Chartered Financial Analyst (CFA) Equity Investments Syllabus

Define a market anomaly and give three examples.

An anomaly is a persistent pattern that appears to allow abnormal risk-adjusted returns, contradicting market efficiency. Examples: the calendar (January) effect, the size/small-firm effect, the value effect (low P/E, low P/B outperformance), and momentum and earnings-announcement (post-earnings-drift) effects.

List four behavioral biases that may explain market inefficiencies.

Loss aversion (feeling losses more than equal gains), overconfidence (overestimating one's information/ability), herding (mimicking others), and anchoring/representativeness. Information cascades and mental accounting are also cited as behavioral causes of apparent anomalies.

How do transaction costs and information-acquisition costs affect market efficiency conclusions?

An apparent anomaly is not exploitable if the cost of transacting and acquiring information exceeds the abnormal return. Efficiency should be judged net of these costs; many documented anomalies disappear once realistic trading and information costs are deducted.

What are the key characteristics that distinguish common shares (equity)?

Common shares represent an ownership (residual) claim with voting rights and a residual claim on assets/income after creditors and preferred holders. Dividends are discretionary, returns and risk are higher than debt, and liability is limited to the amount invested.

Compare callable, putable, and cumulative features as they apply to preference (preferred) shares.

Callable: issuer can buy back shares at a preset price (benefits issuer). Putable: holder can sell shares back to the issuer at a preset price (benefits holder). Cumulative: unpaid (omitted) preferred dividends accumulate and must be paid before any common dividend; non-cumulative omitted dividends are lost.

Distinguish participating from non-participating preference shares.

Non-participating preferred receives only its fixed dividend and the par value at liquidation. Participating preferred receives its fixed dividend plus an additional dividend (and possibly extra liquidation value) if the company's profits/assets exceed a specified level, sharing in upside with common holders.

What is the difference between a Depository Receipt (DR), a sponsored DR, and an unsponsored DR?

A depository receipt is a security trading in one market that represents shares of a foreign company. A sponsored DR is created with the involvement of the foreign company, so holders have voting and other rights. With an unsponsored DR the depository bank retains the voting rights, and the foreign firm is not involved.

How is a company's return on equity (ROE) defined for assessing equity investment returns?

$$\text{ROE} = \frac{\text{Net income}}{\text{Average book value of equity}}$$ ROE measures profitability relative to shareholders' book investment; rising ROE driven by higher net income (rather than shrinking equity) is generally favorable. It links to cost of equity in value creation: value is created when ROE exceeds the required return on equity.

Differentiate a company's book value of equity, market value of equity, and the cost of equity.

Book value of equity = total assets − total liabilities (accounting/historical). Market value of equity = share price × shares outstanding (investors' assessment of present value of future cash flows). Cost of equity = the minimum rate of return equity investors require, used as the discount rate for equity cash flows.

What are the steps in an industry analysis using a top-down (economic) approach?

Identify and group similar companies, classify the industry (e.g., cyclical vs. non-cyclical), determine the industry life-cycle stage, analyze external influences (macro, technology, demographic, government, social), and apply a competitive analysis (e.g., Porter's five forces) before analyzing individual companies.

List Porter's five forces that determine industry competitive intensity and profitability.

(1) Threat of new entrants (barriers to entry), (2) threat of substitutes, (3) bargaining power of buyers, (4) bargaining power of suppliers, and (5) rivalry among existing competitors. High intensity in any force tends to reduce industry profitability.

Name and describe the stages of the industry life cycle.

Embryonic (slow growth, high prices, large investment, high failure risk); Growth (rapid demand, improving profits, falling prices, low competition); Shakeout (slowing growth, intense competition, overcapacity, declining profitability); Mature (little/no growth, consolidation, high barriers, stable market shares); Decline (negative growth, excess capacity, possible exits).

Distinguish a cyclical industry from a non-cyclical (defensive) industry.

A cyclical industry's demand and earnings are highly sensitive to the business cycle, with high earnings volatility and high operating/financial leverage (e.g., autos, construction). A non-cyclical/defensive industry has relatively stable demand regardless of the economic cycle (e.g., utilities, food, healthcare).

What are Porter's three generic competitive strategies a company may pursue?

Cost leadership (low-cost producer offering low prices), differentiation (unique product/brand commanding a price premium), and focus (concentrating on a narrow segment using either a cost or a differentiation approach within that niche).

What elements should a thorough company analysis cover?

