Equity Investment – CFA® Level I Essential Review Summary – by AnalystPrep

Reading 36 – Market Organization and Structure

Financial markets serve a wide variety of purposes, but there are six main categories of activity. They are used for Saving by individuals and organizations in order to grow their assets over time. Borrowing is also done when money is needed now that will be repaid in the future. Companies also Raise Equity Capital by selling ownership shares in exchange for cash today. Derivative securities like futures and forwards contracts can be used to Manage Risk. Spot Market Trading allows for the immediate exchange of one currency or other good for another. Information Motivated-Trading is done by investors who intend to use informational advantages to buy undervalued securities.

Assets sold in financial markets fall into several categories. Debt and Equity Securities are the bonds and stocks that usually get the most attention from the public. Currencies are the different monies issued by governments. Contracts are agreements to trade other assets in the future. Commodities are items with non-trading uses, such as metals and agricultural products. There are also Real Assets such as real estate, industrial machinery, and other assets with long useful lives.

There are a number of types of markets in which assets are bought and sold. Derivatives Markets are where contracts are traded that require delivery of an underlying asset in the future. Spot Markets require immediate delivery of goods traded. Primary Markets are where new financial assets are created and sold by the issuers. In Secondary Markets, financial assets are exchanged between various traders. Money Markets involve debt instruments maturing in less than one year, while Capital Markets involve assets with greater than one year to maturity.

Fixed Income securities are based on the expected repayment of borrowed money along with interest. They are typically classified as short term (less than two years to maturity), intermediate term (2-5 years) and long term (greater than five years). Fixed income investments include notes (maturity under 10 years), bonds (greater than 10 years), convertibles (can be converted into stock in certain conditions), and others.

Equity securities represent ownership claims in companies. These can include Common Stocks, which typically include a right to dividends and voting on company matters, and Preferred Stocks, which usually do not include voting rights but often have specified dividends and have priority over common stock in a liquidation event.

Other types of investment securities include Pooled Investments. These involve indirect ownership of assets through shares or units. Investment pools can be either open-ended or close-ended, depending on whether they create and redeem shares for investor cash flows (open) or if there are a fixed number of shares and new investors must purchase them from existing shareholders (closed). Pooled investments include Mutual Funds, Exchange-Traded Funds (shares are traded on secondary markets), and Asset-Backed Securities.

Contracts include a variety of derivatives, which are so named because they derive their value from an underlying asset. Forward Contracts represent an agreement to trade the underlying asset at some future point at a price agreed upon today. Futures Contracts are also an agreement to trade an asset in the future but are more standardized and are traded through clearinghouses that remove most of the counterparty risk. Swap Contracts involve the exchange of periodic cash flows that are based on the prices of specified assets or interest rates. Options Contracts allow the buyer to buy (call option) or sell (put option) the underlying asset at a specified price by a certain date.

There are also non-financial assets that are traded in investment markets. Commodities include items like precious and industrial metals, agricultural products, and even energy production. These are commonly traded in forward and futures markets as a way of managing risks for producers whose businesses are exposed to the risk of price changes in these materials. Real Assets are tangible properties usually held by operating companies. They typically have larger holding and transactions costs than other asset types but offer income and tax benefits and usually offer diversification benefits due to their low correlation to other asset types.

Financial Intermediaries are firms that provide products and services to participants in investment markets. Brokers fill orders for their clients by matching them with someone willing to take the other side of their trades. Investment Banks help corporate clients issue new investment securities. Exchanges provide places where traders can arrange their trades. Dealers fill client orders by buying and selling directly to them. Depository Institutions such as banks and credit unions raise money from depositors to lend to borrowers. Insurance Companies sell protection to people and institutions to hedge risks.

Related to investment assets, an investor can take several different positions. Long positions mean the investor has possession (cash securities) or will take delivery of the underlying asset (derivative contracts). A short position means the investor must make delivery or is exposed to the inverse of the price change of the security. For example, if an asset moves from $100 to $150, the long party will earn money while the short party stands to lose from his investment. Investors can also take leveraged positions by borrowing money to fund a long or short purchase. This allows an investor to magnify their potential gains (or losses) by taking much larger positions then they could otherwise.

The overall exposures of a leveraged position can be calculated using the Leverage Ratio and Maximum Leverage Ratio.

$$ Leverage\quad Ratio=\frac { Total\quad value\quad of\quad position }{ Equity\quad value\quad of\quad position } $$
$$ Maximum\quad Leverage\quad Ratio=\frac { 1 }{ Initial\quad Margin\quad Requirement } $$

Execution is the manner in which an order is filled. There are a large number of ways that orders can be executed. A common method is the Market Order, where the best price is immediately used. Another is the Limit Order, which is like a market order except a price is specified that the trade must be executed above or below. Brokers sometimes perform Market Taking orders, wherein they take the other side of a market trade by one of their clients.

