Level I Review, Equity Investments

Study session 14 in the Level I CFA Program curriculum concludes the equity topic area with three readings (49-51) on valuation of equity securities. The topic area is arguably one of the single most important in the entire curriculum. It is worth 10% of your Level 1 exam, about 25% of your Level 2 test and 10% of your last exam. As with most of the curriculum throughout the first exam, you will need a strong base to be able to move into deeper detail for the other exams.
Overview of Equity Securities
This is a very basic reading and almost entirely conceptual. Look for the list material and any comparisons with other types of investments, i.e. the differences between debt and equity.
Understand the differences between common and preferred shares like: payment order of dividends, distribution of net assets in a liquidation, and voting rights.
The characteristics of a depository receipt and the types of ADRs is important. You probably won’t need the full detail on types of ADRs but remember that Level  II and III are traded on the exchanges. Level I ADRs are subject to limited reporting requirements and only trade on the OTC market. Regulation S depository receipts are not subject to registration requirements and are only privately placed.
Understand the basic return and risk characteristics of equities, pay attention to standard deviation.
The material on ROE, the cost of equity and investors’ required rates of return is probably the most important in the reading. These will be fundamental concepts across the three exams. Understand how to use the DuPont formula to analyze the sources of changes in a company’s ROE.
Introduction to Industry and Company Analysis
Writing blog entries for the 18 study sessions across the three exams, I am struck with a sense of déjà vu because the same concepts reappear so many years. You will revisit industry and company analysis in both the Level 2 and 3 exams. I know you are tired of studying and trying to find time as it is but spending a little extra time on the Level 1 curriculum to absolutely master the material will pay off big time in the next two years.
Understand the differences between cyclical and non-cyclical companies like stability of demand for products/services and variability in profits due to fixed costs. Understand the basic differences between the sectors, i.e. basic product category and demand stability. If it helps, you might try looking at the fact sheet to the Select Sector SPDRs ETF funds which provide descriptions of each sector.
Porter’s Five Forces Framework is something you will see again so you need to understand it in detail. Understand each of the five forces 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.

The Industry Life Cycle model is also pretty testable so understand the stages (embryonic, growth, shakeout, mature, and decline) and characteristics of each.
Equity Valuation: Concepts and Basic Tools
Understand the differences and advantages/limitations of each of the three major categories of valuation models:
1)      Present value or DCF models provide an intrinsic value estimate of the shares as the sum of future cash flows.

  1. Understand the Gordon growth model and its assumptions, i.e. growth remains constant indefinitely, dividends grow at a constant rate, and the growth rate is less than the required rate of return. A multi-stage DDM is necessary when growth is not constant.
  2. Pay attention to the FCFE model and how it can be used on non-dividend paying stocks

2)      Market multiple models estimate value through a multiplier with earnings, sales, enterprise value or asset-values. These can be applied on a trailing or forward basis.

  1. These are fairly easy to understand but you need to know the limitations, i.e. the multiples are based on trailing (past) data and may not be a good predictor of the future, the multiples reflect relative valuation compared to peers or the index but not intrinsic value.
  2. Understand the difference between the trailing multiple (past data) and the justified (forward) multiple which is based on forecasted data.

Enterprise value is the market cap plus market value of preferred and debt minus any cash and short-term investments. It reflects the real economic value of the company and is helpful when comparing companies with different capital structures.
Study session 15 in the Level I CFA Program curriculum begins the fixed income topic area with four readings.
‘til next time, happy studyin’
Joseph Hogue, CFA


If it’s your desire to be the best
Please take the CFA Program Test.

Read more

Editable Excel Study Plan – Send to Your Inbox

Send Microsoft Excel + PDF files of CFA Program Study Plan to Your Inbox

Manage your subscriptions

CFA exam study material

For general inquiries, please write to us at info@finquiz.com. For pre-sales inquiries, get in touch at sales@finquiz.com.

CFA Institute does not endorse, promote or warrant the accuracy or quality of FinQuiz. CFA® and Chartered Financial Analyst® are registered trademarks owned by CFA Institute. BA II Plus is registered trademark owned by Texas Instruments.

Copyright © 2008-2018 FinQuiz:CFA Exam Prep. All rights reserved.
Terms and Conditions | Privacy Policy | info@finquiz.com

Limited-time discount!| Savings of 50% | Code GET50OFF 16 Days 9 Hours 12 Minutes 59 Seconds