Last Revised: 06/19/2023

2024 Level 1 - Equity Investments

Learning Modules Page

Market Organization and Structure 2

Security Market Indexes 21

Market Efficiency 35

Overview of Equity Securities 45

Company Analysis: Past and Present 56

Industry and Competitive Analysis 68

Company Analysis: Forecasting 75

Equity Valuation: Concepts and Basic Tools 83

Review 101

This document should be used in conjunction with the corresponding learning modules in the 2024 Level 1 CFA® Program
curriculum. Some of the graphs, charts, tables, examples, and figures are copyright 2023, CFA Institute. Reproduced and
republished with permission from CFA Institute. All rights reserved.

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 Last Revised: 06/19/2023

Market Organization and Structure

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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Main Functions
LOS a
- of the Financial System
- explain
1) Facilitate the transfer of:
- capital between providers and users of capital
- risk between those who don’t want it to those willing
to accept it

2) Price Discovery - rates of return so that I = S

3) Facilitate the efficient allocation of capital

LOS a
1) Facilitate transfers - explain

1) Saving - move money to the future

- requires someone else willing to pay (borrow)
Sources ⇒ individuals, business, gov’t.

2) Borrowing - move money to the present

- requires someone else willing to provide (save)
Sources ⇒ individuals, business, gov’t.

3) Raise Equity Capital - indirect investing

- financial claim on assets

4) Managing Risks - hedging, insurance

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LOS a
1) Facilitate transfers - explain
5) exchange assets (on the spot)
i.e. - forex
6) Information-based trading - speculation
- investors ⇒ expect to earn a return for
bearing risk
- speculators ⇒ expect to earn a return in
excess of the required rate of
return
2) Discovery - capital costs money (rate of return)
- when capital supply > demand for capital , price ↓
- when capital supply < demand for capital , price ↑

LOS a
2) Discovery - when supply = demand (S = I) - explain
⇒ equilibrium interest rate
Caution: there is not one market with one interest
- each market has its own supply & rate
demand dynamics and its own equilibrium
3) Efficient allocation of capital
- capital seeks out the best risk-adjusted return

⇒ 1, 2 & 3 require ⇒ speedy transactions (liquidity)

⇒ low transaction costs
⇒ access to information
⇒ regulation

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Classifications
LOS b
Assets: - describe
1) financial assets - securities, currencies
2) physical assets - commodities, real assets

Markets can be classified on the basis of

1) the timing of delivery
- spot markets - immediate delivery
- forward/futures markets - some agreed upon
future date
2) who the seller is
- issuer - primary market
- investor/holder - secondary market

LOS b
Markets can be classified on the basis of - describe
3) the maturity of the instruments traded
- money markets - debt maturity < 1 yr.
- capital markets > 1 yr.

4) Types of securities
- traditional - debt, equity, funds
- alternative - private equity, securitized
debt, hedge funds

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Major Types of Securities

LOS c
1) Securities a) Public - exchanges - describe
b) Private - qualified investors only

① Fixed-Income (Debt)
Notes Bonds Bills CDs Repos MM

② Equities (ownership claims)

Common Preferred Warrants
- voting rights - higher priority - right to purchase
- entitled to claim stock as a pre-
discretionary dividends - entitled to fixed specified price before
- last claim on dividends (stated as a pre-specified date
assets a yield)

LOS c
1) Securities - describe
③ Pooled Investments (i.e. mutual funds, ABS)
- shares/units represent shared ownership of the
assets held

2) Currencies
- monies issued by national monetary authorities
- trade in foreign currency market (24 hrs./day)

3) Contracts - an agreement between 2 parties to do

something in the future
- value depends on the value of its underlying
(security, index, interest rate)

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LOS c
3) Contracts - may be cash settled or require - describe
physical delivery
- physical vs. financial contract
- spot vs. forward/future/swap/options contracts
a) Forward (OTC, customizable)

(long) Buyer to buy at a by a

both have an a specific
(short) Seller to sell specific certain
obligation asset
price date

b) Futures - a standardized, exchange-traded forward

contract

LOS c
3) Contracts c) Swaps - an agreement to exchange a - describe
series of cash flows at periodic dates over
a period of time (i.e. fixed for floating)

d) Options
Call to buy
a right a specific at a specific by a certain
Put to sell
asset price date
the strike expiration
Buyers only
underlying price date
Sellers ➞ obligation

e) Others - Insurance
- Credit Default Swaps

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LOS c
4) Commodities - precious/industrial metals, - describe
energy, agriculture, etc…

spot Forward/Futures
- buyers/sellers of - hedging/speculating
the physical product - usually close positions prior to
delivery date
5) Real Assets (Direct Investing)
- tangible ⇒ property, factories, equipment

- generally illiquid, high mgmt. costs

Intermediaries
LOS d
- facilitate the matching of providers - describe
and users of capital and structuring products/services to
satisfy that function
1) Brokers, Exchanges, Alternative Trading Systems (ATS)
Brokers - fulfill orders for clients
- more critical for large-block traders

Exchanges - provide an auction platform

- must print best bid and ask

ATS - no regulatory authority over members

dark pools ⇒ do not display orders sent to
them
typically inst. investors, large-block trades

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LOS d
2) Dealers - will hold inventory - describe
- will become contract counterparties
- create liquidity
- can also act as a broker
- Primary Dealers ⇒ can buy/sell with the Central Bank

3) Securitizers - buying assets, placing them in a pool, and

selling securities against them

4) Depository Institutions and Other Financial Corporations

- banks, S&Ls, credit unions
- take deposits - pay interest, lend to borrower, charge
interest

LOS d
5) Insurance Companies - describe
- create and sell contracts that protect
buyers from risk (auto, fire, theft, life)
- connect buyers with investors, creditors &
reinsurers
i.e. CAT bonds Insurance tornado
sells sells
creditor Company insurance
policy holder
manages
6) Arbitrageurs
fraud, moral hazard, adverse selection
- trade on mispricing
7) Settlement & Custodial Services (hold securities on behalf
- clearinghouses - arrange for of clients)
final settlement
- act as counterparty for futures contracts

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Positions
LOS e
- long position - benefits from an increase - compare
in price
- owns an asset or has purchased a contract
- short position - benefits from a decrease in price
- sold an asset they do not yet own or has
written a contract

Forwards long position obligated to take delivery asset or

cash
short position obligated to deliver equivalent

LOS e
Options long a call benefit from an - compare

short a put increase in price of the underlying

right obligation
short a call benefit from a drop in price of
long a put the underlying

Swaps - fixed for floating - party that benefits from a

rise in interest rates considered
‘long’
Currency - traded in pairs Buy $100k USD CAD means
i.e. USD.CAD = 1.3250 I am long $100k USD and
(1) short $132.5k CAD

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LOS e
Short: Contracts - must deliver the - compare
underlying at a pre-determined date for a
pre-determined price

Securities - selling securities you don’t own

- broker arranges a borrow and lends
them to you to sell
- if the borrow cannot be maintained, seller
faces a forced buy-in
- to close a short position, seller initiates
a ‘buy-to-cover’ or ‘buy-to-close’ order

Margin
LOS f
- Levered Positions - calculate
- borrowing funds from your broker - interpret
to buy securities
margin loan
⇒ interest rate ⇒ ‘call money’ rate
Initial margin
- minimum margin requirements
Maintenance margin
- may be set by regulation,
the exchange, or the clearinghouse

Leverage Ratio: 𝐕𝐚𝐥𝐮𝐞 𝐨𝐟 𝐏𝐨𝐬𝐢𝐭𝐢𝐨𝐧

max.
𝐕𝐚𝐥𝐮𝐞 𝐨𝐟 𝐄𝐪𝐮𝐢𝐭𝐲 𝟏
leverage =
𝐈𝐧𝐯𝐞𝐬𝐭𝐦𝐞𝐧𝐭 𝐦𝐢𝐧𝐢𝐦𝐮𝐦
Ratio 𝐦𝐚𝐫𝐠𝐢𝐧
𝐫𝐞𝐪𝐮𝐢𝐫𝐞𝐦𝐞𝐧𝐭

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LOS f
e.g./ 100 shares of ABC @ $30/sh. on - calculate
margin
Sell for $24 @ t1 -20%
- interpret
Div. received = 30¢/sh.
-40%
Commission Paid = 10¢/sh.
Leverage Ratio = 2
Call money rate = 6% Sale (100 × 24) 2400
- Comm. (10)
Total ROI?
- Loan (1500)
Purchase (100 × 30) 3000
- Interest (90)
+ Comm. 10
+ Dividends 30
3010
830
- Margin Loan 1500
Orig. Inv. 1510 𝟖𝟑𝟎 − 𝟏𝟓𝟏𝟎
𝐑𝐎𝐈 = = −𝟒𝟓%
𝟏𝟓𝟏𝟎

LOS f
Initial Margin - calculate
- interpret
Maintenance Margin ⇒ triggers margin call back up to Initial
margin
- else ‘forced liquidation’
(𝟏 − 𝐈𝐧𝐢𝐭𝐢𝐚𝐥 𝐌𝐚𝐫𝐠𝐢𝐧)
𝐌𝐚𝐫𝐠𝐢𝐧 𝐂𝐚𝐥𝐥 = 𝐏𝟎 ×
(𝟏 − 𝐌𝐚𝐢𝐧𝐭𝐞𝐧𝐚𝐧𝐜𝐞 𝐌𝐚𝐫𝐠𝐢𝐧)

e.g./ P0 = $60, margin = 50%, maintenance margin = 25%

Loan
(𝟏 − . 𝟓)
𝟔𝟎 × = 𝟒𝟎 30
(𝟏 − . 𝟐𝟓) 𝐈𝐧𝐢𝐭. 𝐌𝐚𝐫𝐠𝐢𝐧
50%
𝟑𝟎 𝐋𝐨𝐚𝐧
= 𝟒𝟎 (𝟏 − 𝐌𝐚𝐢𝐧. 𝐌𝐚𝐫𝐠𝐢𝐧)
Max. 75% . 𝟕𝟓

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Order Types
prices at LOS g, h
prices at which
which dealers Bid Ask they are willing to sell
- compare
and traders
are willing to buy spread
400 10.55 i.e. 10.55 - 10.62 100 × 600
100 10.53
200 10.51 best best bid ask
1000 10.49 bid size
ask size

Execution Instructions: how an order should be filled

1) Market orders - fill immediately at best price
- guaranteed execution, no guaranteed price
2) Limit orders - fill at a specified price or better
- guaranteed price, no guaranteed execution

LOS g, h
To buy - compare
limit $ > ask - at least partially
Ask - marketable limit order filled
bid < limit $ < ask - new price prints
- creates a new market in the market
Bid limit $ = bid all buy orders at
- make the market this price placed
earlier must execute
limit $ < bid
first
- behind the market
- executes only if
(AON - all-or-none) - standing limit orders
price drops

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LOS g, h
Exposure Instructions - display or hide - compare
- hidden ⇒ only brokers & exchanges see them
- display size ⇒ lower than order
i.e. Buy 10,000 , Limit $10.55 , Display size = 500
- also called ‘Iceberg’ order
Validity Instructions - when an order may be filled
Day - expire at end of business (default)
GTC - good-til-cancelled (max. typically 6 mos.)
FOK - fill-or-kill
good-on-close (market on close) execute at the
close of trading

LOS g, h
- compare
Validity Instructions
stop-loss (long pos.) Buy @ $10, stop @
Stop orders $9.50
buy-stop (short pos.)
- Sell @ $10, buy-stop @ $10.50
Clearing Instructions - how final settlement should be
arranged
- usually the broker
- applies when using more than 1 broker
- indication of whether a sale is a
long or short sale

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Primary vs. Secondary

LOS i
Primary Issuer Investor - define
- explain
first time ⇒ IPO
follow up ⇒ secondary offering

Secondary Investor Investor

- provide liquidity, ensures an efficient
primary market

- sets price for secondary offerings

LOS i
Primary Public Offering - define
- explain
Company Investment Investors
Bank
lines up subscribers (book building)
- may be done as
① Underwriting offer ② Best-efforts offer
- buys the entire issue at - acts as broker only
a negotiated offering price - works on commission
- sell on the IPO ‘bought deal’
- makes the spread
Private Placements - securities not offered to the public
- placed with qualified investors

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Trading
LOS j
Buyers must be able to find Sellers - describe
- at low cost
Q: when can they trade?
who arranges the trade?
how do they execute the trade?
how do they learn about price?
When?
Call Market: trades occur only at particular times and
VS. Treasury
- all bids and asks are balanced to places
determine one price (i.e. quantity bid for = quantity
- all trades occur at this price offered)

- many continuous trading markets find their opening

price by this method

LOS j
Call Market: - very liquid in session - describe
- illiquid otherwise
Continuous Markets: trades can be arranged and executed
anytime the market is open
Who:
Call - auction process
Continuous - auction process or dealer bid-ask quotes
(e.g. stock exchanges)
Execution: ① Quote-driven markets (price-driven or dealer
market)
- individual dealers ‘make a market’
in specific securities means they are willing
to buy and sell

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LOS j
Execution: ① Quote-driven markets - describe
- customers trade with dealers (dealers trade with
(bonds, spot commodities) dealers)
- referred to as OTC (over-the-counter)
② Order-driven markets (pure auction market)
- exchanges ⇒ buyers/sellers submit bids/offers
Order-matching rules ⇒ rank buy & sell orders based on:
Price precedence - best bid & best ask
Display precedence - display over hidden at same
price
Time precedence - first over others with same
price and display properties

LOS j
Execution: ② Order-driven markets - describe

Trade pricing rules ⇒ 1) Uniform pricing rule - same

price is used for all trades (used by
Call Markets)
2) Discriminatory pricing rule
- the limit price of the order/quote that
arrived first determines the trade price
e.g./ Ask Size New Market
Bid Order to sell arrives:
Size 10.36 300 10.36 300
10.34 1200 1400 @ Limit of $10.28
10.34 1200
10.32 600 300 filled at $10.30
10.32 600
300 10.30 900 filled at $10.28 10.28 200
900 10.28 new standing order of 400 10.26
400 10.26 200 @ 10.28