The two primary categories of markets are primary and secondary markets. In primary markets, new securities are offered to investors for the first time. This can include shares offered to the public for publicly listed companies or smaller, private listings to qualified investors. The secondary markets are where existing securities are bought and sold between investors.

In Quote-Driven markets, customers trade at prices quoted to them by brokers that facilitate those markets. In Order-Driven markets, trades are arranged by rules to match buy orders with sell orders.

A well-functioning financial system has effective financial intermediaries and financial instruments that allow investors to move money between the future and present at a fair rate of return. They allow borrowers to easily obtain capital, hedgers to offset risks, and traders to easily exchange currencies and commodities. Markets typically require proper regulation. The objectives of market regulation are to control fraud, promote fairness, and prevent undercapitalized financial firms from making excessively risky investments that threaten the stability of the market.

Reading 37 – Security Market Indices

A security market index consists of a given security market segment or asset class. They allow investors to track the performance and risk of these given asset types. They are often used as benchmarks for investment funds or tracked directly by index funds. The value of the Price Return Index is calculated by the following formula:

$$ V=\frac { \Sigma nP }{ D } $$
$$ V=value \quad of \quad index $$
$$ n=units\quad of\quad security\quad in\quad index $$
$$ P=price \quad of\quad security\quad in\quad index $$
$$ D=index \quad divisor $$

There are several steps to constructing a proper index. The first is defining how broad or narrow the target market is. The next is selecting the appropriate securities from within that market. Then the weightings of each security within the index must be determined. The final step is defining how frequently the index will be rebalanced to maintain the correct exposure.

Each method of index weighting has strengths and weaknesses. Price Weightings are the easiest to calculate but have arbitrary weightings. Equal Weightings provide diversified exposure but require frequent rebalancing to maintain. Market Capitalization indices are used commonly by index funds due to less frequent turnover but will cause investors to buy and sell in response to market changes on a lag. Market capitalization weightings also typically have to adjust for the market float to make sure they remain properly investable.

Indices require periodic adjustments to keep their exposures consistent. Rebalancing is when the weights of securities in the index are adjusted, while Reconstitution occurs when the securities in the index are changed. Reconstitution is necessary when certain securities no longer meet the criteria of the index or when new securities do meet them. A common example is the S&P 500 changing its constituent securities when companies at the margin grow or shrink enough to move into or out of the 500 largest in the US.

Indices serve a number of functions for financial markets. They act as gauges of public sentiment as the public tracks their rise and fall over time. Their performance is a useful input in models that use market return and risk, such as the capital asset pricing model or Beta models. Indices act as proxies for the performance of specific asset types or asset classes. They make useful benchmarks for investment managers. They are also useful as model portfolios for passive funds.

Common types of equity index include broad market, multi-market, sector, and style. Broad Market means the index includes more than 90% of a selected market. Multi-market comprises indices from different countries. Sector represents different economic sectors and Style represents groups of securities classified by characteristics like size, value, or growth.

Fixed income indices also come in various types. They can be classified by the issuer’s economic sector, geographic region, currency of payments, or the maturity, credit quality, or other characteristics of the issuance. Fixed income indices can also include specialized categories like high-yield, inflation-linked, and emerging markets.

In addition, indices exist for alternative investments. Commodity indices consist of futures contracts for one or more commodities. These can vary widely since there is no clear best way to weight an index of futures. There are also real estate indices that can be categorized as appraisal, repeat sales, or Real Estate Investment Trusts (REITs).

Reading 38 – Market Efficiency

Market efficiency is the measure of how new information becomes reflected in market prices. In a completely efficient market, security prices will immediately incorporate all new information and it is nearly impossible to create sustained outperformance. The less efficient a market is, the easier it is for active managers to outperform the market. One indicator of market efficiency is how well market prices match up to their intrinsic values. The market price of a security is the price at which it can be bought or sold, while the intrinsic value is the value that would be placed on that security by investors if they had a complete understanding of that asset’s investment characteristics.

Several characteristics have a big impact on the level of efficiency in a market. The number and sophistication of market participants is one. As these go up, the market becomes more efficient. The availability of information is also a big determinant. When information is limited, there will be more inefficiencies in a given market. Limits on trading activity also decrease market efficiency. Activities like short selling make it easier for investors to act on relevant information, which is how that information becomes reflected in market prices.

