Level II Review Equity Investments

Study session 11 in the Level II CFA Program 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 Level II CFA Program 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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