – SWACC
    • NOPAT = Net operating profit after tax, EBIT (1-tax rate)
    • SWACC  = dollar cost of capital, WACC* Capital
  • Market Value Added (MVA) is the NPV calculation of Economic Profit

Be able to calculate dividends under three dividend policies: Stable, constant dividend payout ratio, and residual.

  • Under the stable dividend policy, a payout is set for long term and the target payout ratio is used to find the expected increase. The expected increase is the increase in earnings times the target ratio times an adjustment factor (the reciprocal of the number of years to adjust the dividend)
  • Under the constant payout ratio policy, the dividend fluctuates with net income and may be volatile.
  • Under the residual policy, dividends = earnings – (capital budget*equity % in capital structure)

SS9- Corporate Finance: Financing and Control
The post-merger EPS is the acquirer’s pre-merger earnings plus the target’s pre-merger earnings divided by the post-merger shares outstanding. Remember that the acquirer may have to issue new shares equal to the target’s market cap divided by the acquirer’s stock price.

The Herfindahl-Hirshman Index is something that comes up frequently but really isn’t too difficult. Just take each firm’s market share times 100 and then squared, then add them all up. Realistic numbers are usually above 500 up to 3,000 so make sure you check your answer.  You’ll need to remember the three levels of concentration and the likelihood of an antitrust challenge (i.e. < 1,000, 1,000- 1,800, >1,800)

You may need to calculate the free cash flows for a target company through NOPLAT. NOPLAT is the unlevered net income plus any change in deferred taxes. FCF = NOPLAT + Noncash charges – changes in net working capital – capex. Don’t forget to discount the FCF to a present value using the appropriate rate.

SS10- Equity Valuation
The weighted average cost of capital is a fairly easy calculation but can cost you points if you rush through it. Don’t forget to use the after tax cost of debt, rate (1-tax rate). It is usually preferred to use the target weights for capital structure rather than the current market value weights when finding WACC.

SS11- Industry and Company Analysis
There are some extremely important and testable formulas in this reading. You should be able to work the dividend discount model solving for any one of the variables in case they ask for the discount rate or the dividend growth rate. Remember, the Gordon growth model is a DDM under the constant growth assumption while the H-model or the multi-stage models assume different growth rates.

Under the Gordon growth, value = (current dividend * (1+growth rate)) divided by the required rate minus growth

The H-model is taking a basic DDM (initial dividend rate divided by rate minus long-term growth) but multiplies in a bonus because of supernormal growth (the difference in rates times half the years plus the long-term growth rate). The second part of the equation is a mathematical attempt at estimating a linear (straight line) decline in growth.

Be able to decompose the return on equity in a DuPont Analysis down to its most basic pieces.

ROE = NI/Sales  * Sales/Total Assets * Total Assets/Shareholders’ Equity

If you forget, just remember that ROE is NI/Equity so all the other variables must cancel out (i.e. sales is denominator in NI/Sales and numerator in Sales/Assets). Remember that these are also net profit margin * asset turnover* leverage.

SS12- Valuation models
Free cash flow is an extremely important measurement and you will need it extensively in the equity section of the exam, especially at level II. It represents the cash available to either equity investors or all capital providers after all working capital and fixed capital needs have been accountable. Basically, it is the extra cash available to owners (of debt or equity) after the company’s future operations have been funded.

Free Cash Flow to the Firm (FCFF) is the cash flow available to all capital providers (debt and equity) and equals:

Net income + Net noncash Charges (depreciation and amortization) – Investment in working capital – Investment in Fixed capital + after tax interest expense

Free Cash Flow to Equity (FCFE) is the cash flow available to common shareholders and equals:

Net income + Net noncash Charges (depreciation and amortization) – Investment in working capital – Investment in Fixed +/- net borrowing

  • Notice that FCFE is FCFF except without adding back interest expense and taking net borrowing into account.
  • Understand how to arrive at FCFE or FCFF with CFO
  • FCFF = CFO + INT (1-t) – invest fixed capital
  • FCFE= CFO – invest fixed capital +/- net borrowing

Be able to understand and calculate price multiples like price/earnings, price/book, price/sales, and price/earnings to growth on a trailing and forward basis.

Enterprise value multiples like EV/EBITDA or EV/Sales are important along with the other price multiples. Remember, Enterprise Value is market value equity + market value preferred + market value debt – cash & investments.

In its most basic form residual income is net income minus an equity charge or just the income remaining after a theoretical cost of the equity used.  Net Income – (equity capital*cost of equity)

You may see the calculation including NOPAT which is Net Income + the after tax interest expense so be ready for RI = NOPAT- (WACC*Total Capital) as well.

The valuation model using residual income and book value can be lengthy but is absolutely necessary to learn. Go through a couple of examples until you are sure you have it down for the test.