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LOS j
Execution: ② Order-driven markets - describe
3) Derivative Pricing Rule - use the
mid-point of the bid-ask from another
market

e.g. POSIT
⇒ trades cleared at
10.55 - 10.63
$10.59
③ Brokered Markets - brokers arrange trades
among their clients
- usually for very thin markets (unique items)

LOS j
Information: - describe
Pre-trade transparency
- publish real-time data about quotes
and orders
- all exchanges

Post-trade transparency
- publish data about trade prices
after trade occurs (most dealer markets)
- wider spreads, higher transaction costs

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Well-Functioning System
LOS k
⇒ helps - savers - describe
- borrowers
complete markets
- hedgers
- all the assets/contracts
- asset exchange
exist to satisfy all 4
(spot)
⇒ Features timely & accurate disclosures (supports
information efficiency)
liquidity ⇒ minimizes transaction costs
(operationally efficient)
complete markets
External/Informational efficiency (prices
respond to changes in fundamental values)
⇒ prices reflect all available information

LOS k
⇒ needs intermediaries who: - describe
match buyers & sellers by organizing exchanges,
brokerages, and ATS,
provide liquidity on demand (make markets)
create products to match buyers & sellers
(i.e. ABS)
accept deposits and make loans
provide insurance
provide advisory services
organize clearinghouses (settlement, counterparty)
safeguard assets (custodial or depository services)

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LOS k
A financial system that is - describe
Operationally efficient
is characterized by securities/assets that
have
Informationally efficient prices
which leads to an economy that is
Allocationally efficient

Regulation
LOS l
Control fraud by, or deception of, market - describe
participants Confidence
Set minimum standards of competence for agents, define
and enforce minimum standards of practice
promote fairness
set standards for financial reporting (fair to both user
& provider)
set minimum capital requirements for financial firms
(reduce costs/disruptions of failure)
insurance/pension funds have sufficient capital
to honour their long-term commitments

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Security Market Indexes

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 indexes

h. describe types of equity indexes

i. describe types of fixed-income indexes

j. describe indexes representing alternative investments

k. compare types of security market indexes

LOSs will match between the video and the MM PDFs, but may be
in a different order than the CFAI readings

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Market Index
LOS a
- consists of individual securities that
- describe
represent a given security market,
market segment or asset class a.k.a.
constituent
(most constructed as a portfolio securities
of marketable securities)

- each may have 2 versions depending on how

returns are calculated

① Price Return Index ② Total Return Index

- reflects only prices - assumes reinvestment of
all income received since
inception

LOS a
Uses: - describe
- simple measure to capture performance and
direction of a particular market

- evaluate performance of investment managers

(active)

- construct investment portfolios (passive)

- estimate market/segment risk

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Index Return
LOS b
∑𝐍𝐢'𝟏 𝐧𝐢 𝐏𝐢 VPRI - value of the - calculate
𝐕𝐏𝐑𝐈 = - interpret
𝐃 ‘price return’ index
ni - # of units of security 𝒊
Pi - Price of security 𝒊
depends on
N - # of individual securities in the
the type of
D - value of the divisor index
weighting used
- price a number initially chosen at
- equal inception so that the index has a
- market-cap convenient initial value
- floating-adjusted - divisor changes over time
market-cap so that changes in the index
- fundamental weighting reflect price changes only

LOS b
Single Period Returns - calculate
⇒ Price Return - the %’age change in VPRI 𝟏𝟐. 𝟓𝟎 − 𝟏𝟏 𝟏. 𝟓𝟎 - interpret
= (𝟏𝟏
𝟏𝟏
words
𝑽𝑷𝑹𝑰𝟏 − 𝑽𝑷𝑹𝑰𝟎 𝐩𝐫𝐢𝐜𝐞 𝐕𝐚𝐥𝐮𝐞 𝐚𝐭 𝐭 𝟏 − 𝐕𝐚𝐥𝐮𝐞 𝐚𝐭 𝐭 𝟎
𝐏𝐑 𝐈 = =
𝑽𝑷𝑹𝑰𝟎 𝐫𝐞𝐭𝐮𝐫𝐧 𝐕𝐚𝐥𝐮𝐞 𝐚𝐭 𝐭 𝟎

or/ weighted average of each of the constituent components

𝐍 𝑵
𝑷𝒊 − 𝑷𝒊 𝟎
-
-
𝑷𝒊 − 𝑷𝒊𝟎
𝐏𝐑 𝐢 = 𝟏 - 𝐏𝐑 𝐈 = N 𝐖𝐢 𝐏𝐑 𝐢 = N 𝒘𝒊 Q 𝟏 R
𝑷𝒊 𝟎 - 𝑷𝒊 𝟎
- 𝐢'𝟏 𝒊'𝟏

each component = 𝑾𝟏 𝑷𝑹𝟏 + 𝑾𝟐 𝑷𝑹𝟐 + 𝑾𝟑 𝑷𝑹𝟑 + ⋯ + 𝑾𝑵 𝑷𝑹𝑵

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LOS b
Single Period Returns - calculate
⇒ Total Return - price change + all income - interpret

words 𝐕𝐚𝐥𝐮𝐞 𝐚𝐭 𝐭 𝟏 − 𝐕𝐚𝐥𝐮𝐞 𝐚𝐭 𝐭 𝟎

𝑽𝑷𝑹𝑰𝟏 − 𝑽𝑷𝑹𝑰𝟎 + 𝑰𝟏
𝐓𝐑 𝐈 = 𝐭𝐨𝐭𝐚𝐥 + 𝐈𝐧𝐜𝐨𝐦𝐞
𝑽𝑷𝑹𝑰𝟎 =
𝐫𝐞𝐭𝐮𝐫𝐧 𝐕𝐚𝐥𝐮𝐞 𝐚𝐭 𝐭 𝟎

or/ weighted average of each of the constituent components

- 𝐍 𝑵
𝑷𝒊 − 𝑷𝒊𝟎 + 𝑰𝒊 - 𝑷𝒊 − 𝑷𝒊𝟎 +𝑰𝒊
𝐓𝐑 𝐢 = 𝟏 - 𝐓𝐑 𝐈 = N 𝐖𝐢 𝐓𝐑 𝐢 = N 𝒘𝒊 Q 𝟏 R
𝑷𝒊 𝟎 - 𝑷𝒊𝟎
- 𝐢'𝟏 𝒊'𝟏

each component = 𝑾𝟏 𝑻𝑹𝟏 + 𝑾𝟐 𝑻𝑹𝟐 + 𝑾𝟑 𝑻𝑹𝟑 + ⋯ + 𝑾𝑵 𝑻𝑹𝑵

LOS b
Multiple Period Return - calculate
- interpret
𝑽𝑷𝑹𝑰𝑻 = 𝑽𝑷𝑹𝑰𝟎 Z𝟏 + 𝑷𝑹𝑰𝟏 [Z𝟏 + 𝑷𝑹𝑰𝟐 [ … Z𝟏 + 𝑷𝑹𝑰𝑻 [

e.g./ Period Return (%) Calculation Ending Value

0 1000(1.0) 1,000
1 5.00 1000(1.05) 1,050
2 3.00 1000(1.05)(1.03) 1,081.50

𝑽𝑻𝑹𝑰𝑻 = 𝑽𝑻𝑹𝑰𝟎 Z𝟏 + 𝑻𝑹𝑰𝟏 [Z𝟏 + 𝑻𝑹𝑰𝟐 [ … Z𝟏 + 𝑻𝑹𝑰𝑻 [

+15
e.g./
36.75
0 1000(0) 1,000
1 5.00 + 1.5% 1000(1.065) 1,065.00
2 3.00 + 2.0% 1065(1.05) 1,118.25

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LOS b
e.g./ 2008 2009 - calculate
PRI 7.5% 8.3% - interpret
TRI 12.6% 13.4%
⇒ equity index created at beg. of 2008, VPRI = VTRI = 1000

VPRI (2008) = 1000 × (1.075) = 1075

VPRI (2009) = 1000 × 1.075 × 1.083 = 1164.225 1075(1.083)

VTRI (2008) = 1000 × (1.126) = 1126

VTRI (2009) = 1126 × (1.134) = 1276.884

Index Construction
LOS c
- similar to constructing and managing
- describe
a portfolio of securities

① target market selection

⇒ asset class (equities, fixed-income, real-estate)
⇒ geographic region (Japan, Mexico, Canada)
⇒ exchange (NY, Toronto, London)
⇒ other characteristics (sector, industry, size)

② security selection
- all or just a sample
- fixed number (S&P500) or variable (TOPIX)

③ Weighting ④ Rebalancing ⑤ Reconstitution

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 Last Revised: 06/19/2023

Index Weighting

LOS d, e
⇒ weighting determines how much of
- compare
each security to include in the index - calculate
① Price Weighting (simplest) - analyze

- called an Average (i.e. DJIA)

.9 𝐏𝐢
𝑾𝑷𝒊 =
𝟗𝟎 ∑𝐍𝐢'𝟏 𝐏𝐢
∑𝐍𝐢'𝟏 𝐏𝐢 𝐈𝐧𝐝𝐞𝐱 𝐕𝐚𝐥𝐮𝐞 =
.1 𝟗𝟎 + 𝟏𝟎 𝐃
typically set
∴ stocks with the highest at inception = N
price will have the
greatest impact on the
return of the index

LOS d, e
- any stock split changes all the - compare
weightings - calculate
- analyze
∴ divisor needs to be adjusted to prevent the split
from changing the value of the index

e.g./ % 2-for-1 on A %
A $55 52.38 27.50 35.48
B 22 20.95 22 28.39
C 8 7.62 8 10.32
D 14 13.33 14 18.07
E 6 5.72 6 7.74
Σ = 105 100% 77.50 100%

D = 5
𝟕𝟕. 𝟓𝟎 𝟕𝟕. 𝟓𝟎
VI = 21 𝟐𝟏 = ⇒ 𝐃= = 𝟑. 𝟔𝟗
𝐃 𝟐𝟏

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LOS d, e
② Equal Weighting ($) - compare
- calculate
𝟏 i.e. $10k - analyze
𝑾𝑬𝒊 =
𝐍 5 components
= $2,000 of each component
𝟐𝟎𝟎𝟎 𝟐𝟎𝟎𝟎
= shares of A , = shares of B, etc…
𝐏𝐀 𝐏𝐁

- select a divisor (D) to give the index a convenient

starting value

i.e. $𝟏𝟎, 𝟎𝟎𝟎

= 𝟏𝟎𝟎𝟎 ⇒ initial value of the
𝟏𝟎
index

LOS d, e
② Equal Weighting - compare
- calculate
+/ - simple - analyze
-/ - securities that represent the largest fraction of
the target market value are underrepresented

- those that constitute a small fraction - overrepresented

- after construction, any price change means weightings

are no longer equal

∴ frequent rebalancing required

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 Last Revised: 06/19/2023

LOS d, e
③ Market-Capitalization Weighting - compare
- calculate
𝑸 𝒊 𝑷𝒊 - divide market-cap
𝑾𝑴 - analyze
𝒊 = of the component by sum of all
∑𝑵
𝒋'𝟏 𝑸𝒋 𝑷𝒋
market caps

- float-adjusted Market-Cap weighting

# of shares available
to the investing public Note: most market-cap
weighted indicies are
float adjusted

LOS d, e
③ Market-Capitalization Weighting - compare
- calculate
+/ - components are held in proportion to
- analyze
their value in the target market Q x P
-/ - components whose price have risen the most (or fallen)
have a greater (lower) weight in the index

- leads to overweighting stocks that may

be overvalued and underweighting stocks
that may be undervalued

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LOS d, e
④ Fundamental Weighting
- compare
- attempts to overcome market-cap - calculate
disadvantages - analyze
- uses a fundamental value as a proxy for size rather
than market cap
𝑭𝒊 i.e. book value
𝑾𝑭𝒊 = Revenues
∑𝑵
𝒋'𝟏 𝑭𝒋
CFO
Earnings, etc…
Market
- results in indicies with ratios of 𝑭𝒊
Value
higher than its market-cap counterpart
- weights favour securities that have decreased in
relative value

LOS d, e
④ Fundamental Weighting - compare
- calculate
e.g./ Stock Market-Cap Earnings Earnings Yield - analyze
A $200M 20M 𝟐𝟎g
𝟐𝟎𝟎 = 𝟏𝟎%
B 800M 20M 𝟐𝟎g
𝟖𝟎𝟎 = 𝟐. 𝟓%
$ 1B 40M
𝑭𝒊 Market
Value

A 20% < 50% - higher yield

B 80% > 50% - lower yield
‘Momentum’ ‘Contrarian’
effect effect

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Rebalancing/Reconstitution
LOS f
① Rebalancing - describe
- weights assigned to constituents at inception
drift from their target weights as prices change

· equal-weighted ⇒ reduce weights of securities

𝟏 that have outperformed, increase weights
𝑾𝑬𝒊 =
𝑵
of securities that have underperformed

𝑷𝒊 · price-weighted ⇒ no need to rebalance since

𝑾𝑷𝒊 =
∑𝑵
𝒋&𝟏 𝑷𝒋
the weight of each constituent is
determined by price (i.e. target weights drift
as prices change)
𝑸𝒊 𝑷𝒊 · market-cap weighted ⇒ only need to be
𝑾𝑴
𝒊 = 𝑵
∑𝒋&𝟏 𝑸𝒋 𝑷𝒋 rebalanced to reflect M&A and liquidations

LOS f
② Reconstitution - the process of changing - describe
the securities in the index ⇒ keeps the index
representative

· reflect changes in the target market as a

result of bankruptcy, liquidation, M&A, delistings
· reflect judgement of the selection committee

𝑷𝒊
𝑾𝑷𝒊 = 𝑵 Reconstitution results in a change in all the
∑𝒋'𝟏 𝑷𝒋
weightings (price & market-cap)
𝑸 𝒊 𝑷𝒊
𝑾𝑴
𝒊 = 𝑵
⇒ usually announced prior to the reconstitution
∑𝒋'𝟏 𝑸𝒋 𝑷𝒋
date

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Uses
LOS g
· to gauge market sentiment - good
- describe
indicators of the collective option of market
participants

· used as proxies for measuring/modeling returns, systematic

⇒
risk and risk-adjusted performance (𝛃 in CAPM)
· as proxies for asset classes in asset allocation models
- provide the historical data used to model
risk/return of different asset classes

· as a benchmark for actively managed portfolios

· serve as the basis for the creation of investment

products (typically passive)

Index Types
LOS h
1) Broad market indicies
- describe
- represents more than 90% of the selected
market i.e. Russell 3000 ∼ 99% of the market
cap of the US equity
market
2) Multi-market indicies
- consist of security market indicies from
different countries
- different countries/national markets/economic
development groups weighted differently
(e.g. by GDP)
⇒ a fundamental weighting of the
market-cap weighted indicies

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LOS h
3) Sector Indicies
- describe
- represent a particular sector (Consumer Staples,
Utilities, etc.)
- helps assess manager performance (10 broad sectors)
- are returns due to stock
picking or sector allocation

4) Style Indicies
- growth vs. value
- will require more frequent rebalancing
& reconstitution

Fixed-Income Indicies
LOS i
⇒ broader universe of bonds than stocks
- describe
⇒ universe constantly changing (new issues, calls, maturities)
⇒ Duration (price volatility) is constantly changing

Types/ · Issuer (gov’t., gov’t. agency, corporates)

· Type of financing (general obligation, collateralized)
· Currency of payment
· Maturity
· Credit quality (investment grade, high yield, ratings)
· Inflation protection?