According to the framework laid out by Eugene Fama, there are three forms of market efficiency. In the Weak Form, the market prices of securities reflect all historical information. Therefore, technical analysis cannot earn abnormal returns. In the Semi-Strong Form, security prices reflect all publicly known information, so an investor cannot earn abnormal returns by analyzing public financial disclosures. The Strong Form posits that security prices reflect all public and private information. Research has shown that markets are generally not strong-form efficient, as investors have been able to earn abnormal returns through the application of private information. The table below summarizes what methods can be expected to earn abnormal returns in the different forms of market efficiency:

<h4 style=”text-align:center;”>Market Prices Reflect</h4>
$$
\begin{array}{cccc}
\textbf{Forms of market efficiency} &amp; \textbf{Past market data} &amp; \textbf{Public information} &amp; \textbf{Private information} \\
\hline
\text{Weak form} &amp; \checkmark &amp; &amp; \\
\text{Semi-strong form} &amp; \checkmark &amp; \checkmark &amp; \\
\text{Strong form} &amp; \checkmark &amp; \checkmark &amp; \checkmark \\
\end{array}
$$

Market anomalies are exceptions to the idea of market efficiency. These are persistent occurrences that cannot be linked to relevant information in the markets. They exist in forms such as time series anomalies like the January effect, in which stocks tend to outperform in the month of January. There are also cross-section anomalies such as the size effect, where smaller companies outperform larger companies. Other anomalies include the excess returns that are routinely earned by investors that are able to purchase a stock at its IPO price.

There are behavioral finance concepts that influence our understanding of market efficiency. Traditional finance presumes rationality of market participants, but, generally, markets can behave rationally in aggregate even if the participants do not always do so. Investors tend to exhibit behavioral characteristics like Loss Aversion Bias, wherein they dislike losses more than comparable gains. The Herding Bias is the tendency of investors to trade along with others, which can explain some under- or overreaction behaviors to the news. The Overconfidence Bias leads investors to overestimate their own ability to accurately determine intrinsic values. These and other biases are used to explain behaviors by market participants that would otherwise appear to be irrational.

Reading 39 – Overview of Equity Securities

Equity securities provide investors with a claim on a company’s net assets and ownership rights, such as voting on company matters. Common shares represent an ownership interest in the company. Common shareowners are eligible to vote on Board membership and other major company issues. Preferred shareowners receive preference in dividend distributions and in claims on company assets, but typically do not also have voting rights. Companies often issue multiple classes of share within these categories that have different levels of voting and ownership rights.

Shares of companies can be either public or private, depending on whether they are available to the general public. The public stock market is much larger than private companies, but the number of private equity companies has been increasing in recent years. In exchange for being more easily available for sale, public companies are subject to more stringent reporting requirements. While public company stock securities are more liquid and easier to purchase in the secondary market, private equities are typically purchased in negotiated sales with existing investors.

Technological and communications advancements have made it easier for investors to purchase equities in markets around the world. There are several options for investors that want to invest in equity markets outside of their own country. One option is Direct Investment, in which the investors directly purchase securities in the foreign markets. They can also purchase Depository Receipts, which are securities that trade in a local exchange but represent ownership in a foreign company. There are also Global Registered Shares that are common shares that are traded on different stock exchanges around the world in different currencies.

There are two sources of returns to equity securities: capital appreciation and dividend income. Generally, preferred share investors will expect more of their total return to come from the dividend income on their shares over time.

$$ R=\frac { { P }_{ t }-{ P }_{ t-1 }+{ D }_{ t } }{ { P }_{ t-1 } } $$
$$ { R }_{ t }=Total\quad Return $$
$$ P= Sale \quad Price $$
$$ { P }_{ t-1 }=Purchase\quad Price $$
$$ { D }_{ t }=Dividend\quad Income $$

The goal of issuing equity securities is to raise new capital for investment in company operations. Companies use this capital to maximize long-term shareholder wealth by growing the total company’s value and returning wealth through dividend distributions.

The equity value of a company can be measured by either the book value or market value. The book value of equity reflects the historical operating and financing decisions of its management, while the market value reflects investors’ collective assessment and expectations about the company’s future cash flow from operations. If a company has a high price-to-book ratio (meaning its market price is high relative to its book value), then the market has high growth expectations for the company.

