CFA Equity Investments

• • There are five types of execution orders: Hidden, Limit, All-or-nothing, Market, and Iceberg.
  • There are four types of security index weighting models: Price, Market-cap, Equal, and Fundamental.
  • The Gordon growth model assumes dividends will grow forever at a constant rate.
  • There are three types of equity valuation models: present value, multiplier, and asset-based valuation.

 

Equity Investments are an important asset class in corporate finance and financial reporting. In Level I, you will need to understand the characteristics of a well-functioning financial system. You will also need to understand market efficiencies and behavioral finances. Finally, you will need to have the ability to value equity using multiple formulas.

To properly prepare for the CFA exam, you must study. By utilizing practice questions, you are able to better understand the question format and what to expect when you sit for the exam.

First, you must understand leveraged positions. The leverage ratio measures the amount borrowed relative to the total value of the asset. This is also the trader’s equity. The leverage ratio equals the position value divided by the equity value. There are several common leverage ratios you need to be familiar with.Traders will receive a margin call when the equity price drops below the maintenance margin requirement.

There are also execution orders. A market order occurs when an order is executed immediately at the best price. In a limit order, buyers set their maximum price and issuers set their minimum price. The order is only executed if those respective prices are hit. Limit orders may not always be executed if the markets are moving quickly or if there is not enough liquidity.

All-or-nothing orders occur only when the entire quantity can be traded. Large orders that are only known by the brokers or exchangers that are executing them are referred to as hidden orders. An iceberg order is when a small fraction of a larger hidden order is executed to test the market liquidity before the entire hidden order is executed.

Market Organization and Structure Question Example

A well-functioning securities market least likely has:

1. Informational efficiency
2. Liquidity
3. Accurately priced securities

Answer C. This is not one of the features of a well-functioning securities market.

There are four types of security market index weighting levels.The first is price weighting. The weight of the security is determined by dividing its price by the sum of total prices in the index.

The second is equal weighting. For equal weighting, each security is given equal weight at inception.

The third is market-cap weighting. For this, the weight of each security is determined by dividing its market cap by the total market cap of the index.

The final weight level is fundamental weighting. In this weighting model, the value of the securities is contingent upon different measures like book value, revenues, or cash flow. This means the securities are biased towards the stock price, creating a value tilt.

Security Market Indexes Question Example

wEi=1/N

The formula above represents which security market index weighting level?

1. Price weighting
2. Fundamental weighting
3. Equal weighting

Answer C.

There are three types of equity valuation models. Present value models estimate the present value based on expected future benefits. The multiplier model estimates the intrinsic value based on the multiple of a fundamental variable. Asset-based valuation models estimate the value of equity as the fair value of the company’s assets minus the fair value of liabilities.For a dividend to be paid, there must be a declaration date. Then there is an ex-dividend date. Approximately two days later, there is a holder-of-record date. After the holder-of-record date, the payment date occurs. It’s worth noting that holders of preferred shares receive dividend payments before common shareholders.

The dividend discount model determines the intrinsic value by adding the present value of future dividends to the present value of the terminal value. While the Gordon growth model assumes dividends will grow forever at a constant rate.

Pricing multiples include the price to earnings ratio, price to book ratio, price to sales ratio, price to cash flow ratio, and enterprise value.

CFA Equity Valuation Question Example

Which of the following formulas is not a price multiple?

1. Price per share/book value per share
2. Price per share/sales per share
3. Market value of debts + market price of equity + market value of preferred shares + cash and short-term investments

Answer C.

For the Level II CFA exam, you must be able to develop forecasts with balance sheets, income statements, and cash flow statements. Additionally, you need to know how to determine a firm’s intrinsic value, profitability, and total return.UWorld offers specific studying materials to help you excel from Level I to Level II, including professional online mentoring, Mock Exams, and a dashboard with performance metrics to help keep you on track.

View Level II Review Courses

Unlike Level I, which focused on Equity Investments, Level II will focus on the diverse aspects of equity valuation.

Valuation is estimating the worth of an asset based on variables related to future investment returns, a comparison with similar assets, and the estimates of immediate liquidation. You need to be able to describe applications of equity valuation, contrast absolute and relative valuation models, and conglomerate discounts.

Equity Valuation: Applications and Processes Question Example

The value of an asset between a willing buyer and a willing issuer, when neither of whom is under compulsion to buy or sell is called:

1. Investment value
2. Fair market value
3. Intrinsic value

Answer B.

You will need to be able to compare top-down, bottom-up, and hybrid approaches to developing inputs to equity valuation models. Additionally, having the ability to explain how competitive factors impact pricing and costs is important. You must also be able to analyze and forecast industry, and company, sales and costs when they are impacted by inflation.

Industry and Company Analysis Question Example

Which of the following is not one of Michael Porter’s five factors?

1. Bargaining power of customers
2. Threat of substitute products
3. Taxes and regulations

Answer C.

Discounted dividend valuation includes a variety of calculations including the use of the dividend discount model and the Gordon growth model. You should also be able to calculate and interpret the present value of growth opportunities.