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LOS i
⇒ can be categorized as - describe
· Aggregate or broad market indicies
· Market sector indicies
· Style indicies
· Economic sector indicies
· Specialized indicies (e.g. high-yield, inflation-linked,
emerging market)
e.g./
Investment Grade ➞ maturity ➞ credit rating
𝐀𝐀𝐀g 10-yr. gov’t.
𝐀𝐀

Alternative Investments
LOS j
1) Commodity indicies
- describe
- consist of futures contracts on one or
more commodities
⇒ equal, fixed or price weighted (determined by a
committee)

- different weightings ⇒ different exposures

⇒ different risk/return profiles

- index performance may differ from that of the

underlying commodity due to the use of derivatives
rather than the physical commodity

⇒ introduces exposure to rf, 𝚫Fp, roll yield

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LOS j
2) Real Estate/REIT indicies - describe
consist of shares of publicly traded
REITs
appraisal indicies typically commercial
repeat sales indicies
property
3) Hedge Fund Indicies
⇒ broad global level
⇒ strategy level
⇒ rely on voluntary disclosure
⇒ hedge funds can choose which index to report
performance to (constituents determine the
index)
⇒ poorly performing funds don’t often report
(survivorship bias)

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Market Efficiency

a. describe market efficiency and related concepts, including their importance to

investment practitioners

b. contrast 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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 Last Revised: 06/19/2023

Market Efficiency
LOS a
- the extent to which market prices - describe
incorporate available info.
⇒ inefficiency is what justifies active mgmt.

- price efficiency (informative prices)

⇒ ‘price signal’ determine where capital should
be allocated to earn the highest risk-adjusted
return (avoids malinvestment)
- promotes health & sound economic growth
⇒ information efficiency
- assumes information is timely, complete, correct, and
understandable

LOS a
- asset prices reflect new information - describe

quickly and rationally the unanticipated element

⇒

1 min. - 1 hr.

⇒ prices incorporate all past & present info.

∴ consistent, superior, risk-adjusted returns are not

achievable in an efficient market

passive R > active R

(lower costs)

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 Last Revised: 06/19/2023

Efficient Markets
LOS a
Suppose that a speculative-grade bond issuer announces, just before bond markets - describe
open, that it will default on an upcoming interest payment. In the announcement, the
issuer confirms various reports made in the financial media in the period leading up
to the announcement. Prior to the issuer’s announcement, the financial news media
reported the following:

1) suppliers of the company were making deliveries only for cash payment, reducing
the company’s liquidity
2) the issuer’s financial condition had probably deteriorated to the point that it lacked
the cash to meet an upcoming interest payment
3) although public capital markets were closed to the company, it was negotiating
with a bank for a private loan that would permit it to meet its interest obligations and
continue operations for a least nine months.

If the issuer defaults on the bond, the consensus opinion of analysts is that bondholders
will recover $0.36 to $0.38 per dollar value.

LOS a
- describe
1. If the market for the bond is highly efficient, the bond’s market price is most
likely to fully reflect the bond’s value after default:

A. in the period leading up to the announcement

B. in the first trade prices after the market opens on the announcement day
C. when the issuer actually misses the payment on the interest payment day

2. If the market for the bond is highly efficient, the piece of information that bond
investors most likely focused on in the issuer’s announcement was that the issuer:

A. had failed in its negotiations for a bank loan

B. lacked the cash to meet the upcoming interest payment
C. had been required to make cash payments for supplier deliveries

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Market vs. Intrinsic

LOS b
⇒ Market Value (MV) price at which an - distinguish
asset can be bought or sold (i.e. bid-ask)

⇒ Intrinsic Value (IV - fundamental value) - price of an

asset if complete information & understanding
were used (typically PV - future cashflows)

- requires judgment, IV just an estimate

IV < MV - overvalued (Sell, underweight)

IV ≃ MV - fairly valued (Hold, equal weight)
IV > MV - undervalued (Buy, overweight)

LOS b
- describe
1. An analyst estimates that a security’s intrinsic value is lower than its market value.
The security appears to be:

A. undervalued
B. fairly valued
C. overvalued

2. A market in which an asset’s market values are, on average, equal to or nearly equal to
intrinsic value is best described as a market that is attractive for:

A. active investment
B. passive investment
C. both active and passive investment

3. Suppose that the future cash flows of an asset are accurately estimated. The asset
trades in a market that you believe is highly efficient based on most evidence. But
your intrinsic value estimate exceeds market value by a moderate amount. The most
likely conclusion is that you have:

A. overestimated the asset’s risk

B. underestimated the asset’s risk
C. identified a market inefficiency

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Impediments
LOS c
Inefficient factors Efficient - explain
fewer, few Market Participants more, numerous
narrower Information Availability wider
less, variable Financial Disclosure more, standardized
slow/lagged trans. Limits to Trading speedy transactions
lack of transparency transparency
restrictions no restrictions

Transactions Costs Information - Acquisition Costs

- mispricing would still be classic view return = risk assumed
efficient if within the ∴ info. costs = waste of time
‘bounds of arbitrage’ modern view
(return - info. costs) = risk assumed

Efficiency Taxonomy
LOS d
- contrast
Market Prices Reflect
Forms of Market Past Market Public Private
Efficiency Data Information Information

Weak-form √
Semi-strong-form √ √
Strong-form √ √ √
(Eugene Fama, 1970)

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LOS d
Weak-form/ future returns should be independent of - contrast
past returns or patterns
- no serial correlations
- no trading ‘rules’

Proponents of weak-form EMH assert that abnormal

risk-adjusted returns cannot be earned by using
trading rules and technical analysis, which make
investing decisions based on historical security
market data.

LOS d
Semi-strong form/ - encompasses weak-form - contrast
- considerable research support in developed
markets

Proponents of the hypothesis assert that investors

cannot earn abnormal risk-adjusted returns if their
investment decisions are based on important material
information after it has been made public. They
stress that security prices rapidly adjust to reflect
all public information.

LOS d
Strong form/ encompasses both weak and semi-strong - contrast
forms
research rejects the strong-form hypothesis
(i.e. fails to accept)

Strong-form EMH assumes perfect markets where information

is cost free and available to all. Under strong-form EMH, no one
can consistently achieve abnormal risk-adjusted returns, not
even company insiders.

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Implications
LOS e
1) Security markets are weak-form eff. - explain
∴ technical analysis will not produce
consistent abnormal risk-adjusted returns
2) Security markets are semi-strong eff.
∴analysts must consider what is priced in
and how new info. will affect prices
- fundamental analysis facilitates semi-strong EMH
1 + 2) Portfolio Management ⇒ active managers are actually
a waste of money for investors
(The Loser’s Game)
3) Security markets are not strong-form eff.

Market Anomalies
LOS f
① Time-Series Anomalies - describe
Calendar anomalies
a) January effect - higher returns in equity
markets compared to other months
k
l lac nce b) Turn-of-the-month effect - higher returns on the
a l te
rsi s last trading day and first 3 of next month
pe
c) Day of week effect - avg. Mon. R < 0, and lower
than other 4
d) Holiday effect - day prior to holiday tends to
have higher returns

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 Last Revised: 06/19/2023

LOS f
① Time-Series Anomalies - describe
Overreaction Anomalies
- investors overreact to the release of
unexpected new information
good news inflate bad news depresses
prices prices

use of a contrarian strategy

Momentum Anomalies
- securities that have outperformed in the
short-run continue to outperform (IBD)

LOS f
② Cross-Sectional Anomalies - describe
1) Size effect
- small-cap equities tend to outperform
large-cap equities on a risk-adjusted basis
(not confirmed over time)
2) Value effect
- value stocks outperform growth stocks
· market returns
over time
· MV of equity
(use of 3-factor model for valuation vs.
· BV equity
MVequity CAPM (1-factor) eliminates this anomaly)

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 Last Revised: 06/19/2023

LOS f
3) Other Anomalies - describe
a) Closed-end fund discounts
- to their NAVPS
not d - typically not worth the transaction
p p orte
su costs
by
ent b) Earnings Surprises
sist
con - prices may be slow to adjust
&
t
rs i sten c) IPOs - if you can get shares at the offer
pe e
enc price
evi d
d) Predictability of Returns based on prior
information i.e. economic cycle related

Behavioral Finance
LOS g
- examines investor behavior (observed) - describe
rather than relying on normative assumptions (i.e. rationality)
⇒ investors do not always make efficient
(rational & optional) decisions
- due to cognitive/behavioral biases

① Loss Aversion - tendency to prefer avoiding losses to

acquiring gains
- losses are twice as powerful, psychologically
⇒ can actually lead to ‘loss persistence’
- the unwillingness to actually take a loss

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LOS g
② Herding - investors ignore their own - describe
analysis and make decisions in line with the
direction of the market (can often be rational
to follow)
- correlated strategies, clustered trading

③ Information Cascades - the transfer of information from

whale those who are the first to act upon it, and
watching whose decisions influence others (results in
serial correlations, perhaps overreactions to
information)
④ Overconfidence - investors have an inflated view of
their ability to process information

LOS g
- many more - describe

Implications ⇒ for the market - unclear

- even if some investors
exhibit bias, as long as enough do not,
markets will remain efficient
⇒ for the investor
- know thyself
- if you are subject to certain
biases, develop rules to avoid the trap
e.g. Position limits, loss limits, excessive gain/loss
timeouts.

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 Last Revised: 06/19/2023

Overview of Equity Securities

a. describe characteristics of types of equity securities

b. describe differences in voting rights and other ownership characteristics among

different equity classes

c. compare and contrast 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. contrast 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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 Last Revised: 06/19/2023

Equity Securities
LOS a, b
- a few global facts ① 𝐄𝐪𝐮𝐢𝐭𝐲 𝐌𝐚𝐫𝐤𝐞𝐭 𝐂𝐚𝐩 - describe
~ 50%
𝐆𝐥𝐨𝐛𝐚𝐥 𝐆𝐃𝐏 - long-run
avg.

30% ∼70% ② from 1900 - 2011 gov’t. bonds/bills - rr ∼ 2%

equity markets - rr ∼ 4%
70% 30%
∅ ③ equity ownership ∼ 20% - 50% of population
(developed countries) CPP

Company
Debt Equity residual claim on assets
- liability
- interest - cap. gains + div.

LOS a, b
Common Shares: - describe
- ownership interest in the company (residual claim)
- Share in operating performance (cap. app., dividends)
- participate in governance process (voting rights)
⇒ major corporate decisions (e.g. M&A)
⇒ election of BoD

Statutory voting cumulative voting

- each share = 1 vote total votes = # of shares ×
# of directors
i.e. 4 directors up for re-election/election
100 for 1 100 shares × 4 directors = 400
total
or = 100 each 400 for 1
votes or total
100 each = 400
100 each votes

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 Last Revised: 06/19/2023

LOS a, b
Common Shares: - describe
- different classes each with different ownership
and voting rights, and even different claims on
net assets in liquidation event
i.e. Class A Class B
- held by investing - held by insiders
public (typically founding family)
60% voting rights 40% voting rights
⇒ Callable - issuer has the right to buy back shares at a
pre-determined call price
⇒ Putable - investor has the right to sell shares back to the
company at a pre-determined put-price

LOS a, b
Preference Shares: (preferreds) - describe

- do not participate in operating performance

- no voting rights
- receive dividends before common stock
- dividend stated as a yield on par (can be fixed
typically > common yield or variable)
i.e. rate - reset
- dividend still discretionary
- higher priority claim on net assets than common
- can be perpetual, convertible, callable, putable
- prices like debt, pays like equity (i.e. div. vs. int.)