Corporate profile and industry context, demand and supply analysis, pricing, competitive position and strategy, financial-ratio and statement analysis, projections of revenue/earnings/cash flow, and a valuation/recommendation. It integrates SWOT (strengths, weaknesses, opportunities, threats) and the firm's strategy execution.

In forecasting, contrast the bottom-up, top-down, and hybrid approaches.

Bottom-up starts at the individual company/product level and aggregates upward (e.g., units × price). Top-down starts with the macroeconomy/industry and works down to the company (e.g., market size × market share). A hybrid approach combines both to cross-check estimates and avoid double counting.

How can analysts forecast revenue using a 'growth relative to GDP' versus a 'market growth and market share' top-down approach?

Growth-relative-to-GDP: forecast company revenue growth as a premium or discount to forecast nominal GDP growth. Market-growth-and-market-share: forecast the size/growth of the company's market, then multiply by the company's expected market share to get its revenue.

Distinguish fixed costs from variable costs when modeling a company's cost structure and margins.

Variable costs change proportionally with output/revenue (e.g., raw materials), so gross margin is relatively stable. Fixed costs (e.g., rent, depreciation) do not vary with volume, creating operating leverage: as revenue rises, fixed costs are spread over more units, expanding operating margin.

What is the impact of inflation on a company's revenue and cost forecasts?

Analysts must assess pass-through: whether the company can raise prices to offset rising input costs. Strong pricing power preserves margins; weak pricing power means cost inflation compresses margins. Inflation affects revenue (price × volume) and each cost line differently, so they should be modeled separately.

How does the choice of forecast horizon and terminal-value assumption affect a company forecast?

A short explicit horizon shifts most value into the terminal value, increasing sensitivity to terminal assumptions. The horizon should extend until the company reaches a steady state (stable growth, margins, and reinvestment). The terminal year's normalized earnings and a sustainable long-run growth rate drive the terminal value.

List the three major categories of equity valuation models.

(1) Present value (discounted cash flow) models — dividend discount and free cash flow models; (2) multiplier (market multiple) models — price multiples (P/E, P/B, P/S) and enterprise value multiples; (3) asset-based valuation models — value of equity as market value of assets minus liabilities.

State the general dividend discount model (DDM) formula.

$$V_{0} = \sum_{t=1}^{\infty} \frac{D_{t}}{(1+r)^{t}}$$ The intrinsic value of a share equals the present value of all expected future dividends $D_{t}$ discounted at the required return on equity $r$.

State the Gordon (constant) growth dividend discount model and its key assumptions.

$$V_{0} = \frac{D_{1}}{r-g} = \frac{D_{0}(1+g)}{r-g}$$ Assumptions: dividends grow at a constant rate $g$ forever, $r > g$, and the growth rate and required return are stable. It is best for stable, mature, dividend-paying firms.

Give the formula for the sustainable growth rate and its drivers.

$$g = b \times \text{ROE}$$ where $b$ is the earnings retention ratio $(1 - \text{dividend payout})$ and ROE is return on equity. Sustainable growth is the rate a firm can grow without issuing new equity, financed by retained earnings.

Write the two-stage dividend discount model valuation expression.

$$V_{0} = \sum_{t=1}^{n} \frac{D_{t}}{(1+r)^{t}} + \frac{D_{n+1}/(r-g_{L})}{(1+r)^{n}}$$ The first term discounts dividends during the high-growth stage; the second term is the present value of the terminal (Gordon-growth) value based on the long-run growth rate $g_{L}$.

How is the required return on equity estimated using CAPM?

$$r = R_{f} + \beta\,[E(R_{m}) - R_{f}]$$ where $R_{f}$ is the risk-free rate, $\beta$ is the stock's systematic risk, and $E(R_{m}) - R_{f}$ is the equity risk premium. The result is the discount rate used in DDM and FCFE models.

Define Free Cash Flow to the Firm (FCFF) and give the formula from net income.

FCFF is cash available to all capital providers (debt and equity) after operating expenses, taxes, and needed investments. $$\text{FCFF} = \text{NI} + \text{NCC} + \text{Int}(1-\text{tax}) - \text{FCInv} - \text{WCInv}$$ where NCC is non-cash charges, Int is interest expense, FCInv is fixed capital investment, and WCInv is working capital investment.

Define Free Cash Flow to Equity (FCFE) and give the formula from FCFF.

FCFE is cash available to common shareholders after debt obligations. $$\text{FCFE} = \text{FCFF} - \text{Int}(1-\text{tax}) + \text{Net borrowing}$$ Equivalently, $\text{FCFE} = \text{NI} + \text{NCC} - \text{FCInv} - \text{WCInv} + \text{Net borrowing}$. It is discounted at the required return on equity.