Discounted Dividend Valuation Question Example

There are three phases to a business life cycle; growth, transition, and mature. In which phase would the Gordon growth model be most appropriate?

1. Growth
2. Transition
3. Mature

Answer C.

Over half of the Level III CFA exam will be based on Equity Investments, Portfolio Management, and Wealth Planning.Candidates all over the world rely on UWorld to help them pass Level III.

The questions in Level III will vary a bit from the previous sections of the CFA exam. This will include an essay question and an item set question.

Percy Macdonald, CFA, works as an analyst for a mutual fund research house and has over 20 years of experience in the investment industry. He has been recently tasked with providing house recommendations regarding two German equity funds. Both funds have similar mandates to provide a return at or above the DAX Total Return index and fall into the ‘enhanced index funds’ segment of the German equity mutual fund universe. Both of the funds have been in existence for only the past 12 months.In order to assess the funds, Macdonald reviews their performance relative to the index. Details of their performances over the past 12 months are shown in Exhibit 1 Enhanced Equity Index Fund Performance.

Exhibit 1: Enhanced Equity Fund Performance

Month	DAX TR	Fund A	Fund B
1	0.13%	0.16%	0.25%
2	1.65%	1.48%	1.57%
3	-0.98%	-0.87%	-1.08%
4	-1.13%	-1.09%	-0.89%
5	-1.86%	-2.32%	-1.76%
6	2.87%	2.89%	2.68%
7	0.42%	0.65%	0.36%
8	0.19%	-0.08%	0.32%
9	1.62%	1.69%	1.37%
10	2.32%	1.98%	2.00%
11	-1.64%	-1.48%	-1.59%
12	0.67%	0.75%	0.33%

Equity Investment Constructed Response (Essay) Question Example

Compare the performance of Fund A and Fund B by calculating their respective tracking errors.

Equity Investment Item Set Question Example

Enter given or calculated values and percentages in the following spreadsheet. Enter amounts to two decimal places. If no entry is required, enter a zero (0).

Line Item	Fund A	Fund B
Mean monthly excess return (%pm)
Tracking error (% pm)
Annualized tracking error

Answer:

Line Item	Fund A	Fund B
Mean monthly excess return (%pm)	-0.042%	-0.058%
Tracking error (% pm)	0.220%	0.200%
Annualized tracking error	0.763%	0.691%

Fund A

Month	Excess Return (A)	Squared Excess Return
1	0.03%	0.00001%
2	-0.17%	0.00029%
3	0.11%	0.00012%
4	0.04%	0.00002%
5	-0.46%	0.00212%
6	0.02%	0.00000%
7	0.23%	0.00053%
8	-0.27%	0.00073%
9	0.07%	0.00005%
10	-0.34%	0.00116%
11	0.16%	0.00026%
12	0.08%	0.00006%
Sum	-0.500%	0.0053%
Mean	-0.042%

Standard deviation of monthly excess return=(0.0053%/11)1/2=0.220%

This is the monthly tracking error of Fund A.

To annualize, multiply the monthly TE by the square root of 12:TEA=0.220×121/2=0.763%

Fund B

Month	Excess Return (B)	Squared Excess Return
1	0.12%	0.00014%
2	-0.08%	0.00006%
3	-0.10%	0.00010%
4	0.24%	0.00058%
5	0.10%	0.00010%
6	-0.19%	0.00036%
7	-0.06%	0.00004%
8	0.13%	0.00017%
9	-0.25%	0.00062%
10	-0.32%	0.00102%
11	0.05%	0.00003%
12	-0.34%	0.00116%
Sum	-0.700%	0.0044%
Mean	-0.058%

Standard deviation of monthly excess return=(0.0044%/11)1/2=0.200%

This is the monthly tracking error of Fund B.

To annualize, multiply the monthly TE by the square root of 12:TEB=0.220×121/2=0.691%

Note: The above calculation of tracking error is the standard deviation between the fund and benchmark returns, that is, σRP–RB. Tracking error is also often calculated as the standard deviation of the excess returns (i.e., ER = RP – RB), which will usually give a slightly different result; that is, σER.

The following study tips can be used across each level of the CFA exam.

Use CFA Level I Equity Investments to Get a Strong Grounding in This Topic

Building a strong foundation from Level I will help you understand the true logic of Equity Investments instead of just memorizing formulas.

Also Practice Quantitative Equity Questions

Although most questions will focus on qualitative elements, it is important you understand how to calculate formulas, like free cash flows and the rate of return.

UWorld’s study materials can help you cover this topic and other aspects of the Equity Investments components.

View UWorld’s CFA Program Review Courses

Understand the Practical Application of Equity Valuation Models

There are three types of equity valuation models that you must be familiar with: present value models, multiplier models, and asset-based valuation.

These are vital methods you will need to evaluate modern Equity Investments, both on the CFA exam and in your future career as a Chartered Financial Analyst.

Sign Up for a Study Program With Excellent Success Rates

When investing in a study platform, review all of the resources available to you. UWorld offers an array of study sessions with experienced instructors, online mentoring, and more. With a 90% pass rate, UWorld will help you pass the CFA exam the first time.