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LOS a, b
Preference Shares: (preferreds) - describe
Cumulative: unpaid dividends accrue over time
must be paid in full before any
common dividends can be paid
Non-cumulative: do not accrue (forfeited permanently)
will have to offer a higher yield

Participating: ① in any increase in dividends if

company profits exceed some level OR/
if company issues special dividends
② in proceeds from a liquidity event
i.e. 2x partic. on $25 par value = $50 distribution

LOS a, b
Preference Shares: (preferreds) - describe

Non-Participating - stated preferred div. only + par

value
Convertible - to common
- participate in equity participation
usually has a while getting a higher yield
‘forced conversion’ - common in private equity (i.e. VC)
clause (typically done so as not to re-price
the common)
forced-conversion - if the common $ > conversion price,
company may force conversion by calling
at low price
⇒ avoids ‘overhanging convertibles’

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Public vs. Private

LOS c
Public ⇒ IPO - secondary markets - distinguish

Private ⇒ Private Placement - no secondary market

institutional investors (PE/VC)
accredited investors
not listed on public exchanges
prices are not market-determined
highly illiquid
issuer not required (regulatory) to publish
financial statements
Note: if # of shareholders > 50, classified as a public company

LOS c
Types of Private Investments: - distinguish

1) Venture Capital - seed to growth financing

- VC firm set-up as a limited
partnership
- usually 10-year life
- 3 to 5 yr. investment phase
- YRS-10: Sell, IPO, liquidate
2) LBO/MBO - use of debt to purchase all
group of outstanding shares of a publicly
mgmt.
investors traded company
- usually restructured and re-issued

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LOS c
Types of Private Investments: - distinguish
3) Private Investment in Public Equity (PIPE)
- restricted stock usually at a
- preferreds discount
Advantages of Private Equity:
- management focused more on long-term value
creation
- inefficient markets ⇒ higher risk-adjusted
returns
- lower company costs due to lack of - filing requirements
- listing fees
- regulatory costs

Non-Domestic Equity
LOS d
⇒ Companies are able to issue shares in - describe
international markets
- wider shareholder base
- lower cost of capital
⇒ Investors gain access to foreign companies
- diversify risk away from ‘domestic only’ exposure
Restrictions still exist
- limit amount of control foreign investors have
over domestic companies
- give domestic investors the opportunity to own
the shares of foreign companies conducting business
in the domestic market
- reduce volatility of capital in/out-flows

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LOS d
- reducing these restrictions tend to lead - describe
to improved equity market performance

⇒ Increased number of companies have issued shares in

markets outside their home country
- dual-listing
Benefits/ improves awareness about the company’s
products/services
enhances liquidity (of the shares)
increases corporate transparency
(need to meet a greater number
of filing requirements)

LOS d
Methods/ - describe
① Direct Investing
- buy/sell directly in foreign market
purchase price, sale price, gains/losses
& dividends in foreign currency
(exchange rate risk)
must be familiar with trading,
clearing & settlement regulations of
the foreign market
may lead to less transparency & more
volatility (or vice versa)

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LOS d
Methods/ ② Depository Receipts - describe

- trades like an ordinary share on a local

exchange
- represents an economic interest in a
foreign company

deposits Domestic Market

Buyer
may not be
shares dom. $
1-for-1
Foreign Domestic Domestic
Co. Bank issues Exchange
receipts Seller
dom. $
transfer agent all divs. in
custodian dom. $

LOS d
Methods/ ② Depository Receipts - describe

sponsored ⇒ foreign company has a direct involvement

in the issuance of receipts
- investors in DRs have the same rights as
direct owners
Level 1 1 ADR - trade OTC
Level 2 & 3 - must register with SEC
- follow regulatory guidelines
Rule 144A - QIBs (private placements)
unsponsored ⇒ foreign company has no direct involvement in
the issuance of receipts
- the depository has the rights of ownership,
not the investor

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LOS d
Methods/ ② Depository Receipts - describe
in
GDR - global depository receipt - issued by depository USD
bank outside both issuer’s home country and the U.S.
- except for
ADR - American depository receipt P.P.
- denominated in USD and trade like common shares
in the U.S.
③ Global Registered Shares - ordinary shares that are
quoted and traded in different currencies on
different stock markets
i.e. BOM on TSX in CAD + on NYSE in USD
TD
④ Basket of Listed Depository Receipts (BLDR)
(i.e. ETF)

Risk and Return

LOS e
- 2 main sources of return in any one period - compare
1) capital gains (𝐏𝐭 − 𝐏𝐭8𝟏 ) + 𝐃𝐭
𝐑𝐭 =
2) dividends 𝐏𝐭8𝟏
- for DRs and direct foreign investments
ees
3) currency gains/losses trans. f nv.
no re-i
im med. t. disc.
P) mk
- over multiple periods (DRI 3-5%
4) dividend (reinvestment) (compounding effect)
(does not have to be same co.)

Risk ⇒ therefore refers to the uncertainty of the

above future returns and cash flows

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LOS e
⇒ Preferreds are less risky than common - compare
- Pref. Div. known and fixed (generally) (𝐃𝐭 )
- dividend accounts for a large portion of the
(less uncertainty about future CFs) Pref. sh. 𝐑 𝐭
- Pref. receive div. & distributions before common
- rank behind all debt. (up to par)

- Cumulative less risky than Non-Cumulative

⇒ Common shares - large part of 𝐑 𝐭 made up to (𝐏𝐭 − 𝐏𝐭,𝟏 )
- Putable less risky than Callable/Non-Callable
- Callable more risky than Non-Callable
⇒ Public Less risky than Private

Financing a Company
LOS f, g
- companies issue equity to raise - explain
(A = L + E)
capital (for many reasons/uses) - distinguish
- ultimate goal of mgmt. is to increase the
BV of the company and maximize the MV of its
equity
direct BV = A - L ∴ increase Ret. Earn.
control
indirect MV = # of shares × P0
control
primarily determined by investor’s
expectations about the amount,
timing and uncertainty of future
cash flows

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LOS f, g
⇒ Accounting Return on Equity - explain
𝐍𝐈𝐭 𝐍𝐈𝐭 - Pref. Div. - distinguish
𝐑𝐎𝐄𝐭 = =
𝐀𝐯𝐠. 𝐁𝐕𝐄𝐭 (𝐁𝐕𝐄𝐭 + 𝐁𝐕𝐄𝐭8𝟏 )/𝟐

Note: NI ⇒ total net income available to common shareholders

(i.e. Net Income - Preferred Dividends)
NI rises faster than BVE
𝐑𝐎𝐄𝐭 can increase if
NI falls slower than BVE
- Price-to-Book Ratio
- higher ratio indicates that the
𝐌𝐕𝐄𝐭 ⁄𝐬𝐡. 𝐌𝐕𝐄𝐭 market is pricing in higher
=
𝐁𝐕𝐄𝐭 ⁄𝐬𝐡. 𝐁𝐕𝐄𝐭 future growth opportunities

LOS h
ROE - the rate of return earned by a - compare

company on its equity capital

- uses accounting net income (s.t. estimates, methods)
- can be managed ⇒ issue debt to buyback shares
decreases equity ⇒ BVE ↓
Intrinsic Value ⇒ PV(expected future cash flows)
discounted at the ‘required rate of
return’
Cost of Equity ⇒ the discount rate needed to equate
the expected future cash flows with the
offering price

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Company Analysis: Past and Present

a. describe the elements that should be covered in a thorough company research

report

b. determine a company’s business model

c. evaluate a company’s revenue and revenue drivers, including pricing power

d. evaluate a company’s operating profitability and working capital using key

measures

e. evaluate a company’s capital investments and capital structure

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Company Analysis Past and Present

Company Research Reports

Company Research Reports

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Company Research Reports

Business Models
Step One in the framework is to identify the firm’s business model:
- The business model should identify the key drivers of financial results, position
- Identifies key areas that require further investigation
- Allows the analyst to set expectations

Key Elements Information Sources

Products/Services Issuer
Key Customers/Groups Public Third-Party
Sales Channels Proprietary Third-Party
Customer Acquisition Proprietary Primary Research
Delivery Mechanisms
Price and Payment Structure
Resource, Supplier Relationships

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Key Elements
Products/Services
Key Customers/Groups
Sales Channels
Customer Acquisition
Delivery Mechanisms
Price and Payment Structure
Resource, Supplier Relationships

Key Elements
Products/Services
Key Customers/Groups
Sales Channels
Customer Acquisition
Delivery Mechanisms
Price and Payment Structure
Resource, Supplier Relationships

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Revenue

Revenue Analysis
Revenue Drivers
‘Causative factors’ explaining the level of, and changes in, revenue
What are they?
How have they evolved over time?

Two approaches to determining revenue drivers

- Bottom-up
or a combination
- Top-down

Bottom-Up : micro factors - look within the company

Price, Volume, Product Line, Geographic, etc.

Top-Down : macro factors - look at economy

GDP Growth, Market Size, etc. industry and company analysis reading

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Revenue Analysis
Prices are constrained by a company’s pricing power - The ability to set prices and terms
without affecting sales volume
Pricing Power is a function of : market structure, competitive positioning within the market

Highly Competitive Markets : low barriers, available substitutes, little differentiation, low
switching costs
e.g. Retail, oil & gas, fresh food, insurance, bank loans/deposits
many markets become competitive as innovation slows ➞ commoditization
Firms are price takers
Long-Run economic profit = zero (can low-cost producers maintain > zero?)

Less Competitive : high barriers, customer loyalty, switching costs

e.g. Branded Goods, Patented Pharmaceuticals
Higher degree of Pricing Power : Value Based, Cost Based, Price Discrimination

Analysis: Price trend v. Cost trend (margins)

Revenue Analysis
Warehouse Club - Bottom Up
Sales Membership Fees
Fresh Food Packaged Food Non Food Other Number of Members Price
Vol.: 13% 40% 28% 19%

Growth : Sales Per Store (Sq. Ft.?)

Number of Stores

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Operating Profitability and Working Capital

Operating Costs : generate/are related to current period revenue
Acquisition, Production, Sale, Improvement, Delivery of goods and services
Management of business activities
Compliance with Laws and Regulations
[investing costs relate to acqn. and prodn of long-term assets, financing costs relate to debt
and equity]
Classification Issues: Intuition Income Statement Cashflow
Research and Development
Depreciation/Amortization
Interest Expense
Income Taxes
Categorization: Behavior With Output Nature IFRS/US GAAP Function Preferred
Variable Compensation Cost of Goods Sold
Fixed Raw Materials Sales and Marketing
[Degree operating leverage] Merchandise General and Admin.
Office Supplies Research and Development

Operating Profitability and Working Capital

Operating Cost and Behavior with Output:
Operating Profit = [Q × (P - VC)] - FC
Quantity Sales Fixed Costs
(Price-Variable Costs)
Contribution Margin : Contribution margin must be positive!
Quantity Sold must be enough to cover FC

Degree of Operating Leverage (DOL) = % change operating profit

% change sales

Practical use may be limited - disclosure by nature not required by IFRS/US GAAP
- output volume not disclosed
- split of VC v. FC may vary across product lines
- useful if disclosure is typical in industry ...

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Operating Profitability and Working Capital

Contribution margin per barrel?
Oil Industry Typical Disclosures : Last 12M
(P - VC)
Sales Volume (thousands of barrels) 154,812
Average Price $49.66
Total Revenues (millions) $7,688 Operating Profit?
Production Costs per Barrel:
Lease Operating Expense 11.21
Production and Ad Valorem Taxes 3.40 Change in operating profit for a
Transportation 2.63 10% increase in sales volume?
Production Costs $17.24
Other Operating Expenses (millions)
Depreciation 1,275
General and Admin. 150 Degree of operating leverage?

Operating Profitability and Working Capital

Measures of profitability using costs disclosed by function (a typical income statement)

Revenue
(Cost of Goods Sold) mostly variable
Gross Profit good approximation of contribution margin
(Operating Expenses) mostly fixed (sales, R&D, general and admin.)
EBITDA
(Depreciation and Amortization) will be fixed if straight line
EBIT or Operating Profit

Major driver of operating costs over the long run is output:

Economies of Scale - Cost per unit decreases as output increases
- Compare size (revenues) to operating cost margin
Economies of Scope - Cost per unit decreases as number of product lines increases
- Compare profitability of integrated company with stand alone

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Operating Profitability and Working Capital

Analyze trend in categories of operating costs using their drivers:
Cost Driver Metric
Cost of Goods Sold Revenue Gross Margin
Sales, General, Admin. Revenue SG&A as a % of revenue
Depreciation and Amortization Gross Fixed Assets useful economic life (gross FA/
Depn.& Amtn.)
Industry Specific (warehouse club)

Store Opening Costs Stores Opened Cost per Store Opened

Membership Fees ? ?

Operating Profitability and Working Capital

Gross margin (line) steady SG&A margin (line)

COGS (bars) increased steady
SG&A increased

Useful life (line) steady

depn. & amtn. increased Cost per opening (line)
increasing

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Operating Profitability and Working Capital

Working capital can be analyzed using activity ratios - DOH, DSO, Payables days
- cash conversion cycle

Capital Investments and Capital Structure

Long-Run Aim : Return on Capital Invested > Cost of Capital (Economic Profit)
Analyst : Compare ROIC to WACC.

Drivers: Uses of Capital Drivers: Sources and cost of each source of capital
Cash on hand CFO and...
Net working capital (+) Net working capital (-)
Capital expenditure Debt issuance
Acquisitions Equity issuance
Debt repayment Asset disposals
Dividends and share repurchases

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Capital Investments and Capital Structure

debt issuance < increase

in cash
Returns to shareholders
no equity issued and CAPEX very similar

no acquisitions

Capital Investments and Capital Structure

Risk : Debt finance increases financial risk.

Measure : Degree of financial leverage = % change net income

% change operating income

Interest coverage = EBIT

‘interest’

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Capital Investments and Capital Structure

Positive ROIC - WACC spread

Degree of financial leverage ≃ 1.0

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Industry and Competitive Analysis

a. describe the purposes of, and steps involved in, industry and competitive analysis

b. describe industry classification methods and compare methods by which companies

can be grouped

c. determine an industry’s size, growth characteristics, profitability, and market share

trends

d. analyze an industry’s structure and external influences using Porter’s Five Forces
and PESTLE frameworks

e. evaluate the competitive strategy and position of a company

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Industry and Competitive Analysis

LOS B: Classification methods

LOS C: Industry survey

LOS D: Porter’s 5 Forces

PESTLE

LOS E: Apply it!

