Level II Review Equity Valuation

Study session 10 in the Level II CFA Program curriculum begins the material on equity valuation. The topic represents the single biggest percentage of your Level II CFA Program score at 20% to 30% and some fairly difficult concepts. The session, the first of three, includes two readings (30-31).
Equity Valuation: Applications and Process
The reading is a basic introduction to the industry of equity valuation. It starts with some basic definitions that appear elsewhere and most candidates will already have seen.
Porter’s Five forces is pretty easily testable so you should have a good understanding of each and how it relates to industry analysis. Beyond the exam, the concept is pretty well known in the business world and you’ll need to know it sooner or later.

  • Greater rivalry (competition) within the industry means lower profitability as companies compete on price and brand identification.
  • The higher the threat of new entrants the lower profitability will be as companies lower prices to avoid attracting competitors. Barriers to entry like high capital expenses or regulation important here.
  • The lower the threat of substitutes the higher the profitability as companies can exercise more control on prices. Pay attention to switching costs for consumers.
  • Bargaining power of buyers is relative to the number of consumers and relative size of each for the product.
  • Bargaining power of suppliers is relative to the number of suppliers for an input and how easily it is to switch suppliers.

Understand the difference between the competitive strategies: cost leadership, differentiation, and focus.
Probably the most important material here is the different valuation models. Besides being able to calculate each, be aware of the advantages/limitations of each.  Absolute valuation models specify an asset’s intrinsic value and provide a point estimate (dividend discount, FCFF, FCFE, residual income, and asset based valuation). Relative valuation models compare the asset’s value with a benchmark or with peers (price multiples, enterprise multiples). Relative models are simple and use less assumptions but do not provide an estimate of intrinsic value. A stock may be cheap relative to peers but very expensive if the whole market or sector is overvalued.
Return Concepts
The reading is more quant focused but still fairly basic. There is some extremely important foundational concepts here so you want to spend the time to master the material.  You will have already seen some of the material, i.e. discount rates, IRR, required return, and arithmetic vs. geometric means.
The Capital Asset Pricing Model (CAPM) is hugely important (Sharpe, Markowitz, and Miller were awarded the Nobel Prize in Economics for its development) and appears across the curriculum. Understand the assumptions of the model: risk averse investors that make decisions based on mean return and variance and that only systemic risk is important.
Within the CAPM equation, you will need to be able to calculate the adjusted beta which is just 2/3 of the historical beta plus 1/3. Be able to estimate a beta for a nonpublic company using comparables as well.
Understand the types of multifactor models and their appropriate factors: Fama-French (market, size, value), Pasor-Stambaugh (market, size, value, liquidity), BIRR (confidence, time horizon, inflation, business cycle, market timing).
Understanding and calculating the Weighted Average Cost of Capital is also a foundational concept that you will need to master. The concept is pretty intuitive, a firm’s cost of capital (spending) is a weighted average of the cost from each source (debt or equity). Debt is normally less expensive and tax shielded but can be risky at high amounts.
Use the market value of debt or equity when available. Remember, the company’s capital structure may change over time so it is preferable to use target weights instead of current market value weights.
Study session 11 in the Level II CFA Program curriculum continues the material on equity investments with industry analysis and begins some bottom-up concepts.
‘til next time, happy studyin’
Joseph Hogue, CFA

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