Course Content
MARKET ORGANIZATION AND STRUCTURE
This chapter is covered in Reading 36 of Study Session 12 of the institute. After reading this chapter, the candidate should be able to: a. explain the main functions of the financial system; b. describe classifications of assets and markets; c. describe the major types of securities, currencies, contracts, commodities, and real assets that trade in organized markets, including their distinguishing characteristics and major subtypes; d. describe types of financial intermediaries and services that they provide; e. compare positions an investor can take in an asset; f. calculate and interpret the leverage ratio, the rate of return on a margin transaction, and the security price at which the investor would receive a margin call; g. compare execution, validity, and clearing instructions; h. compare market orders with limit orders; i. define primary and secondary markets and explain how secondary markets support primary markets; j. describe how securities, contracts, and currencies are traded in quote-driven, order-driven, and brokered markets; k. describe characteristics of a well-functioning financial system; l. describe objectives of market regulation.
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LOS A: Main Functions of Financial System
LOS B: Classification of Assets and Markets
LOS C: Types of Assets
LOS D: Financial Intermediaries
LOS E: Positions of Investors
LOS F: Margin
LOS G and H: Order Types
LOS I: Primary and Secondary Markets
LOS J: Trading
LOS K: Well Functioning System
LOS L: Objectives of Market Regulations
SECURITY MARKET INDEXES
This chapter is covered in Reading 37, of Study Session 12 of the material provided by the institute. After reading this chapter, a student should be able to: a. describe a security market index; b. calculate and interpret the value, price return, and total return of an index; c. describe the choices and issues in index construction and management; d. compare the different weighting methods used in index construction; e. calculate and analyze the value and return of an index given its weighting method; f. describe rebalancing and reconstitution of an index; g. describe uses of security market indices; h. describe types of equity indices; i. describe types of fixed-income indices; j. describe indices representing alternative investments; k. compare types of security market indices.
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LOS A: Security Market Index
LOS B: Index Return
LOS C: Index Construction
LOS D and E: Index Weightings
LOS F: Rebalancing and Reconstitution of Indices
LOS G: Uses of Security Market Indices
LOS H: Types of Equity Indices
LOS I: Fixed Income Indices
LOS J and K: Alternative Investment’s Indices
MARKET EFFICIENCY
This chapter is covered in Reading 38, of Study Session 12 of the material provided by the institute. After reading this chapter, a student should be able to: a. describe market efficiency and related concepts, including their importance to investment practitioners; b. distinguish between market value and intrinsic value; c. explain factors that affect a market’s efficiency; d. contrast weak-form, semi-strong-form, and strong-form market efficiency; e. explain the implications of each form of market efficiency for fundamental analysis, technical analysis, and the choice between active and passive portfolio management; f. describe market anomalies; g. describe behavioral finance and its potential relevance to understanding market anomalies.
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LOS A: Market Efficiency
LOS B: Market Value Vs. Intrinsic Value
LOS C: Factors That Affects the Market Efficiency
LOS D and E: Weak, Semi-Strong, & Strong Form of Market Efficiency
LOS F: Market Anomalies
LOS G: Behavioral Finance
OVERVIEW OF EQUITY SECURITIES
This topic is covered in the reading 39 of study session 13 of the study material provided by the institute. After reading this chapter a student should be able to: a. describe characteristics of types of equity securities; b. describe differences in voting rights and other ownership characteristics among different equity classes; c. distinguish between public and private equity securities; d. describe methods for investing in non-domestic equity securities; e. compare the risk and return characteristics of different types of equity securities; f. explain the role of equity securities in the financing of a company’s assets; g. distinguish between the market value and book value of equity securities; h. compare a company’s cost of equity, its (accounting) return on equity, and investors’ required rates of return.
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LOS A and B: Equity Securities
LOS C: Public & Private Equity Securities
LOS D: Non-Domestic Equity
LOS E: Risk and Return Characteristics of Different Types of Equity Securities
LOS F: Role of Equity Securities in Financing of Company’s Assets
LOS G: Market Value Vs. Book Value
LOS H: Cost and Return on Equity
INTRODUCTION TO INDUSTRY AND COMPANY ANALYSIS
This topic is covered in reading 40 of study session 13 of the study material provided by the institute. After reading this chapter a student should be able to: a. explain uses of industry analysis and the relation of industry analysis to company analysis; b. compare methods by which companies can be grouped, current industry classification systems, and classify a company, given a description of its activities and the classification system; c. explain the factors that affect the sensitivity of a company to the business cycle and the uses and limitations of industry and company descriptors such as “growth,” “defensive,” and “cyclical”; d. explain how a company’s industry classification can be used to identify a potential “peer group” for equity valuation; e. describe the elements that need to be covered in a thorough industry analysis; f. describe the principles of strategic analysis of an industry; g. explain the effects of barriers to entry, industry concentration, industry capacity, and market share stability on pricing power and price competition; h. describe industry life cycle models, classify an industry as to life cycle stage, and describe limitations of the life-cycle concept in forecasting industry performance; i. compare characteristics of representative industries from the various economic sectors; j. describe macroeconomic, technological, demographic, governmental, and social influences on industry growth, profitability, and risk; k. describe the elements that should be covered in thorough company analysis.
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LOS A: Industry Analysis
LOS B and C: Grouping and Classification of Company
LOS D: Peer Group
LOS E: Components of Industrial Analysis
LOS F: Principles of Strategic Analysis of Industry
LOS G: Effects of Various Factors
LOS H: Life Cycle Models
LOS I and J: Industry Comparison
LOS K: Elements of Thorough Company Analysis
EQUITY VALUATION: CONCEPTS AND BASIC TOOLS
This topic is covered in reading 41 of study session 13 of the study material provided by the institute. After reading this chapter a student should be able to: a evaluate whether security, given its current market price and a value estimate, is overvalued, fairly valued, or undervalued by the market; b describe major categories of equity valuation models; c describe regular cash dividends, extra dividends, stock dividends, stock splits, reverse stock splits, and share repurchases; d describe dividend payment chronology; e explain the rationale for using present value models to value equity and describe the dividend discount and free-cash-flow-to-equity models; f calculate the intrinsic value of a non-callable, non-convertible preferred stock; g calculate and interpret the intrinsic value of equity security based on the Gordon (constant) growth dividend discount model or a two-stage dividend discount model, as appropriate; h identify characteristics of companies for which the constant growth or a multistage dividend discount model is appropriate; i explain the rationale for using price multiples to value equity, how the price to earnings multiple relates to fundamentals, and the use of multiples based on comparables; j calculate and interpret the following multiples: price to earnings, price to an estimate of operating cash flow, price to sales, and price to book value; k describe enterprise value multiples and their use in estimating equity value; l describe asset-based valuation models and their use in estimating equity value; m explain the advantages and disadvantages of each category of the valuation model.
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LOS A : Intrinsic Value and Market value
LOS B: Categories of Equity Valuation Model
LOS C: Dividends, Stock Splits, and Share Repurchases
LOS D: Dividends Payment Chronology
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LOS E: Present Value Models
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LOS F: Intrinsic Value of Non-Callable Non-Convertible Preferred Stock
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LOS G: Gordon Growth Model
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LOS H: Multi-Stage Dividend Discount Models
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LOS I and J: Price Multiples
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LOS K: Enterprise Value Multiples
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LOS L: Asset Based Valuation
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LOS M: Advantage and Disadvantages of Each Model
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Equity Investments
About Lesson