Purpose and Steps

same business models, product markets, factor markets
same supply and demand opportunities and risks

Median Industry Profitability

Business Model variation, Competitive Strategy, Size, Execution

variation around the mean

Relative importance of industry v. company specific factors RE: Economic Profit

(ROIC - WACC)
Industry most important factor in sustainability of economic profits
Company specific effects much larger for low performing firms than high
no floor ceiling

Aim of Industry and Competitive Analysis:

1. Estimate industry ‘base rate’ and its drivers
2. Form forward-looking opinion on potential structural changes
3. Analyze firm’s strengths/weaknesses to determine their position v. base rate

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Industry Classification
The Simple Definition: Companies that sell similar products or services
The Problems : include substitutes? Companies in multiple industries, geography,
Third Party Schemes updates...
Early gov’t. agency methods: country specific, grouped by production characteristics, not
More recent commercial methods: GICS (Global Industry Classification Scheme) updated
public companies
ICB (Industry Classification Benchmark)
TRBC (The Refinitiv Business Classification) + private, non-profit,
gov’t.
Global, grouped using demand approach, undated frequently

Industry Classification
Limitations
1. Groupings of companies with business model variations or that sell substitutes
e.g. Application Software: Shopify: e-commerce payment processing
Check Point Software: security software
2. Multi-Product Companies
e.g. Amazon: Consumer discretionary
- Most of its profits are generated by Amazon Web Services (AWS)
3. Geography
e.g. Healthcare: companies do not compete globally
4. Changes in groupings affecting comparability
e.g. Fintech: Payment Processors: Information Technology or Financial Sector?
Alternative Methods: Geography - country of incorporation, groups: developed, emerging,
Business Cycle - defensive, cyclical: By sector frontier

Statistical Similarities - clustering analysis

ESG characteristics

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Industry Survey
Size and Historical Growth Rate

Size = Total Annual Sales from product or customer perspective

may not be all sales from every constituent e.g. Retail: Amazon Retail Sales √
AWS X
Growth Rate = Year over year each year
or Compound growth rate for multi years
Breakdown into contributions from volume and price/mix useful

Estimate contribution of private companies using gov’t. / 3rd party data

Industry Survey
Growth Characteristics
Use historical growth pattern to characterize industry growth - magnitude
- sensitivity to business
cycle
Limitations: High correlation in severe downturn, life cycle can impact growth
Style Box
defensive Utilities Biotech
sensitivity
cyclical Crude oil Fintech
Mature Growth

Driven by business model magnitude

Are products discretionary?
Interest Rate Exposure Full saturation Not yet reached full saturation

Subscription? Growth in line with Idiosyncratic drivers separate

economy or declining from GDP

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Industry Survey
Industry Profitability Measures
Return on Invested Capital - after-tax operating profits
- not distorted by capital structure
- data not readily available unless publicly traded
Use time series to assess trends
Use percentiles (e.g. Quartiles) to assess distribution
Market Share Trends
Measured using Annual Revenue v. Industry Size
- trends are key, as is organic growth v. acquisition
An industry with many small firms may be highly competitive, consolidation decreases
! competition
Herfindahl-Hirschman Index (HHI): - 𝐬𝐢 𝟐 = sum of squared market shares
𝐢#𝟏

Monopoly HHI = 10,000 (1002) High Concentration Moderate Concentration

2,500+ 1,500 - 2,500
(Acquisition causing 200 + increase may face regulatory
challenge)

Structure and External Influences

Porter’s Five Forces
Threat of Threat of Bargaining Power Bargaining Power Rivalry Amongst
New Entrants Substitutes of Customers of Suppliers Existing Competitors

Historic # substitutes Number/size Number/size History

Network effects Easy to switch? Are products Easy to switch Concentration
Economies of Scale Innovation of critical for customer Differentiated? Differentiated Products?
Economies of Scope substitutes % of customer # substitutes Exit barriers?
Customer Loyalty budget Slow growth?
Switching Costs Can customers
Preferential Access ‘backward integrate’
Gov’t. Policies

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Structure and External Influences

External Influences : PESTLE
Political Economic Social Technological Legal Environmental

Fiscal Policy GDP Trends Sustaining Laws Low Carbon

Monetary Policy Inflation Demographics Disruptive Regulations Transition Risk
Regulation Interest Rates [External?]
Gov’t. Purchasing Cycle

Competitive Strategy
An effective strategy is evidenced by a track record of economic profit
But how to assess it on a forward-looking basis?
Three Questions
1. Does it create a defense against the five industry forces?
2. Does it benefit from, or at least not clash with, external industry forces? (PESTLE)
3. Does the company have the resources and capabilities to make it work?

Three Strategies

Cost Leadership Differentiation Focus

Lowest Cost Producer Superior Product Focus on specific
customer group

Strategy 4 : Stuck in the middle.

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Competitive Strategy

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Company Analysis: Forecasting

a. explain principles and approaches to forecasting a company’s financial results and

position

b. explain approaches to forecasting a company’s revenues

c. explain approaches to forecasting a company’s operating expenses and working

capital

d. explain approaches to forecasting a company’s capital investments and capital

structure

e. describe the use of scenario analysis in forecasting

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Company Analysis: Forecasting

Principles and Approach

Perspective in this module: longer-term-oriented forecast for straightforward public
issuer

What to Forecast (forecast objects)

1. Drivers of Financial Statement Lines e.g. Sales : Stores opened, sales per store
operating expenses : % of sales
2. Individual Financial Statement Lines - less material lines, those without clear drivers
e.g. depreciation expense
3. Summary Measures e.g. Free Cash Flow, EPS, Total Assets ➞ efficient but less transparent
(typically used when measure is stable, predictable, disclosures are
minimal)
4. Ad Hoc Objects - items not yet reported in financial statements
e.g. Forecast Result of legal proceedings
Use forecast objects that are disclosed regularly: gross margin √ by product line?
Avoid overly complex models

Principles and Approach

Forecast Approaches
Historical Results Historical Base Rates Management Guidance Analyst’s Discretion
and Convergence
Assume past is precedent Assume convergence to Public company published All other methods
peer group average management guidance
simple, default discretion required in check track record surveys
industry structure not choosing object, sample, sensitivity to business quantitative models
expected to change time frame cycle (no informational probability
advantage for mgmt.) distribution
low sensitivity to suited to mature, stable used when change
business cycle industries - Tesla? is likely
non-material items not for cyclical or climate change
dominant companies
alphabet and meta
Forecast Horizon: Determined by investment strategy, cyclicality, company factors, employer

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Forecasting Revenues
Forecast Objects : Top-Down
Growth Relative to GDP: 1. Forecast growth rate of nominal GDP - Real GDP growth (volume)
- inflation forecast
2. Adjust for company specifics - +/- bps for life cycle, bus. cycle

Market Growth and Market Share: 1. Forecast growth rate for company’s product market - v.
GDP?
2. Forecast market share e.g. Product market today = 250 bn
Forecast growth = 10%
Market share today = 5%
Expected market share growth = 0%
Forecast Objects: Bottom-Up
Volumes and Average Selling Prices - useful for industries that disclose (airlines, asset
managers)
Product-Line or Segment Revenues - if disclosed and segments have different economic
exposures
Capacity-Based Measures - Retail e.g. number stores and sales per store
Return or Yield Based Measures - e.g. net interest income for banks

Forecasting Revenues
Non-Recurring Items (exclude!)
Disclosed (easy) : changes in exchange rates may use proprietary forecasts
extra days/weeks in a period
acquisitions/divestitures
other (unusual/infrequent) Financial Reporting Quality?

Not Quantified (not as easy) : Require Judgment

e.g. COVID-19: large increase in e-commerce sales as a % of retail sales
will this recur, is it a ‘new normal’?
[it did not] [no]

Forecast Approaches
Any of the four!

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Forecasting Revenues

Forecasting Expenses
Disclosures RE: expenses are less detailed than revenue - Analyst likely to use aggregated
data
Cost of Goods Sold (COGS)
Revenue is the key driver ➞ use % sales or gross margin
Typically large/largest cost ➞ be accurate! considerations - Price Shocks ➞ Hedging?
- Growth Substitutes
- New Products
- Differing Business Models
e.g. owned stores v. franchised
Understand impact of changing input prices:
e.g. : Year 1: Sales 100 increase is fully passed on Sales 125
COGS (25) input costs double COGS (50)
Gross Profit 75 Gross Profit 75
COGS as % sales 75% COGS as % sales 40%
Gross Margin 25% Gross Margin 60%

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Forecasting Expenses
SG&A Expenses
Relationship with sales not as direct as COGS
selling and distribution may be modeled using sales
general more fixed - driver may be wage inflation

Company’s presenting segmental disclosures will disclose segmental EBITDA, operating

margins Analyst may use these summary measures rather than COGS and S,G&A

Forecasting Expenses
5 yrs. 1. Assuming total sales growth of 2% and
constant overall underlying profit margin,
29,308
15,203 calculate sales, OP cost and OP profit margin
15,077 in 5 years.
Sales (51,990 × 1.025) 57,390
OP Profit Margin 19.1%
Operating Costs 46,428
Operating Profit 10,962

6,648 2. Assuming segmental growth rates (6%, -5%,

2,666 7%) and constant segmental operating profit
2,235 margin:
Sales (29,308 + 15,203 + 15,077) 59,588
Operating Profit (6,648 + 2,666 + 2,235) 11,549
OP Profit Margin 19.38%

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Forecasting Working Capital

Efficiency Ratios! (Note: example uses year-end balances)

Year 3: DSO = 10,161 × 365 = 15.08 Year 6: Acc. Receivable = 15 × 380,292 = 15,716
245,866 365
DOH = 41,671 × 365 = 73 Inventory = 73 × 319,445 = 63,657
209,114 365
DPO = 72,199 × 365 = 126 Acc. Payable = 126 × 319,445 = 110,292
209,114 365

Forecasting Capital Structure

Forecasted long-term assets are based on cash flow statements and income statements

PPE increases due to decreases due to

capital expenditure depreciation

maintenance CAPEX growth CAPEX useful lives

historic depn. plus more discretionary
inflation adjustment

Forecasted capital structure ➞ use leverage ratios

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Forecasting Capital Structure

Assume PPE CAPEX = % of Revenue (Year 3 level)
Intangible CAPEX = % of Revenue (Year 1 level)
Goodwill remains at Year 3 level
Depn. & Amtzn. % of Beginning net PPE, net
intangibles
(Year 3 level)
Total Fixed Assets in Year 4: 12,326
PPE (net) at end Yr. 3 : 6,306
CAPEX (1.2% × 290,122): 3,481
Dep’n. (7% × 6,306) : (441)
9,346 9,346
Intangibles (net) end Yr. 3: 4,013
CAPEX (0.2% × 290,122): 580
AMTZN (47% × 4,013) : (1,866)
2,727 2,727
Year 4 Forecast Revenue 290,122
Goodwill (= Year 3) 253 253

Forecasting Capital Structure

Assume : EBITDA margin of 6%

Gross debt to EBITDA Ratio of 1.25

Forecasted gross debt year 4:

EBITDA = 6% × 290,122 = 17,407
Gross debt = 1.25 × 17,407 = 21,759

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Other Approaches

Scenario Analysis
Final Step in Forecasting - incorporate risk factors - Business Cycle
- Inflation/Deflation
- Competition
- Technology
Analyst should forecast a range of scenarios, not a point estimate

Assessing impact of tablet sales on PC sales

Assume cannibalization factors: 40% for Consumers

15% for Non-Consumers

Average Selling Price : Consumer USD 85

Non-Consumer USD 155

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Equity Valuation: Concepts and Basic Tools

a. evaluate whether a 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 an 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 advantages and disadvantages of each category of valuation model

LOSs will match between the video and the MM PDFs, but may be
in a different order than the CFAI readings

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IV versus MV
LOS a
- goal is to identify mispriced securities - evaluate
(i.e. IV ≠ MV)

IV - intrinsic value/fundamental value

MV - market value
< - overvalued + 10% - 20% tighter
IV = MV - fairly valued
bands
> - undervalued - 10% - 20%

· also depends
on the confidence of the inputs ⇒ more confidence

· also depends on the expected time frame of

convergence of IV and MV

Valuation Models
Page 2
- 3 major categories of valuation model LOS b
1) Present Value Models (discounted cash flow) - describe
- present value of the future benefits to be
received from the security
- either future dividends paid (dividend discount model)
or future cash available to pay dividends (FCFF/FCFE)

2) Multiplier Models - market value or Enterprise Value

multiples
- price is some multiple of some fundamental variable
e.g./ P/E or P/S (stated on a forward basis based on an
estimate, or on a trailing basis based on observed values)

3) Asset based valuation models

(estimated value of Assets) - (estimated value of
Liabilities + est. value
of Pref. shares)

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Dividends & Repurchases

Page 3
· Dividend - a distribution paid to shareholders
LOS c
based on the number of shares owned - describe
- regular cash dividend - paid at regular intervals
- extra or special dividend - paid by a company that does
not pay at regular intervals or as a supplement

➞ not a legal obligation ➞ they are discretionary

➞ declared/authorized by the BoD

· Stock Dividend - bonus issue of shares - additional shares

issued (typically 2% - 4%) instead of cash
- not relevant for valuation

· Stock Splits/Reverse Stock Splits - no economic effect

↓ ↓
increase # of shares decrease # of shares
e.g. 2-for-1 (P0/sh. ↓) e.g. 1-for-10 (P0/sh. ↑)

Page 4
· Share Repurchase - an alternative to cash LOS c
dividends - describe
- company uses cash to buy back its own stock

Transaction:
Treasury Stock $ ➞ a contra-equity account
PPE
Cash $ - Accum.Dep.

these shares are not considered for dividends, voting or

computing EPS

Reasons for:
a) signaling a belief that their shares are undervalued
b) flexibility on amounts and timing
c) tax efficiency (deliver capital gains vs. dividends)
d) nullify the effect of employee stock options

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Dividend Payment Chronology

Page 5
dividends are stock begins trading
LOS d
now contractual without the dividend - describe
Declaration Ex-Dividend
Date Date
-

-
May 29 Sept 28 Sept 29 Oct 21
Holder of Payment
Record Date Date

- settlement = T + 2 ∴ to be a shareholder of record on

Sept. 29, must buy the stock by close of Sept. 27
$10 cum.-dividend
stock ‘opens’ lower
date
by the amount of
9.75
the dividend
9.50
-25¢ +25¢
Sept. 28

Present Value Models

LOS e
⇒ Save today to have more tomorrow
- explain
(defer consumption) (future benefits) - describe
to have
∴ Value
present value of future
today
benefits
Simplest PV model ⇒ Dividend Discount Model (DDM)
9 V0 - value of share today
𝐃𝐭
𝐕𝟎 = N Dt - expected dividend in year t
(𝟏 + 𝐫)𝐭
𝐭'𝟏 r = required rate of return

usually estimated using CAPM

𝑽𝟎 𝒕𝟏
= 𝐫𝐟 + 𝛃(𝐫𝐄 − 𝐫𝐟 )