We’ll conclude the Level 2 must know formulas on Friday with study session 13-18. Let me know if you have any questions or think I missed an important formula.

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


Which formulas are the most important for the CFA Level 2?

There are a ton of formulas you need to know for the Level 2 exam. For me, as with others, it is the most quantitatively intensive test I’ve ever taken.

But do you really need all those formulas, and how do you memorize so much in such a quick time?

In this post and continued through the next two Tuesdays, we’ll look at the most important formulas in the second exam and how to approach the massive amount of material. The usual disclaimer applies, while I have been writing on the exams for quite a while and took them myself, no one knows what will actually show up on the exam. All the curriculum is testable. I can only tell you what I have seen through my own experience and what I have seen on successive versions of the curriculum over the last four years.

We’ll start with a general approach to the formulas then look at each study session to pick out the most important formulas.

Remembering every single calculation from the curriculum is not practical for most candidates and it does seem that the Institute targets some material as more important than others. That said, it is extremely easy to get into the punter’s trap. I call the punter’s trap where you find a tough formula and decide to skip it and focus on easier points instead. Something like punting in football instead of going for the extra yardage. The problem is, once you start doing this it gets easier to do it again and again. Pretty soon, you are skipping a good portion of the curriculum and you are guaranteed some lost points on the exam. Spend the time and get these formulas down.

There’s two things you can do to help get through the tough formulas.

  • First, you need to understand what is conceptually happening in the formula. Trying to understand the myriad of symbols is crazy. If  WACC = (Vd/(Vd +Vce))rd (1-t) + (Vce/(Vd+Vce))rce) doesn’t make you go cross-eyed you are a stronger person than I am. Think about it intuitively and it makes sense. The overall cost of a firm’s funding capital is the cost and proportion of equity and debt. The percentage of each funding type relative to the total is multiplied by its cost. Debt is tax advantaged, so you need the after-tax cost.
  • Secondly, you have to work these formulas through practice and repetition. One of the most popular posts here shows that active learning (engaging the material through practice and conversation) allows you to remember much more than passive learning. The best way to approach tough formulas is to put them on flash cards. Write out a full practice question like those at the end of the chapters. Then work the questions each day. When you are able to do one easily, put it aside so the time necessary each day decreases. You will want to review them all every couple of weeks to make sure you haven’t forgotten any.

We’ll go through each study session to look at the high level important questions but make sure you are doing the end-of-chapter and blue-box questions in the curriculum. If the Institute is taking the time to write out a problem, then they want you to know the formula and you could see it on the exam.

There are no calculations in the first two study sessions, just ethics material but this is extremely important to your overall grade so you may want to review our posts on ethics and standards.

SS2/3 – Quantitative Methods
You need to know how to calculate the sample covariance and correlation coefficient. Learn the basics of the formula but you can do both of these on your calculator so learn how to input the data and you’ll save a lot of time.

You need to know how to calculate a value for a regression model, which is pretty easy by just plugging the numbers into the variables in the formula. The correlation coefficient is just the covariance divided by the standard deviations of each variable. Ryx = COVyx/sysxwith the covariance being the sum of the differences (y- average y)(x – average x) divided by the sample size minus one.

Remember, the slope estimate (b1) is the covariance divided by the variance. What gets most candidates is the various statistics on the ANOVA chart so learn the parts and be able to interpret their meaning.

Predicting the value of a time series or the autoregressive model is similar to the regression model, just plug in the numbers. Be sure you can work a formula with a seasonal lag as well. You may also need to calculate a mean reverting level.

SS4 – Economics
Forex can be tough, especially with the confusion around direct and indirect quotes. You need to be able to calculate the bid-ask spread as well as calculate the profit on a triangular arbitrage. I have included two video explanations to get you started.

A good explanation of Bid and Ask quotes is available on YouTube at:
http://www.youtube.com/watch?v=PmjUx8ZcsoY

Cross rates and arbitrage are easily testable and will really test whether you understand forex quotes and calculations. A good explanation of triangular arbitrage is available on YouTube at:
http://www.youtube.com/watch?v=FElk-K1vb_I

The forward premium or discount on a currency is just the relative difference between the forward and spot price (Fxy – Sxy)/ Sxymultiplied by the annualized time in the contract (12/# of months until settlement)

Interest rate parity is an important concept and the formula is fairly easy. It’s just the relative interest rates (1+rx/1+ry) times the spot price.

SS5 – FRA Inventories and Long-term Assets
You’re required to calculate the effect of inflation or deflation on inventory costs and ratios but I see this as more a conceptual problem. Understand what affect inflation or deflation has on the LIFO or FIFO methodologies and you’ll be fine.

We’ll cover study sessions 6-12 in the post next Tuesday and the remaining sessions in the post after that. We’ll be using the other posts through the next couple of weeks to review strategies for the exams and how to prepare.

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