Present Value Models

a.  The main rationale behind using this model is that the intrinsic value of a security is the present value of all the future dividends receivable from it.

b.  The consumption is deferred today by the investors to have the benefits at some future point in time, and these future benefits are discounted using the expected rate of return to get its present value.

c.  The simplest form of the present value model is the dividend discount model (DDM). As per this model, the value of the share is calculated as follows:

Dividend Discount Model Formula Equity Investment CFA Level 1 Study Notes

Where,

            V0        = Value of share today.

            Dt             = Expected Dividend in the year t.

            r           = required rate of return.

The required rate of return used in this model is usually calculated using the CAPM or Capital Asset Pricing Model. As per CAPM, the required rate of return is calculated as follows:

Capital Asset Pricing Model CAPM formula Equity Investment CFA Level 1 Study Notes

Where,

re              = required rate of return

rf               = risk-free rate

β          = beta coefficient

rm         = market return

e.  If there is a single holding period, i.e. the security would be held for only one period (here t=1). The securities in these cases are sold at the end of period one. The value of such securities at the beginning of the period is the discounted value of the dividend receivable one year hence plus the discounted value of the price it would fetch when it would be sold in the market. In the form of an equation it can be written as:

single holding period return formula Equity Investment CFA Level 1 Study Notes

Where,

Dt        = Dividend at the end of period t

Pt              = Price at the end of period t

Where t is usually 1.  

And the price of the security at the time t is:

price of the security at the time t Equity Investment CFA Level 1 Study Notes

f.  If there are multiple holding periods, i.e. t >1, the value of the security at the time zero is the discounted value of all the future dividends and the price it would fetch when sold. Thus the value of the security would be:

Multiple Holding Period Return Formula Equity Investment CFA Level 1 Study Notes

We can also write this equation as:

Multiple Holding Period Return Comprehensive Formula Equity Investment CFA Level 1 Study Notes

f.  All three equations, whether of the basic model, or single-period model, or the multiple period models; all give the same value of the security. This is mainly because, in the latter two models, the price at which the security is expected to be sold is nothing but the discounted value of all the future cash flows starting at time t.

Free Cash Flow to Equity

a.  This model is like the dividend discount model, discussed above; except for a significant change that free cash flow to equity replaces dividends in this model.

b. The free cash flow to equity reflects the dividend-paying capacity of the company and not the actual dividends paid. Thus, it is most useful for the non-dividend paying stocks and the companies with a high capital reinvestment opportunity.

c.  The value of the firm as per this model is:

value of the firm as per FCFE Model Equity Investment CFA Level 1 Study Notes

Where,

CFO    = Cash flow from operations

CFInv    = Capital Expenditure

FCFE is nothing but free cash flow to equity, it can be calculated using the following formula:

Free cash flow to equity Equity Investment CFA Level 1 Study Notes

Where,

            V0        = Value of share today.

            FCFEt   = Free cash flow to equity in the year t.

            r           = required rate of return.

d.  Here also the r, i.e. the risk-free rate is calculated using the CAPM as follows:

Capital Asset Pricing Model CAPM formula Equity Investment CFA Level 1 Study Notes

Where,

rf                                 = risk-free rate is the rate of return on government bond or company bond yield.

β(rm– rf)           = market risk premium and is subject to economic judgment.

 

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