Equity Investments - Exam Ready Notes

CFA Level 1 Equity Investments: In-Depth Notes

Overview

• Exam Weight: 11–14% (approx. 20–25 questions)
• Main Focus: Equity as an asset class, market structure, valuation, analysis, and performance measurement.
• Learning Modules:
  1. Market Organization and Structure
  2. Security Market Indexes
  3. Market Efficiency
  4. Overview of Equity Securities
  5. Company Analysis: Past & Present
  6. Industry and Competitive Analysis
  7. Company Analysis: Forecasting
  8. Equity Valuation: Concepts and Basic Tools 

1. Market Organization and Structure

Key Concepts

• Financial Systems:
  • Facilitate the transfer of capital from savers to borrowers.
  • Provide liquidity, price discovery, and risk management.
• Types of Markets:
  • Primary: Where new securities are issued (IPOs, rights issues).
  • Secondary: Where existing securities are traded (NYSE, LSE).
  • Money Markets: Short-term debt instruments (T-bills).
  • Capital Markets: Long-term debt and equity (stocks, bonds).
• Order Types:
  • Market Order: Buy/sell immediately at best available price.
  • Limit Order: Buy/sell at a specified price or better.
  • Stop Order: Converts to market order when price hits trigger.
  • Hidden, All-or-nothing, Iceberg Orders: Used for large or sensitive trades.
• Positions:
  • Long: Buy and hold, profit if price rises.
  • Short: Borrow and sell, profit if price falls.

• Leverage:
  • Use of borrowed funds to amplify returns (and risk).

Leverage Ratio:

Margin Call Price:

Where P₀ = initial purchase price.

Market Regulation:

• • Ensures fairness, transparency, and investor protection.

2. Security Market Indexes

Purpose & Types

• Purpose:

  • Measure market/sector performance, benchmark portfolios, serve as basis for ETFs and index funds.
• Types of Indexes:
  • Price-weighted: Average of component prices (e.g., Dow Jones).
  • Market-cap weighted: Weighted by market value (e.g., S&P 500).
  • Equal-weighted: All components equally weighted.
  • Fundamental-weighted: Weighted by metrics like sales, earnings.

Key Formulas

Worked Example

Suppose a price-weighted index contains two stocks: A ($30), B ($20).

Index = (30 + 20)/ 2 = 25

If A rises to $33 and B to $22,

Index  = (33+22) / 2 = 27.5

Return = (27.5 – 25)/25 = 10%.

3.Market Efficiency

Efficient Market Hypothesis (EMH)

• Weak Form: Prices reflect all historical price info (technical analysis ineffective).
• Semi-Strong Form: Prices reflect all public info (fundamental analysis ineffective).
• Strong Form: Prices reflect all public and private info (no one can consistently outperform).

Diagram: Forms of Market Efficiency

Implications for Investors

• Hard to consistently outperform the market, especially after costs.
• Passive strategies (indexing) may be more appropriate in efficient markets.

Behavioral Finance Biases

• Overconfidence: Overestimating one’s knowledge/ability.
• Herding: Following the crowd.
• Loss Aversion: Preferring to avoid losses over acquiring gains.

4.Overview of Equity Securities

Types of Equity Securities

• Public vs. Private Equity:
  1. Public: Exchange-traded, regulated, liquid.
  2. Private: Not traded publicly, less liquid, includes venture capital, buyouts.
• Return Sources:
  • Dividends and capital gains.
• Risk and Return Characteristics:
  • Equity Risk Premium: Expected return above risk – free rate
  • Risks: Market, company – specific, liquidity, currency, political
• Depository Receipts
  • ADR/GDR: Certificates representing foreign shared, traded on local exchanges
• Non-Domestic Equity:
  • Investing in foreign companies via direct purchase or depository receipts.

How Equity Creates Value

• Shareholder value increases with higher earnings, dividends, and favorable market perception.

5.Company Analysis: Past & Present

Past Analysis (Historical):

• • Focuses on financial statements, performance trends, and ratios over previous periods.
  • Key metrics: Revenue growth, profit margins, ROE, leverage, liquidity.
  • Goal: Understand how the company has performed and how it managed risks and resources.

Present Analysis (Current):

• • Focuses on the company’s current operations, market position, and financial health.
  • Includes: Competitive advantage, management quality, product pipeline, market share, industry outlook.
  • Goal: Assess current strength and identify factors affecting near-term performance.

Why Both Matter

• Historical analysis reveals trends and stability, while present analysis shows current viability and risks.
• Combined, they help estimate future cash flows and value, critical for valuation models (like DCF, FCF, or multiples).

6.Industry and Competitive Analysis

Industry classification helps investors and analysts group companies based on their business activities to analyze performance, risks, and trends for portfolio decisions.

Commercial Industry Classification:

• • Examples: GICS (Global Industry Classification Standard), Russell, ICB (Industry Classification Benchmark).
  • Used by index providers and portfolio managers for benchmarking.

Statistical Systems:

• • Examples: NAICS (North American Industry Classification System), SIC (Standard Industrial Classification).
  • Used by governments and regulators for economic data.

