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

1.    Multi-Stage Dividend Discount Models

1.1.         Two-Stage DDM

a.  This model makes use of two growth rates; a higher initial growth rate for a finite period and then low growth perpetuity.

b.  For the latter, i.e. the low growth rate perpetuity, the intrinsic value can be estimated using Gordon’s Growth Model called the terminal value.

c.  For the first part, we can explicitly discount the value of all the dividends during the period along with the terminal value, calculated in the previous step to find the intrinsic value of the stock.

d.  Thus the intrinsic value as per a two-stage DDM would be:

two-stage DDM formula Equity Investment CFA Level 1 Study Notes

Where,

Vn        =

gs              = initial slower growth rate.

gL             = longer-term growth rate

r           = required rate of return

 

For Example:

Suppose there is a stock, which is currently paying a dividend at $ 1 per year per share. This dividend is expected to grow at 8% per annum initially for the next 3 years and then at the rate of 4% per annum, infinitely. The required rate of return of the stock is 10%. We have to calculate the intrinsic value of the stock.

We are given the following information:

Particulars

Value

D0

$ 1

gs

8%

gl

4%

R

10%

The intrinsic value of the stock would be:

two-stage DDM formula Equity Investment CFA Level 1 Study Notes

We, therefore, calculate the terminal value at the end of the third year (i.e. Vn) first.

V3        =  (Dn+1) / (r – gL)

= [1 × (1 + 0.08)3 × (1 + 0.04)1] / [0.10 – 0.04]

 = $32.75

Now we can calculate the intrinsic value of the stock today as follows:

V0 = [1 × (1 + 0.08)1 / (1 + 0.10)1] + [1 × (1 + 0.08)2 / (1 + 0.10)2] + [1 × (1 + 0.08)3 / (1 + 0.10)3] + [32.75 / (1 + 0.10)3]

= $ 27.50

 

1.2.         Multiple Stage Model

The two-stage model can be extended in a similar fashion to accommodate for the change in growth rates multiple times, till it becomes stable in the long run.

2.    Identifying Appropriate Model for The Companies

The model that is most appropriate for a company depends on the level of growth, maturity, and nature of the company. The valuation models and the list of companies for which they are most suitable are:

a.  The Constant Growth Model. This model is most suitable for:

     i.  the companies with stable growth,

    ii.  the companies at the maturity phase,

   iii.  non-cyclical companies, and

   iv.  the dividend-paying companies.

b.  The Two-Stage DDM. This model is most suited for the companies at the maturity stage that are expecting a transition. It is mainly for the older companies out of a growth stage or a revitalized company.

c.  The Three-Stage DDM. This model is best suited for fairly young companies that are about to enter the growth stage. These companies can expect three stages, i.e. growth, transition, and maturity.

 

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