A company’s cost of equity is the minimum expected rate of return that it must offer its investors to purchase shares in the primary market and hold them in the secondary market. The return on equity is the measure by which investors determine whether management is effectively using their equity capital to generate profits. Return on equity is calculated by dividing the company’s net income by its average book value over the time period being analyzed.

$$ ROE=\frac { NI }{ \frac { \left( { BVE }_{ t }+{ BVE }_{ t-1 } \right) }{ 2 } } $$

Reading 40 – Introduction to Industry and Company Analysis

Industry analysis is used to understand a company’s business and its business environment. Analysts use it to identify potential active equity investments and for measuring how sector selection impacted the performance of an active strategy. Industries are a classification that groups companies by common characteristics. Industries can be categorized by the nature of the products or services they provide, by how cyclical their operations are, or by statistical similarities of past returns.

There are several standard industry classification systems. The Global Industry Classification Standard was developed by Standard & Poor’s and MSCI Barra and assigns companies to one of 154 sub-industries based on principle business activity. The Russel Global Sectors puts companies into one of 141 industries based on the products or services a company provides. The Industry Classification Benchmark developed by Dow Jones and FTSE places companies into one of 114 subsectors based on their primary source of revenue. Each classification system sorts their sectors and subsectors into broader sectors and industries that combine for higher-level attributes.

Companies can be sorted by how sensitive their operations are to economic and business cycles. Cyclical companies will experience greater volatility in earnings and growth over time. A limitation of cyclicality as a classification is that the sensitivity to cycles is a spectrum rather than a discrete difference. Groupings by statistical similarities can also have the same problem of drawing arbitrary distinctions between companies that might otherwise be very similar. It is up to the analyst to understand the important differences between companies in different industries and how that will impact their inclusion in an investment portfolio.

A thorough industry analysis must include identification of an industry’s life cycle, specific important segments within that industry, and the range of economic forces that have the biggest impacts on operations for companies in that industry.

An important framework for strategic analysis of companies and industries is Michael Porter’s Five Forces:

1. Threat of Entry
2. Power of Suppliers
3. Power of Buyers
4. Threat of Substitutes
5. Rivalry Among Existing Competitors

Factors that influence industry profitability include barriers to entry. High barriers that prevent new entrants from the market keep profit margins higher for existing firms. Lower barriers to entry lead to more competition and make it difficult for firms to maintain market share. Another important factor is the level of concentration in the industry. Highly concentrated industries tend to have more pricing power and can sometimes coordinate with their competition to keep out entrants and maintain higher prices.

There are five stages to the life cycle of an industry. The Embryonic stage is characterized by slow growth, high prices, and low sales volumes.  The Growth stage is characterized by increasing demand, improving profitability, and relatively low competition. The Shakeout stage features slowing growth, increasing competition, and declining profitability. Mature industries have little growth, consolidation among firms, and high barriers to entry. Decline involves negative growth, excess production capacity, and intense competition.

External factors can have significant impacts on industry growth. Macroeconomic trends, both cyclical and structural, can speed or slow industry growth and profitability by impacting costs of money and consumer behaviors. Technology can also influence growth trends by radically changing industries or introducing entirely new business models. Demographics also change how industries perform through changing spending habits.

A thorough company analysis must include an overview of the company and its operations, identification of the characteristics and trends of its industry, analysis of demand and supply for its products or services, explanation of the pricing environment the company faces, and interpretation of all relevant financial ratios.

Reading 41 – Equity Valuation: Concepts and Basic Tools

An equity security is considered to be fairly valued if its current market price is approximately equal to its value estimate. While there are many uncertainties associated with calculating an estimated valuation, they can provide investment insight when compared to how a company is valued by the market. Companies are considered over- or under-valued when their market value is higher or lower than their estimated value.

There are three categories of models used to calculate equity security values: Discounted Cash Flow Models, Market Multiple Models, and Asset-Based Valuation Models.

Discounted Cash Flow Models are based on finding the present value of the expected future cash flows to the investor. One example is the Dividend Discount Model, which finds the present value of futures dividends and the expected eventual selling price of the stock. This model is especially useful for mature companies but is less applicable for complex companies in uncertain economic environments.

$$ V=\sum _{ }^{ }{ \frac { { D }_{ t } }{ { \left( 1+r \right) }^{ t } } +\frac { { P }_{ n } }{ { \left( 1+r \right) }^{ n } } } $$
$$ V=present\quad value\quad of\quad stock\quad today $$
$$ { D }_{ t }=dividend\quad at\quad time\quad t $$
$$ { P }_{ n }=expected\quad selling\quad price\quad at\quad time\quad n $$
$$ r=required\quad rate\quad of\quad return $$