Sector vs. Industry Levels:

• • Sectors are broad categories (e.g., Energy, Financials).
  • Industries are narrower groupings (e.g., Banks, Oil & Gas).

Use in Competitive Analysis:

• Helps assess industry growth prospects, risk exposures, and competitive forces (Porter’s Five Forces).
• Essential for top-down portfolio strategies and relative valuation.

Industry Life Cycle

Porter’s Five Forces

1. Threat of New Entrants: Risk that new competitors can easily enter the market and reduce profitability.
2. Bargaining Power of Suppliers: Ability of suppliers to raise costs or reduce quality, squeezing margins.
3. Bargaining Power of Buyers: Power of customers to demand lower prices or better terms.
4. Threat of Substitutes: Risk of alternative products/services reducing demand.
5. Industry Rivalry: Intensity of competition among existing firms, driving down prices and profits.
6. Company Analysis: Forecasting

Forecasting Inputs

When analyzing a company for valuation, analysts forecast future performance by using three main categories of inputs:

1. Macroeconomic Inputs
   • GDP growth, inflation, interest rates, currency trends.
   • Helps estimate the overall economic environment affecting revenue and costs.
2. Industry Inputs
   • Industry growth rates, competitive dynamics (Porter’s Five Forces), regulatory changes, pricing trends.
   • Provides context for market share and pricing power assumptions.
3. Company-Specific Inputs
   • Historical financial data, revenue drivers (volume & price), cost structure, capital expenditures, working capital needs, tax rates, financing structure.
   • Used to build projections for revenue, expenses, and cash flows.

• Revenue Drivers: Units sold, price per unit.
• Cost Structure: Fixed vs. variable costs.
• Margins: Gross, operating, net profit margins.
• Growth Assumptions: Based on historical data, industry trends, macroeconomic factors.

8.Equity Valuation: Concepts and Basic Tools

Valuation Approaches

1. Discounted Cash Flow (DCF) Models

• Dividend Discount Model (DDM):

Where D_t = dividend at time t ,r = required return.

• Gordon Growth Model (Constant Growth DDM):

Where D₁ = next year’s dividend, g = growth rate

Worked Example: Gordon Growth Model

Suppose a stock pays a $2 dividend next year, required return is 8%, and growth rate is 3%.

                         V₀ = 2 / (0.08 – 0.03) = $40

Free Cash Flow Models

These models value a company by discounting its future free cash flows (cash available to investors) at an appropriate discount rate.

Free Cash Flow to Firm (FCFF):

Cash flow available to all capital providers (debt + equity).

FCFF = Net Income + NCC + [Int × (1 − tax rate)] − FCInv – WCInv

NCC = Non Cash Charges (Depreciation and Amortization)

Int = cash interest paid​

FCInv = fixed capital investment (net capital expenditures)​

WCInv = working capital investment

FCFE (Free Cash Flow to Equity):

Cash flow available only to equity shareholders after debt obligations.

FCFE = Net Income + Depreciation – CapEx –    working Capital + Net Borrowing

Multiplier (Relative) Models

Asset-Based Models

These models value a company by estimating the market or fair value of its assets minus its liabilities.

• Value based on net asset value (assets – liabilities).

1. Types:
   • Book Value Approach: Uses balance sheet values (less common for valuation).
   • Adjusted Net Asset Value: Adjusts assets and liabilities to fair market value (common in practice).
2. Best Use Cases:
   • Firms with tangible, liquid assets (e.g., REITs, natural resource firms).
   • Liquidation scenarios or valuing holding companies.

        3. Limitation:

• • • Less effective for companies with intangible assets or strong earnings power (e.g., tech firms).

Enterprise Value

Enterprise Value (EV) represents the total value of a company, considering both equity and debt holders.
It is often viewed as the theoretical takeover price because it accounts for all sources of capital.

EV = Market Cap + debt – Cash

Why EV Matters (vs Market Cap)

• Market Capitalization only measures equity value and ignores debt.
• EV adjusts for capital structure, making it better for comparing companies with different debt levels.

Example:

A company has:

Market Cap = ₹500 crore

Debt = ₹200 crore

Cash = ₹50 crore

EV=500+200−50=₹650crore

This means an acquirer would effectively pay ₹650 crore to buy the company (equity + debt payoff, minus cash).

Cost of Equity (CAPM) Formula

The Capital Asset Pricing Model (CAPM) estimates a company’s cost of equity based on risk and return:

9. Key Formulae Summary Table

10. Exam Tips & Application

• Focus on Concepts: Most questions are qualitative, testing your understanding of equity as an asset class, market structure, and valuation models.
• Practice Calculations: Especially for DDM, FCFE, and index returns.
• Know When to Use Each Valuation Model:
  • DDM for stable, dividend-paying firms.
  • FCFE for firms with unpredictable dividends.
  • Multiples for quick relative valuation.
  • Asset-based for firms with tangible assets or in liquidation.
• Interpretation Over Memorization: Understand what the numbers mean and how to apply them.
• Behavioral Finance: Be aware of common biases that can affect market efficiency.