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9 LOS e
𝐃𝐭 - explain
𝐕𝟎 = N ⇒ why use ∞
(𝟏 + 𝐫)𝐭 - describe
𝐭'𝟏

- holding period, t = 1
𝐃𝐭 𝐏𝐭 𝐃𝐭<𝟏 𝐏𝐭<𝟏
𝐕𝟎 = + where 𝐏𝐭 = +
(𝟏 + 𝐫) (𝟏 + 𝐫)
𝐭 (𝟏 + 𝐫) (𝟏 + 𝐫)
so at t = 2
𝐃𝐭 𝐃𝐭<𝟏 𝐏𝐭<𝟏 𝐃𝐭<𝟐 𝐏𝐭<𝟐
𝐕𝟎 = + + where 𝐏𝐭<𝟏 = +
(𝟏 + 𝐫) (𝟏 + 𝐫)𝟐 (𝟏 + 𝐫)𝟐 (𝟏 + 𝐫) (𝟏 + 𝐫)
and at t = 3
𝐃𝐭 𝐃𝐭<𝟏 𝐃𝐭<𝟐 𝐏𝐭<𝟐 and so on…
𝐕𝟎 = z + + {+
(𝟏 + 𝐫) (𝟏 + 𝐫)𝟐 (𝟏 + 𝐫)𝟑 (𝟏 + 𝐫)𝟑
t = n
𝐧
𝐃𝐭 𝐏𝐧
𝐕𝟎 = |N }+~ • ⇒ terminal stock value
(𝟏 + 𝐫)𝐭 (𝟏 + 𝐫)𝐧
𝐭'𝟏

LOS e
e.g./ YR1 YR2 YR3 - explain
Div. 2.00 2.10 2.20 - describe
P3 = 20
r=10% 𝟐. 𝟎𝟎 𝟐. 𝟏𝟎 𝟐. 𝟐𝟎 𝟐𝟎
𝐕𝟎 = + + +
Find V0 (𝟏. 𝟏𝟎) (𝟏. 𝟏𝟎)𝟐 (𝟏. 𝟏𝟎)𝟑 (𝟏. 𝟏𝟎)𝟑

= 𝟏. 𝟖𝟏𝟖 + 𝟏. 𝟕𝟑𝟔 + 𝟏. 𝟔𝟓𝟑 + 𝟏𝟓. 𝟎𝟐𝟔

= $𝟐𝟎. 𝟐𝟑

V0 depends directly on dividends expected to

be received and indirectly on the (dividends
subsequent to the end of the holding period)

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LOS e
e.g./ D0 = $4
- explain
g = 20% (expected growth rate in the
- describe
dividend for one year)
rf = 6%
rE = 11% What is V0?
𝒕=𝟏
𝛃 = 1.2 𝐃𝐭 𝐏𝐭 Dt = D0(1 + g)
𝐕𝟎 = +
est. P1 = $15.40 (𝟏 + 𝐫) (𝟏 + 𝐫) = 4(1.2)
𝟒. 𝟖𝟎 𝟏𝟓. 𝟒𝟎 = 4.80
= +
(𝟏. 𝟏𝟐) (𝟏. 𝟏𝟐)
r = rf + 𝛃(rE - rf)
= 𝟒. 𝟐𝟗 + 𝟏𝟑. 𝟕𝟓 = .06 + 1.2(.11 - .06)
= 𝟏𝟖. 𝟎𝟒 = .06 + 1.2(.05)
= .06 + .06
= .12

LOS e
- FCFE ⇒ free cash flow to equity - explain
- describe
reflects dividend paying capacity
(useful for non-dividend paying stocks)

CFO - (CFInv + Net Borrowings)

CAPEX
Usually CAPM
9 Recall 𝐫 = 𝐫𝐟 + 𝛃(𝐫𝐄 − 𝐫𝐟 )
𝐅𝐂𝐅𝐄𝐭 economic
𝐕𝟎 = N
(𝟏 + 𝐫)𝐭 or/ r = rf + risk premium judgement
𝐭'𝟏
gov’t. company’s
Dt bond yield
bond

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Preferred Shares
LOS f
- non-callable, non-convertible
- calculate
(perpetual)
𝐃𝟎 Recall: dividend
𝐕𝟎 = PV of a perpetuity stated as a fixed
𝐫
yield
𝟓. 𝟓𝟎
e.g./ $100 par value @ 5.5% , r = 6% 𝐕𝟎 = = 𝟗𝟏. 𝟔𝟕
. 𝟎𝟔

e.g./ maturity at time n ⇒ same as a bond

𝐧
𝐃𝐭 𝐅𝐕 e.g. $20 par value @ 6% semi
𝐕𝟎 = N + maturing in 6 years, r = 8%
(𝟏 + 𝐫)𝐭 (𝟏 + 𝐫)𝐧
𝐭'𝟏
FV = 20
PMT = .60 CPT PV = $18.12
n = 12
I/Y = 4

LOS f
e.g./ Non-Callable, Non-Convertible, Perpetual - calculate
Par value = $100 @ 4.75%
Credit Rating = Ba1/BB, required return on BB = 7.5%
𝐃𝟎 𝟒. 𝟕𝟓 What if the
IV = ? 𝐕𝟎 = = = $𝟔𝟑. 𝟑𝟑
𝐫 . 𝟎𝟕𝟓 shares were
callable?

e.g./ Retractable Term Preferred Shares

FV = 25
Par value $25 @ 5% quarterly n = 34
retractable in 34 quarters at par PMT = (25 x .05)/4
r = 15.5% = 0.3125
I/Y = 𝟏𝟓. 𝟓A𝟒 = 𝟑. 𝟖𝟕𝟓
CPT PV = $12.71

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Gordon Growth Model

LOS g
- allows for growth/change of the
- calculate
dividend over time - interpret
⇒ Gordon Growth - assumes dividends grow indefinitely
at a constant rate
(non-cyclical, mature companies)
9
𝐃𝟎 (𝟏 + 𝐠)𝐭 (𝟏 + 𝐠) (𝟏 + 𝐠)𝟐 (𝟏 + 𝐠)9
𝐕𝟎 = N = 𝑫𝟎 ‚ + + ⋯ + ƒ
(𝟏 + 𝐫)𝐭 (𝟏 + 𝐫) (𝟏 + 𝐫)𝟐 (𝟏 + 𝐫)9
𝐭'𝟏
⇒ r strictly greater than g

infinite geometric series

𝐃𝟎 (𝟏 + 𝐠) 𝐃𝟏
𝐕𝟎 = = sums to (𝟏 + 𝐠)
𝐫−𝐠 (𝐫 − 𝐠)
(𝟏 − 𝐠)

LOS g
e.g./ D0 = $5
𝐃𝟎 (𝟏 + 𝐠) 𝟓(𝟏. 𝟎𝟒) - calculate
g = 4% 𝐕𝟎 = = = $𝟏𝟑𝟎/𝐬𝐡. - interpret
𝐫−𝐠 . 𝟎𝟖 − . 𝟎𝟒
r = 8%
PV of a growing perpetuity
𝐃𝟎
- if g = 0 , 𝐕𝟎 = PV of a perpetuity
𝐫

how do we get g?
g = div. growth rate
g = b × ROE
b = earnings retention rate
(1 - DPR)
ROE = return on equity

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LOS g
- calculate
- interpret

IV = ? with
r = 19%
𝐃𝟎 (𝟏 + 𝐠)
𝐕𝟎 =
D0 = 2.28 r = .19 g = ? 2.28 = 1.35(1 + g)4 𝐫−𝐠

𝟐. 𝟐𝟖(𝟏. 𝟏𝟒) = g = .14

𝐕𝟎 = = $𝟓𝟏. 𝟗𝟖 ∴ share price of $38.91 undervalued
. 𝟏𝟗 − . 𝟏𝟒
𝟐. 𝟐𝟖(𝟏. 𝟏𝟑)
𝟐. 𝟐𝟖 if g = 13% 𝐕𝟎 = = 𝟒𝟐. 𝟗𝟒
if g = 0 𝐕𝟎 = = $𝟏𝟐 . 𝟏𝟗 − . 𝟏𝟑
. 𝟏𝟗
∴ g adds $39.98 to V0 if g = 13% 𝟐. 𝟐𝟖(𝟏. 𝟏𝟑)
𝐕𝟎 = = 𝟑𝟔. 𝟖𝟏
r = 20% . 𝟐 − . 𝟏𝟑

LOS g
- calculate
- interpret
strictly
15.8
15.9
19%

- model is extremely sensitive to changes in

both r and g

· as r ➞ g, P0 ↑ dramatically, hence the requirement

that g must be strictly less than r

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assumptions: LOS g
- calculate
1) Dividends are the correct
- interpret
metric for valuation purposes

2) g is forever ⇒ perpetual and never changes

3) r is also constant over time

4) g is strictly less than r

- alternatives
a) modify the model (for varying patterns of
growth)
b) use a cash flow measure
other than dividends (for non-dividend
paying stocks)
c) use some other approach

LOS g
e.g./ D5 = 4.00 (expected) - calculate
g = 6% (t5 onwards) - interpret
r = 10%
4.00 4.00(1.06)....
0 5 6 7 g = 6%
r = 10%

𝐃𝟓 (𝟏 + 𝐠) 𝟒. 𝟎𝟎(𝟏. 𝟎𝟔)
𝐕𝟓 = = = $𝟏𝟎𝟔
𝐫−𝐠 . 𝟏 − . 𝟎𝟔
𝟒. 𝟎𝟎
(𝟏. 𝟏)𝟓 𝟒
𝐕𝟒 …. 𝟏 − . 𝟎𝟔†
𝟏𝟎𝟔 𝐕𝟎 = =
(𝟏 + 𝐫)𝟒 (𝟏 + 𝐫)𝟒
(𝟏. 𝟏)𝟓
= 𝟐. 𝟒𝟖𝟒 + 𝟔𝟓. 𝟖𝟏𝟖 = 𝟔𝟖. 𝟑𝟎 = 𝟔𝟖. 𝟑𝟎

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LOS g
- Multistage DDM - calculate
- interpret
2-stage: makes use of 2 growth rates

high g low g
𝐠𝐬 𝐠𝐋
2 - initial finite - perpetuity
1 period
Vn use Gordon Growth
use DDM + terminal
V0 value
model to estimate Vn

𝐧
𝐃𝟎 (𝟏 + 𝐠 𝐬 )𝐭 𝐕𝐧 𝐃𝐧<𝟏
𝐕𝟎 = N + 𝐕𝐧 =
(𝟏 + 𝐫) 𝐭 (𝟏 + 𝐫)𝐧 𝐫 − 𝐠𝐋
𝐭'𝟏
𝐃𝐧<𝟏 − 𝐃𝟎 (𝟏 + 𝐠 𝐬 )𝐧 (𝟏 + 𝐠 𝐋 )

LOS g
e.g./ D0 = $5.00 - calculate
gs = 10%/a for 3 years - interpret
gL = 5%/a subsequent
r = 15% D3 = 5.00(1.1)3
g = 10%
g = 5%
-

0 1 2 3 4 -5
5.00
𝟓(𝟏. 𝟏) 𝟓(𝟏. 𝟏)𝟐 r = 15%
𝐕𝟎 = +
𝟏. 𝟏𝟓 (𝟏. 𝟏𝟓)𝟐
𝟑
𝐃𝟑 (𝟏 + . 𝟎𝟓) 𝟓. 𝟎𝟎(𝟏. 𝟏)𝟑 (𝟏. 𝟎𝟓)
𝟓(𝟏. 𝟏) 𝟔𝟗. 𝟖𝟕𝟕𝟓 𝐕𝟑 = =
+ + . 𝟏𝟓 − . 𝟎𝟓 . 𝟏𝟓 − . 𝟎𝟓
(𝟏. 𝟏𝟓) 𝟑 (𝟏. 𝟏𝟓)𝟑
= 𝟔𝟗. 𝟖𝟕𝟕𝟓
= $𝟓𝟗. 𝟔𝟖 (90 Sec)

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Model Appropriateness

LOS h
- constant growth - stable growth
- identify
- maturity phase
g < (1 - DPR)ROE
- non-cyclical
- dividend paying company

- multi-stage DDMs - rapidly growing companies

FCFE
growth fairly young company
3-stage DDM ⇒ transition just entering growth
maturity stage

transition older companies out of

2-stage DDM ⇒ growth stage or a
maturity
revitalized company

Price Multiples
LOS i, j
- ratios that compare the share price - explain
with some sort of monetary flow or value - calculate
earnings book value - interpret
sales
cash flow
𝐏𝟎 𝐏g = 𝐏𝟎 𝐏g = 𝐏𝟎 𝐏g = 𝐏𝟎
𝐏𝐄 = 𝐁 𝐁𝐕g 𝐒 𝐒𝐚𝐥𝐞𝐬g 𝐂𝐅 𝐅𝐂𝐅g
𝐄𝐏𝐒
𝐬𝐡. 𝐬𝐡. 𝐬𝐡.
(or OCF/sh.)

