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.    Price Multiples

a.  Price multiples are the ratios that compare the share price with some sort of money flow or value.

b.  The monetary flow can be in the form of earnings, sales, or cash flows. The value multiples, on the other hand, can be in the form of book value.

c.  Some of the common price multiples and their respective formulas are:

Price Multiple Ratios

Formula

Advantages of this ratio

Disadvantages of this ratio

Price-Earnings Ratio (P/E Ratio)

 P0 / (EPS)

·       Easy to use;

·       Most common measure for appropriateness of price of the stock; and

·       Strongly correlated to long-term returns

·       Useless if the EPS is less than zero;

·       Useless if the earnings are volatile; and

·       Earnings are just an accounting measure and not the economic measure of the profitability of a company.

Price-Sales Ratio

 P0 / (Sale per share)

·       This multiple is less affected by the accounting choices made by the management, thus less biased.

·       This is a better metric if the EPS is less than zero.

·       The management bias may still creep in, as the revenue recognition issues still apply to this method as well.

·       This method ignores the cost structure of the company.

Price-Cash Flow (P/CF) Ratio

P0 / (Cashflow per share)

·       This is a better economic measure than just being a mere accounting measure.

·       The cash flows are more difficult to manipulate, thus less subject to any sort of bias.

·       The cash flow tends to be less volatile than the EPS.

·       This multiple is more reliable in the longer run.

·       This method ignores the non-cash revenues.

Price-Book Value (P/BV) Ratio

 P0 / (Book Value Per Share)

·       This is a more stable measure.

·       This multiple can also be used even if the EPS is negative.

·       This multiple is more appropriate for the firms in distress

·       This method ignores the relative asset size in comparison.

·       The book value is generally equal to the market value.

d.  These ratios are calculated for the required companies or stocks and compared with the specified value such as the industry standards, historical data, etc. If the ratio is less than the specified value, the stock is considered as undervalued; if it is equal to the specified value, the stock is valued fairly; and if it is greater than the specified value, the stock is considered as overvalued.

e.  We know that as per Gordon’s Growth Model,

Gordon Growth Model Formula Equation Equity Investment CFA Level 1 Study Notes
Now, for a stock to be considered fairly valued, its intrinsic value i.e. V0 should equal its market price, i.e. P0. Therefore,

Equity Investment CFA Level 1 Study Notes
If we divide both sides by EPS, we get:

Deriving P/E Ratio Equity Investment CFA Level 1 Study Notes
Here, is the P/E multiple and represents the dividend payout ratio (or DPR).
Thus, to be considered fairly price or justified,

PE Ratio Formula Equity Investment CFA Level 1 Study Notes
This is also called the justified P/E ratio.

e.  So, if we go by the above equation, the P/E multiple is positively related to:

     i.  DPR (This is only if we strictly go by the formula or the above equation of P/E multiple. In reality, however, the higher the DPR, the lower is the retention and the re-investment rate; so there is a dividend displacement of earnings.)

    ii.  g. Thus, the closer the growth rate is to the required rate of return, the higher is the price and thus a higher P/E multiple.

f.  The P/E multiple is negatively correlated to the required rate of return on equity.

g.  The analyst can choose the best-suited multiple for a company or a stock. He may even choose to have multiple, multiples and then compare them with a benchmark value, typically called the ‘comps’.
This benchmark value can be obtained from:

     i.   the values of a closely matched individual stock,

    ii.  average values of the peer group or the industry,

   iii.  average multiple derived from the trend or the time-series analysis.

The main rationale behind comparing the multiples of one company with the benchmark is the ‘Law of One Price’. According to this law, identical assets should sell for the same price.

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