How do you value the firm and equity using single-stage (constant-growth) FCFF and FCFE models?

Firm value $$= \frac{\text{FCFF}_{1}}{\text{WACC} - g}$$ and equity value from FCFF = firm value − market value of debt. Equity value directly from FCFE $$= \frac{\text{FCFE}_{1}}{r - g}$$ where $r$ is the required return on equity. WACC discounts FCFF; required return on equity discounts FCFE.

When is FCFE preferred over the DDM, and when is FCFF preferred over FCFE?

Use FCFE instead of DDM when dividends differ significantly from a firm's capacity to pay (e.g., low/no dividends, or buybacks) or for a control perspective. Use FCFF rather than FCFE when the firm's capital structure (leverage) is unstable or it has negative FCFE, because FCFF and WACC are less sensitive to leverage changes.

Define the price-to-earnings (P/E) ratio on a trailing versus leading basis, and give the justified P/E from the Gordon model.

Trailing P/E = price / most recent 4 quarters' EPS; leading (forward) P/E = price / next 12 months' (forecast) EPS. The justified leading P/E from the Gordon model is $$\frac{P_{0}}{E_{1}} = \frac{1-b}{r-g}$$ where $1-b$ is the payout ratio.

What is the PEG ratio and how is it interpreted?

$$\text{PEG} = \frac{\text{P/E}}{g}$$ where $g$ is the expected earnings growth rate (in percent). It standardizes P/E for growth; a lower PEG suggests a more attractively priced stock per unit of growth, though it assumes a linear price-growth relationship and ignores risk differences.

Distinguish the method of comparables from the method based on forecasted fundamentals for using multiples.

Method of comparables: value a stock by comparing its multiple (e.g., P/E) to those of similar firms or a benchmark; cheap if its multiple is below peers. Method based on fundamentals: derive a justified multiple from a valuation model (e.g., Gordon growth) and the firm's own fundamentals, then compare to the actual multiple.

Why are enterprise value (EV) multiples such as EV/EBITDA used, and how is EV calculated?

$$\text{EV} = \text{Market value of equity} + \text{Market value of debt} - \text{Cash and investments}$$ EV/EBITDA is useful for comparing firms with different capital structures and is meaningful even when net income or EPS is negative, because EBITDA is a pre-interest, pre-tax, pre-depreciation flow available to all capital providers.

Define the residual income valuation model and the formula for residual income.

Residual income is net income in excess of the equity charge (cost of equity capital). $$\text{RI}_{t} = \text{NI}_{t} - r \times B_{t-1} = (\text{ROE} - r)\,B_{t-1}$$ Value: $$V_{0} = B_{0} + \sum_{t=1}^{\infty} \frac{\text{RI}_{t}}{(1+r)^{t}}$$ where $B_{0}$ is current book value of equity and $r$ is the required return.

What is the single-stage residual income model's justified price-to-book ratio?

$$\frac{P_{0}}{B_{0}} = 1 + \frac{\text{ROE}-r}{r-g} = \frac{\text{ROE}-g}{r-g}$$ A firm trades above book value when ROE exceeds the required return $r$; the larger the spread $(\text{ROE}-r)$, the higher the justified P/B.

Name the three major approaches to valuing a private company.

(1) The income approach (discount expected future cash flows — FCF, capitalized cash flow, or excess earnings); (2) the market approach (apply multiples from guideline public companies, guideline transactions, or prior firm transactions); (3) the asset-based approach (value of assets minus liabilities).

What factors make private company valuation more challenging than public company valuation, leading to discounts?

Stock is illiquid (lack of marketability) and ownership stakes may be non-controlling (lack of control). Information is limited, reporting may be tax-driven, and required returns are higher. These give rise to a discount for lack of control (DLOC) and a discount for lack of marketability (DLOM).

How are the discount for lack of control (DLOC) and the discount for lack of marketability (DLOM) applied to a private equity value?

DLOC is applied to remove the value of control when valuing a minority interest: $$\text{DLOC} = 1 - \frac{1}{1 + \text{control premium}}$$ The total discount combines both: $$\text{Total discount} = 1 - (1-\text{DLOC})(1-\text{DLOM})$$ DLOM reflects the cost/inability to readily sell the shares.

What are the three definitions (standards) of value commonly used in private company valuation?

Fair market value (price between willing, informed, unpressured buyer and seller), market value, fair value (for financial reporting or litigation), investment value (value to a specific buyer given synergies), and intrinsic value. The appropriate standard depends on the purpose of the valuation (e.g., transactions, tax, litigation).