- denominators may be based on trailing values

or forward values

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LOS i, j
Price-to-Earnings (P/E)
+ - explain
- - calculate
- easy to use · useless if EPS < 0, - interpret

- most common measure if earnings are volatile

- strongly correlated to long-term · earnings are an accounting
returns measure

+ Price-to-Sales (P/s)
-
- not influenced by actg. choices - rev. recognition issues
- better metric if EPS < 0 still apply
- ignores cost structure

LOS i, j
Price-to-Cash Flow (P/CF)
+ - explain
- - calculate
· more of an economic measure - interpret
- ignores non-cash
· more difficult to manipulate
revenues
· tends to be less volatile than EPS
· more reliable over long-term

+ Price-to-Book Value (P/BV)

-
· more stable measure - ignores relative asset
· can be used even if EPS < 0 size in comparisons
· appropriate for firms in
- book value ≠ market value
distress

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LOS i, j
< undervalued - explain
Ratio = specified fairly valued - calculate
> value overvalued - interpret

EPS

.96
.84 𝟑𝟔
.72 Σ = 3.12 𝐏𝐄𝐭𝐭𝐦 = = 𝟑𝟎𝐱
𝟏. 𝟐𝟎 (overvalued)
.60
.48
.36 𝟑𝟔
Σ = 1.20 𝐏𝐄𝐟 = = 𝟏𝟏. 𝟓𝟑𝐱
.24 𝟑. 𝟏𝟐
.12 (undervalued)
actual estimated Q
YR1
Target Price = 15 × 3.12 = $46.80
industry P/E = 15 Strong - ‘Buy’
P0 = $36.00

LOS i, j
𝐃𝟏
Recall 𝐕𝟎 = - explain
𝐫−𝐠 - calculate
- interpret
𝐃𝟏
Let’s assume that V0 = P0 , then 𝐏𝟎 =
𝐫−𝐠

𝐃𝟏g
Divide P0 & D1 by EPS 𝐏𝟎g 𝐄𝐏𝐒 DPR
𝐄𝐏𝐒 = 𝐫 − 𝐠

𝐃𝐏𝐑
justified = 𝐏g =
𝐄 𝐫−𝐠

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LOS i, j
𝐏g = 𝐃𝐏𝐑 So, P/E is positively related - explain
𝐄 𝐫−𝐠
to - calculate
① DPR - questionable however
- interpret
called the - higher DPR, lower retention
‘justified P/E’ rate, lower re-investment
(i.e. justified by the (dividend displacement of
fundamentals) earnings)
② g ⇒ (1 - DPR)ROE
∴ P/E is positively
related to ROE

…and negatively related to r.

LOS i, j
- Based on comparables - explain
multiple 1 - calculate
Company multiple 2 versus Benchmark value - interpret
multiple 3 (i.e. compared to) of the multiple(s)
etc.…

Rationale: · a closely matched

‘Law of one Price’ individual stock
typically · avg. multiple of a
- identical assets
called peer group or industry
should sell for the
‘comps’ · avg. multiple derived
same price
from trend or time-series
analysis

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LOS i, j
e.g./ Company P/S - explain
A .14 ⇒ A appears - calculate
B .26 undervalued ‘Relative’ to its - interpret
C .32 peers
or/
D .48
E .64 ⇒ E appears overvalued
‘Relative’ to its peers

e.g./ Year
2016 2015 2014 2013 2012
P/E 11.2 13.6 15.2 16.1 15.8

appears undervalued ‘Relative’ to its

historical trend

Enterprise Value Multiples

LOS k
- rather than estimate the value of - describe
equity, estimate the value of the enterprise
(𝐏𝟎 × # 𝐨𝐟 𝐬𝐡𝐚𝐫𝐞𝐬) + 𝐌𝐕(𝐏𝐫 ) + 𝐌𝐕(𝐃𝐞𝐛𝐭) − 𝐂𝐚𝐬𝐡
MV(equity)

cost of a takeover
· most useful when
comparing companies with
significant differences in capital structure

Note: EV may be difficult

e.g./ 𝐄𝐕0
𝐄𝐁𝐈𝐓𝐃𝐀 to calculate for companies
whose debt is not publicly traded

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Asset-Based Valuation
LOS L
- uses MVs of a company’s A & L to
- describe
determine the value of the company as a whole

- more frequently used with:

· private companies
· companies with few/no intangibles or
off-book assets (i.e. reputation)
· companies with high proportion of CA & CL
· companies being liquidated
· financial companies

Not suitable for · companies whose MV of A & L are

difficult to determine or have a significant
amount of intangible assets

1. Using DDM,
E find V0 (r = 10%)
✓
E 𝐃𝟏
𝐕𝟎 = 𝐃𝟎 = (𝟏 + 𝐠)
E 𝐫−𝐠
E
E
𝟑. 𝟏𝟎 = 𝟐. 𝟒𝟑(𝟏 + 𝐠)𝟓

‰𝟑. 𝟏𝟎g𝟐. 𝟒𝟑 − 𝟏 = 𝐠
𝟓

= 𝟒. 𝟗𝟗𝟎𝟕%
~𝟓%
𝐃𝟎 (𝟏 + 𝐠)
= 𝟐. 𝟒𝟑(𝟏. 𝟎𝟓) = 𝟐. 𝟓𝟓
② Find IV assuming avg. PEttm is
appropriate. 𝐏 (𝟏𝟑. 𝟐 + 𝟏𝟔. 𝟒 + 𝟏𝟓. 𝟐 + 𝟏𝟒)g
g𝐄 = 𝟒 = 𝟏𝟒. 𝟕 𝟐. 𝟓𝟓
𝐈𝐕 = 𝟒. 𝟎𝟎 × 𝟏𝟒. 𝟕 = $𝟓𝟖. 𝟖𝟎 (U) 𝐕𝟎 = = $𝟓𝟏. 𝟎𝟎
. 𝟏 − . 𝟎𝟓

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Asset-Based Valuation
= MV MV(A) = 5000 +
= MV 15000 + 30000
+ 55000 = 105,000
x 1.1 = MV

= MV MV(L) = 3,000 + 17,000

= MV + 25,000 = 45,000

= MV
1000 shares
MV(A) - MV(L) = 105,000
20% - 45,000
DDM ⇒ $51 P0 = $50.80 60,000
P/E ⇒ $58.80 𝟔𝟎, 𝟎𝟎𝟎
𝐕𝟎 = = $𝟔𝟎
𝟏𝟎𝟎𝟎

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REVIEW

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Market Organization & Structure

Review - 1
Functions of Financial System/ saving
capital
1) Facilitate transfer of borrowing
risk
- providers/users of capital ➞ indiv., bus., gov’t.
- information-based trading (speculator return > req. r)
2) Price Discovery - what is the price of risk
3) Facilitate the efficient allocation of capital
- hedging, insurance
- capital seeks out best risk-adjusted return
- requires/ speedy transactions
low transaction costs
access to information
regulation

Review - 2
Assets/ - financial assets - stock, bonds, currencies
- physical assets - commodities, real estate
Markets classified by/
spot
1) timing of delivery forward/futures
2) who the seller is primary
secondary
money mkt.
3) the maturity of the instruments traded
capital mkt.
4) types of securities traditional (debt, equity)
alternative (private equity, securitized
Securities/ debt)
① Fixed-Income (notes, bills, bonds, CDs, Repos, MM)
② Equities (common, preferred, warrants)
③ Pooled Investments (mutual funds, ABS)

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Review - 3
Currencies - forex
Contracts - a financial contract between 2 parties
underlying financial asset
physical asset
- some cash settled, some physical settlement
a) Forwards
Buyer both have an to buy a specific at a specific by a
Seller obligation to sell asset price certain
b) Futures - exchange-traded forwards (standardized) date

c) Swaps - an exchange of cash flows

d) Options Call to buy a specific at a specific by a certain
a right
Put to sell asset price date
Sellers ➞ an obligation
e) Others - Insurance, Credit Default Swaps

Review - 4
Commodities - spot
hedging
- forward/futures
speculation
generally illiquid
Real Assets - property, factories, equipment high mgmt. costs
⇒ Intermediaries/
1) Brokers, Exchanges, ATS (Alternative Trading Systems)
best bid and ask dark pools - do not display
order sent to them
2) Dealers - hold inventory
- act as market makers (create liquidity)
- Primary Dealers (can buy/sell w/ Central Bank)
3) Securitizers
4) Depository Institutions/Other Financial Corporations
- banks, credit unions (deposit taking)
5) Insurance Companies

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Review - 5
⇒ Intermediaries/
6) Arbitrageurs
7) Settlement & Custodial Services - hold securities on
behalf of clients
⇒ Positions/ long - benefits from an increase in price
short - benefits from a drop in prices
forward/future long - takes delivery
short - delivers
options long - buy a call or put
short - sell a call or put
swaps - party that benefits from a rise in rates = long
Currencies - traded in pairs, long one, short the other
⇒ Levered Positions/ margin = me , loan = broker
- interest rate on loan = ‘call money’ rate

Review - 6
⇒ Levered Positions/
Initial margin
- margin requirements
maintenance margin

Leverage Ratio = 𝐕𝐚𝐥𝐮𝐞 𝐨𝐟 𝐏𝐨𝐬𝐢𝐭𝐢𝐨𝐧 𝐦𝐚𝐱. 𝟏

𝐕𝐚𝐥𝐮𝐞 𝐨𝐟 𝐄𝐪𝐮𝐢𝐭𝐲 𝐥𝐞𝐯𝐞𝐫𝐚𝐠𝐞 =
𝐦𝐢𝐧𝐢𝐦𝐮𝐦
𝐏𝐨𝐬𝐢𝐭𝐢𝐨𝐧 𝐑𝐚𝐭𝐢𝐨
𝐦𝐚𝐫𝐠𝐢𝐧
𝟏 − 𝐈𝐧𝐢𝐭𝐢𝐚𝐥 𝐌𝐚𝐫𝐠𝐢𝐧 𝐫𝐞𝐪𝐮𝐢𝐫𝐞𝐦𝐞𝐧𝐭
Margin Call = 𝐏𝟎 × ~ •
𝟏 − 𝐌𝐚𝐢𝐧𝐭𝐞𝐧𝐚𝐧𝐜𝐞 𝐌𝐚𝐫𝐠𝐢𝐧
e.g./ P0 = $60 margin = 50% maintenance margin = 25%
𝟏 − .𝟓
𝐂𝐚𝐥𝐥 = 𝟔𝟎 ~ • = 𝟔𝟎…. 𝟓g. 𝟕𝟓† = 𝟒𝟎
𝟏 − . 𝟐𝟓
⇒ Order Types/ Execution Instructions
Bid - Ask 1) Market buy on the Ask
sell on the Bid
spread
2) Limit - specified price

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Review - 7
⇒ Order Types/ market - guaranteed execution, but not price
limit - guaranteed price, but not execution
x x x x x
Bid Ask
behind the marketable
to Buy: make the create a
market limit order
market new market
Standing limit all earlier orders
order at the bid executed
first
⇒ Exposure Instructions/ display or hide, or display a certain size

⇒ Validity Instructions/ when an order is to be filled

Day - default
GTC - good-til-cancelled
FOK - fill-or-kill
good-on-close - market order on close

Review - 8
⇒ Validity Instructions/
stop loss (stop a long pos.)
Stop orders
buy stop (stop a short pos.)

⇒ Clearing Instructions/ applies when using more than 1 broker

⇒ Primary Market/ IPOs Issuer Investor
underwriting offer - Inv. Bank buys entire issue
- sells to market (spread = income)
best efforts offer - acts as a broker only
(commission = income)
⇒ Secondary Market/ Investor - Investor
⇒ Private Placements/ securities not offered to the public
⇒ Call Markets/ trades occur only at particular times & places
- all bids/asks balanced to determine one
price - all trades occur at this price

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Review - 9
⇒ Continuous Market/ anytime trading when mkt. is open
- auction market or dealer market
⇒ Quote Driven Markets/ dealer markets (dealer supplies both
(OTC) bid & ask)
⇒ Order-Driven Markets/ pure action markets
(exchanges)
order matching rules/
price precedence - best bid & best ask
display precedence - displayed over hidden at same
price
time precedence - first over others w/ same
price & display
trade pricing rules/ uniform pricing - Call Mkt.

discriminatory pricing (auction mkt.)

Review - 10
derivative pricing rule/ mid point of bid-ask from
another market
⇒ Brokered Markets/ brokers arrange trades (unique items)
⇒ Trade Information/ pre-trade transparency - bid/ask known before
trade
post-trade transparency - prices known after
trades executed
⇒ Well-functioning financial system/
timely & accurate disclosures (information efficiency)
liquidity (operational efficiency)
complete markets - assets/contracts exist to
satisfy savers, borrowers, hedgers, asset
external information efficiency exchanges
- prices reflect all information
+ financial intermediaries + regulation

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Security Market Indicies

Review - 1
Index ⇒ constituent securities representing a given
security market (or asset class)
- 2 versions ① Price Return - reflects only prices
② Total Return - reinvestment of all income

uses/ · evaluate performance (active mgrs.)