Another discounted cash flow model commonly used is the Free Cash Flow to Equity model. This finds the present value of future cash flows that will be available for distribution as dividends. It can be helpful in situations where dividends are not proscribed or especially volatile. It is useful because it does not rely only on the dividend policy of the firm, but more assumptions must be made compared to some other models. It is calculated the same as any other present value, but you need to first find the Free Cash Flow to Equity (FCFE):

$$ CFO=NI+NCE-WC $$
$$ FCFE=CFO-FCInv+NB $$
$$ NI=Net\quad Income $$
$$ NCE=Non-Cash\quad Expenses $$
$$ WC=Working\quad Capital $$
$$ FCInv=Fixed\quad Capital\quad Investment $$
$$ NB=Net\quad Borrowing $$

Preferred stock can be valued using a similar method since their dividends are often specified and more consistent over time. You can use the same Dividend Discount Model as with common shares, but you use the par value (F) of the shares in place of the expected future price (P_t):

$$ V=\sum _{ }^{ }{ \frac { { D }_{ t } }{ { \left( 1+r \right) }^{ t } } + } \frac { F }{ { \left( 1+r \right) }^{ n } } $$

When using Dividend Discount Models, it is important to be able to forecast the expected future growth of dividends. One approach is the Gordon Constant Growth model, which assumes a constant and consistent growth rate for dividends into perpetuity:

$$ V=\sum _{ }^{ }{ \frac { { D }_{ 1 } }{ r-g } } $$
$$ { D }_{ 1 }=expected\quad dividends\quad in\quad year\quad 1 $$
$$ r=required\quad rate\quad of\quad return $$
$$ g= growth\quad rate $$
$$ g=b\ast ROE $$
$$ b=earnings\quad retention\quad rate\left( 1-dividend\quad payout\quad ratio \right) $$
$$ ROE=Return\quad on\quad Equity $$

There are also models that incorporate multiple growth rates, which is helpful for less mature companies that will grow faster in the short term before settling into a long-term sustainable growth rate in the future. They are similar to the single rate models except that a different growth rate (g_s) is used to calculate the short-term dividend growth than the one used (g_l) to calculate the long-run sustainable growth.

$$ V=\sum _{ }^{ }{ \frac { { D }_{ 0 }{ \left( 1+{ g }_{ s } \right) }^{ 1 } }{ { \left( 1+r \right) }^{ t } } +\frac { { V }_{ n } }{ r-gl } } $$
$$ { V }_{ n }=\frac { { D }_{ n+1 } }{ r-gl } $$
$$ { D }_{ n+1 }={ D }_{ 0 }{ \left( 1+{ g }_{ s } \right) }^{ n }\left( 1+gl \right) $$

Market Multiple Models are another approach to determining the value of a company. They use information from how the market is valuing the company and accounting information to develop a calculated value. Since these models incorporate comparable companies into calculating their multiples, it can be especially helpful when trying to value a company with limited or negative earnings. One such model is the justified price to earnings multiple.

$$ \frac { { P }_{ 0 } }{ { E }_{ 1 } } =\frac { p }{ r-g } $$
$$ \frac { { P }_{ 0 } }{ { E }_{ 1 } } =justified\quad forward\quad { P }/{ E } $$
$$ p=payout\quad ratio $$
$$ r=required\quad rate\quad of\quad return $$
$$ g=dividend\quad growth\quad rate $$

There are a number of different multiples models that can be used for company valuation purposes. The price to earnings ratio (P/E) is the most commonly referenced and is the stock price divided by the earnings per share. Other ratios often used include the price to book ratio, the price to sales ratio, and the price to cash flow ratio.

A slightly different approach to multiples valuation that doesn’t rely solely on the market price of the security is to use the Enterprise Value (EV). This is the value of the company as it relates to what it would cost in a takeover. It is the total market value of all outstanding stock, plus the market value of all debt, and minus the value of all cash and cash equivalent securities. One of the most often used formulas involving enterprise value is the EV/EBITDA (earnings before interest, taxes, depreciation, and amortization) ratio.

The third category of valuation model is the Asset Based Valuation Model. These are based on the market or fair value of a company’s assets and liabilities. These models are most applicable to companies with high proportions of current (and marketable) assets and few intangibles. Intangible assets can be difficult to value and their book or holdings values may not be relevant to the market value for an investor. These models are the simplest to calculate and do not require projection assumptions. They also don’t take into account expected cash flows, earnings, or growth rates and so often aren’t the best for valuing a going concern (unless used in conjunction with other approaches).