· construct investment portfolios (passive)
· estimate market risk
∑𝐍𝐢'𝟏 𝐧𝐢 𝐏𝐢
𝐕𝐏𝐑𝐈 = a number chosen at inception
𝐃 value of
so the index has a nice
divisor
price initial value - divisor changes
return over time so that
fundamental
price changes in index
weightings reflect price
equal
market-cap changes only
float adjusted market cap

𝑽𝑷𝑹𝑰𝟏 − 𝑽𝑷𝑹𝑰𝟎 Review - 2

⇒ Returns/ · Single Period 𝐏𝐑 𝐈 =
𝑽𝑷𝑹𝑰𝟎
𝐍 𝑵
or weighted average of 𝑷𝒊 − 𝑷𝒊 𝟎 𝑷𝒊 − 𝑷𝒊 𝟎
𝐏𝐑 𝐢 = 𝟏 ⇒ 𝐏𝐑 𝐈 = N 𝐖𝐢 𝐏𝐑 𝐢 = N 𝒘𝒊 Q 𝟏 R
each component : 𝑷𝒊 𝟎
𝐢'𝟏 𝒊'𝟏
𝑷𝒊 𝟎
each component
𝑵
𝑽𝑷𝑹𝑰𝟏 − 𝑽𝑷𝑹𝑰𝟎 + 𝑰𝟏 𝑷𝒊 − 𝑷𝒊𝟎 + 𝑰𝒊
⇒ Total Return/ 𝐓𝐑 𝐈 = or 𝐓𝐑 𝐢 = 𝟏 = N 𝒘𝒊 𝑻𝑹𝒊
𝑽𝑷𝑹𝑰𝟎 𝑷𝒊𝟎
𝒊'𝟏
(VPRI = VTRI at inception)

· Multiple Period Returns/

𝑽𝑷𝑹𝑰 = 𝑽𝑷𝑹𝑰𝟎 Z𝟏 + 𝑷𝑹𝑰𝟏 [Z𝟏 + 𝑷𝑹𝑰𝟐 [ + ⋯ + Z𝟏 + 𝑷𝑹𝑰𝑻 [ · if no

income
𝑽𝑻𝑹𝑰 = 𝑽𝑻𝑹𝑰𝟎 Z𝟏 + 𝑻𝑹𝑰𝟏 [Z𝟏 + 𝑻𝑹𝑰𝟐 [ + ⋯ + Z𝟏 + 𝑻𝑹𝑰𝑻 [
𝐕𝐏𝐑𝐈𝐓 = 𝐕𝐓𝐑𝐈𝐓

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Review - 3
⇒ Index Construction/ ① target market selection
asset class, geography, sector, industry, size?
② security selection - all or a sample?
- fixed or variable
③ weightings ④ Rebalancing ⑤ Reconstitution

how much of each security to include

① Price weighting (simplest) 𝐏𝐢 𝐈𝐧𝐝𝐞𝐱 ∑𝐍𝐢'𝟏 𝐰𝐢 𝐏𝐢

𝑾𝑷𝒊 = 𝐍 =
(called an average, not an Index) ∑𝐢'𝟏 𝐏𝐢 𝐕𝐚𝐥𝐮𝐞 𝐃
adjusted for
② Equal weighting 𝐖𝐢𝐄 = 𝟏g𝐍
splits
e.g./ $10k in 5 stocks
$2000 into as soon as a
weighting = 𝟏g𝟓 = .2 ⇒
each stock price changes, no
longer have equal
- may under/over represent securities
weighting

Review - 4
⇒ Index Construction/ ③ market-cap weighted Index
𝑸 𝒊 𝑷𝒊
④ float-adjusted 𝑾𝑴
𝒊 = 𝑵
∑𝒊'𝟏 𝑸𝒊 𝑷𝒊
# of shares - most market-cap indicies
available to the are float adjusted
investing public

· components are held in proportion to their value

· components whose prices have risen the most have
a greater weight overweight overvalued stocks
may
underweight undervalued stocks
⑤ Fundamental weighting
BV
𝑭𝒊 Contrarian effect - will overweight
𝑾𝑭𝒊 = Rev.
∑𝑵
𝒊'𝟏 𝑭𝒊 undervalued stocks
CFO
- underweight overvalued stocks
Earnings

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Review - 5
⇒ Rebalancing/ weights drift over time
𝐖𝐢𝐄 = 𝟏g𝐍 · equal weighting - reduce weights of components
that have outperformed, increase ones that
𝑷𝒊
𝑾𝑷𝒊 = have underperformed
∑𝑵
𝒊'𝟏 𝑷𝒊 · price weighting - no need to rebalance
𝑸 𝒊 𝑷𝒊 · market cap weighting - only need rebalancing
𝑾𝑴
𝒊 = 𝑵
∑𝒊'𝟏 𝑸𝒊 𝑷𝒊 to reflect M&A and liquidations

⇒ Reconstitution/ · changing the securities in the index

· results in a change in all weightings
· reflect changes in target market, bankruptcy, M&A

⇒ Uses of Indicies/ gauge market sentiment, a proxy for measuring

risk & returns, proxies for asset classes, a benchmark for
active managers, basis for the creation of investment products

Review - 6
⇒ Types/ 1) Broad market Index
2) Multi-market Index - indicies from different
countries (e.g. countries by GDP)
3) Sector Indicies
growth
4) Style Indicies
value

⇒ Fixed-Income Indicies/ · aggregate/broad market

· market sector
· style
· economic sector
· specialized

⇒ Alternative Investments/ ① Commodities - futures contracts

② Real Estate/REIT Index
appraisal
repeat sales
③ Hedge Fund Index - rely on voluntary
disclosure

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Market Efficiency
Review - 1
- the process by which the markets incorporates info.
- price efficiency - informative prices (avoids malinvestment)
- prices incorporate all past & present info.
- general conclusion/ consistent superior risk-adjusted returns
are not achievable passive R > active R

⇒ Market Value (MV) - price at which asset can be bought or sold

⇒ Intrinsic Value (IV) - price of asset if complete information
and understanding were used

IV < MV - overvalued IV > MV - undervalued

IV ≃ MV - fairly valued
+⁄− 10%

Review - 2
⇒ Impediments to efficiency/
- few market participants
characteristics - lack of information availability
of private - less financial disclosure
markets - trading is limited
- lack of transparency
- restrictions risk
classic view (return = assumed
⇒ Information Acquisition Costs/
modern view (return - Info. = risk
⇒ Forms of Efficiency/ costs assumed
Past data public info. private info.
weak √
semi-strong √ √
strong √ √ √

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Review - 3
⇒ Weak form/ future returns independent of past returns
- technical analysis useless
- no abnormal risk-adjusted returns based on past prices
⇒ Semi-strong form/ no abnormal risk-adjusted returns based
on public information
- both technical & fundamental analysis useless
- must consider what is priced in (only unanticipated
information affects prices)
⇒ Strong/ research rejects strong-form hypothesis
⇒ Time-Series Anomalies/
January
Calendar
- all lack turn-of-the month (last day + first 3)
persistence Day of the week (avg. M. r. < 0)
Holiday effect (day prior)

Review - 4
⇒ Time-Series Anomalies/
Overreaction/ investors overreact to unexpected info.
(use of a contrarian strategy)
Momentum/ securities that have outperformed in
the short-run continue to outperform
⇒ Cross Sectional Anomalies/
1) size effect - small cap tend to outperform large cap
equities on a risk-adjusted basis
2) Value effect/ value stocks outperform growth
stocks over time
(3-factor model eliminates this effect)
Other Anomalies/ closed-end fund discount
none supported by earnings surprises
persistent & IPOs
economic
consistent evidence Predictability of Returns based on prior info. cycle
related

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Review - 5
⇒ Behavioral Finance/ investors do not always act
rationally due to cognitive/behavioral biases (+ emotional)
① Loss Aversion/ tendency to avoid taking losses
- leads to ‘loss persistence’
② Herding/ ignore personal analysis and make decisions
in line with the direction of the market
③ Information Cascades/ serial correlation - acting on
actions of someone who acted on information
④ Overconfidence/ inflated view of your ability

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Overview of Equity Securities

Review - 1
⇒ Common Shares/ ownership interest (residual claim)
voting rights (governance)
Statutory voting cumulative voting
1 vote/sh. # shares × # directors
return - cap. gains, dividends
dual-class shares (ownership & voting differences)
Callable/Putable
⇒ Preferred Shares/ no voting rights
usually stated dividend (before common div.)
(still discretionary)
higher priority of claims
can be perpetual, convertible, callable, putable
prices like debt
Cumulative/ unpaid dividends accrue over time
(may also be non-cumulative)

Review - 2
⇒ Preferred Shares/ in increases in divs. if profit
participating over some level
proceeds of a liquidity event
convertible - typically ‘forced conversion’ clause
⇒ Public/ - secondary market
⇒ Private/ not listed, private placement, prices not market determined
highly illiquid (inefficient market)
1) Venture Capital
2) LBO/MBO - leveraged/mgmt. buyout
3) PIPE - private investment in public equity
restricted stock
Adv./ focus on long-term value creation
higher risk-adjusted return

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Review - 3
companies can list in international markets
- more filing requirements
investors can buy in international markets
- typically limits on foreign ownership
Direct Investing ⇒ price + Divs. forex risk
Depository Receipts - foreign company deposits shares
with Domestic Bank
issues receipts in domestic
currency on exchange
L1 - OTC Sponsored foreign company directly involved
L2 & 3 - exch. investors have ownership rights
Unsponsored foreign company not involved
depository has rights of ownership

Review - 4
GDR - global depository receipt - issued outside
home country of company and outside U.S.
ADR - American depository receipt - issued in U.S.
⇒ Global Registered Shares/ ordinary shares traded on different
exchanges in different currencies
⇒ Risk & Return/ 1) capital gains (𝐏𝐭 − 𝐏𝐭8𝟏 ) + 𝐃𝐭
𝐑𝐭 =
2) dividends 𝐏𝐭8𝟏
3) currency gains/losses
4) reinvestment of dividends (Total Return)
Book Value = A - L 𝐍𝐈𝐭 𝐍𝐈𝐭
𝐑𝐎𝐄𝐭 = =
Market Value = # shares × P 𝐀𝐯𝐠. 𝐁𝐕𝐄𝐭 (𝐁𝐕𝐄𝐭 + 𝐁𝐕𝐄𝐭8𝟏 )g
𝟐

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Review - 5
Price-to-Book 𝐌𝐕𝐄𝐭g higher ratio
𝐬𝐡. = 𝐌𝐕𝐄𝐭
𝐁𝐕𝐄𝐭g 𝐁𝐕𝐄𝐭 overvalued
𝐬𝐡. or/ higher growth
opps. priced in
Intrinsic Value (IV)
PV (expected future cash flows)

Cost of Equity 𝐫𝐞 = 𝐫𝐟 + 𝛃(𝐑 𝐦 − 𝐫𝐟 )

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Equity Valuation
Review - 1
IV - Intrinsic Value MV - Market Value
< - overvalued
IV = MV + 10 - 20%
fairly valued
> undervalued
- 10 - 20%

- must consider expected time frame of convergence

⇒ Valuation Models/
dividends
1) Present Value Models
cash flow
2) Multiplier Models - MV or EV

3) Asset-based valuation
⇒ Present Value Models/ 9
𝐃𝐭
1) Dividend Discount Model ⇒ 𝐕𝟎 = N
(𝟏 + 𝐫)𝐭
𝐧 𝐭'𝟏
𝐃𝐭 𝐏𝐧
𝐕𝟎 = N + 𝒓𝒆 = 𝐫𝐟 + 𝛃(𝐑 𝐦 − 𝐫𝐟 )
(𝟏 + 𝐫)𝐭 (𝟏 + 𝐫)𝐧
𝐭'𝟏
(usually)
explicit forecast terminal
period value

Review - 2
⇒ Present Value Models/
2) FCFE · free cash flow to equity
(useful for non-dividend paying stocks)
CFO - FCInv + Net Borrowings
1
𝐅𝐂𝐅𝐄𝐭 CAPEX judgement
𝐕𝟎 = G
(𝟏 + 𝐫)𝐭 𝐫 = 𝐫𝐟 + 𝛃(𝐑 𝐌 − 𝐫𝐟 ) or r = rf + risk premium
𝐭&𝟏

gov’t. company’s bond

bond yield
⇒ Preferred Shares/ 𝐕 = 𝐃𝟎
𝟎
𝐫 (perpetuity)
- div. stated as a yield (stable)
⇒ Gordon Growth Model/ - assumes divs. grow indefinitely at a
constant rate
(g < r) 𝐃𝟎 (𝟏 + 𝐠) 𝐃
𝐕𝟎 = = 𝟏g𝐫 − 𝐠 - a growing perpetuity
𝐫−𝐠
sensitive to changes in r & g

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Review - 3
⇒ Gordon Growth DDM/ 1) Divs. are correct metric for
assumes valuation
2) g is forever

3) r is constant

4) g < r g - (1 - DPR)ROE = RR ROE

⇒ Multi-Stage DDM - uses 2 growth rates
𝐠𝐬 high g low g (perpetuity) 𝐠𝐋
(Initial growth period)
𝐧
𝐃𝟎 (𝟏 + 𝐠 𝐬 )𝐭 𝐕𝐧 𝐃𝐧<𝟏 𝐃𝐧3𝟏 = 𝐃𝟎 (𝟏 + 𝐠 𝐬 )𝐧 (𝟏 + 𝐠 𝐋 )
𝐕𝟎 = N + 𝐕𝐧 =
(𝟏 + 𝐫)𝐭 (𝟏 + 𝐫)𝐧 𝐫−𝐠 𝐃𝐧<𝟏
𝐭'𝟏

- rapidly growing companies

growth
transition
2-stage 3-stage transition
maturity
maturity

Review - 4
⇒ Price Multiples/
⇒ P/E - easy to use, most common 𝐏
𝐏𝐄 = 𝟎g𝐄𝐏𝐒
- useless if E < 0
⇒ P/S - not influenced by actg. measures 𝐏g = 𝐏𝟎
𝐒 Œ𝐒𝐚𝐥𝐞𝐬
- ignores cost structure g𝐬𝐡.
⇒ P/CF - less volatile than EPS 𝐏g = 𝐏𝟎
𝐂𝐅 Œ𝐅𝐂𝐅g
- ignores non-cash revenues 𝐬𝐡.
⇒ P/BV - more stable, appropriate for 𝐏g 𝐏
𝐁𝐕 = 𝟎Œ𝐁𝐕
firms in distress g𝐬𝐡.
⇒ Justified P/E/ - denominator may be
𝐃𝟏
- assume V0 = P0, then 𝐏𝟎 = based on trailing values or
𝐫−𝐠
forward values
𝐏𝟎g 𝐃𝟏 /𝐄𝐏𝐒 𝐃𝐏𝐑
𝐄𝐏𝐒 = 𝐫 − 𝐠 𝐏𝐄 =
𝐫−𝐠

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Review - 5
⇒ Justified P/E/ 𝐃𝐏𝐑 P/E positively related to:
=
𝐫−𝐠 ① DPR
· higher DPR, lower RR, ② g = RR(ROE)
lower reinvestment …and negatively related to r
(dividend displacement of earnings)

⇒ Comparables/ Company vs. closely matched stock

peer group/industry multiple
- rationale - ‘Law of One avg. historical trends
Price’
⇒ Enterprise Value/ (𝐏𝟎 × # 𝐨𝐟 𝐬𝐡𝐚𝐫𝐞𝐬) + 𝐌𝐕(𝐏𝐫 ) + 𝐌𝐕(𝐃𝐞𝐛𝐭) − 𝐂𝐚𝐬𝐡
- most useful for comparing companies with sig. diff. in
capital structure
e.g. 𝐄𝐕g
𝐄𝐁𝐈𝐓𝐃𝐀

Review - 6
⇒ Asset Based Valuation/
- use MV of A & L to determine value of company

for/ · private companies

· companies with no/few intangibles

· high proportions of CA & CL

· companies being liquidated

· financial companies

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