CFA Equity Investments Flashcards

24 sample cards from the Equity Investments deck

Sampled from the end of the deck, so these are different cards from the ones shown on the syllabus page.

1. Under weak-form efficiency, which type of analysis cannot consistently generate abnormal returns?

   Technical analysis, because if prices already reflect all past price and volume data, studying historical price patterns cannot yield consistent abnormal (risk-adjusted) returns.

2. Under semi-strong-form efficiency, which type of analysis cannot consistently generate abnormal returns?

   Fundamental analysis based on public information cannot consistently produce abnormal returns, because prices already fully reflect all publicly available information. Only genuinely private information could add value.

3. If markets are strong-form efficient, can insiders earn abnormal returns? What does empirical evidence suggest?

   Under strong-form efficiency, even insiders cannot earn abnormal returns because prices reflect all information, public and private. Empirical evidence generally rejects strong-form efficiency, since insiders (and specialists) have been shown to profit from private information.

4. Define an abnormal return and its relationship to market efficiency.

   An abnormal return is the return in excess of the risk-adjusted expected (equilibrium) return: $$AR = R_{actual} - E(R)$$ In an efficient market, consistent positive abnormal returns (net of costs) should not be achievable.

5. What is the intrinsic value of an asset and how does it relate to market price in an efficient market?

   Intrinsic value is the value an investor would assign given a hypothetically complete understanding of the asset's characteristics. In an efficient market, market price is an unbiased estimate of intrinsic value, so on average price equals intrinsic value.

6. Name three factors that contribute to (or affect) market efficiency.

   (1) Number of market participants and analysts following an asset; (2) availability of information and financial disclosure; (3) impediments to trading such as limits to arbitrage and transaction/information costs. More participants and easier, cheaper trading increase efficiency.

7. Distinguish the January effect and the value effect as market anomalies.

   The January effect (turn-of-the-year effect): stock returns, especially small caps, are abnormally high in January. The value effect: low P/E, low P/B, and high-dividend-yield (value) stocks tend to outperform growth stocks on a risk-adjusted basis, contradicting semi-strong efficiency.

8. In behavioral finance, define loss aversion and overconfidence.

   Loss aversion: investors dislike losses more than they value equivalent gains, so they take excessive risk to avoid realizing losses. Overconfidence: investors overestimate the accuracy of their forecasts, leading to overtrading and mispricing that can persist.

9. State the general form of the Dividend Discount Model (DDM) for a stock held indefinitely.

   $$V_0 = \sum_{t=1}^{\infty} \frac{D_t}{(1+r)^{t}}$$ where $D_t$ is the expected dividend in period $t$ and $r$ is the required rate of return on equity.

10. Write the one-year holding-period DDM valuation formula.

    $$V_0 = \frac{D_1 + P_1}{1+r}$$ where $D_1$ is the dividend expected at year-end, $P_1$ is the expected year-end price, and $r$ is the required return on equity.

11. State the Gordon (constant) growth dividend discount model formula.

    $$V_0 = \frac{D_1}{r - g} = \frac{D_0(1+g)}{r - g}$$ valid when $r > g$; $D_0$ is the current dividend, $g$ is the constant growth rate, and $r$ is the required return.

12. In the Gordon growth model, solve for the required rate of return $r$.

    $$r = \frac{D_1}{P_0} + g$$ The required return equals the forward dividend yield plus the constant dividend growth rate.

13. What are the key assumptions of the Gordon growth model?

    Dividends grow at a constant rate $g$ forever; the required return $r$ is constant and $r > g$; and the growth rate $g$ is expected to be sustained indefinitely (best suited to stable, mature, dividend-paying firms).

14. Write the sustainable growth rate formula using the retention ratio and ROE.

    $$g = b \times ROE$$ where $b$ is the earnings retention ratio $= 1 - \text{dividend payout ratio}$, and $ROE$ is the return on equity.

15. What is the two-stage dividend discount model used for, and give its structure conceptually?

    It values firms expecting an initial period of high (possibly non-constant) growth followed by constant long-run growth. Value = PV of the finite short-term dividends + PV of the terminal value computed with the Gordon model at the start of the stable phase: $$V_0 = \sum_{t=1}^{n} \frac{D_t}{(1+r)^{t}} + \frac{1}{(1+r)^{n}}\cdot\frac{D_{n+1}}{r - g_L}$$

16. State the preferred stock valuation formula for a fixed, non-callable, perpetual preferred share.

    $$V_0 = \frac{D_p}{r}$$ where $D_p$ is the fixed annual preferred dividend and $r$ is the required return; the dividend is treated as a perpetuity.

17. Define the price-to-earnings (P/E) ratio and distinguish trailing from forward (leading) P/E.

    $$P/E = \frac{\text{Price per share}}{\text{Earnings per share}}$$ Trailing (current) P/E uses EPS over the most recent 12 months; forward (leading) P/E uses next year's expected EPS.

18. Derive the justified (fundamental) forward P/E ratio from the Gordon growth model.

    Dividing $V_0 = \frac{D_1}{r-g}$ by $E_1$ and using $D_1 = E_1(1-b)$: $$\frac{P_0}{E_1} = \frac{1-b}{r - g}$$ where $1-b$ is the dividend payout ratio.

19. Derive the justified (leading) price-to-book value ratio.

    $$\frac{P_0}{B_0} = \frac{ROE - g}{r - g}$$ A stock's justified P/B rises when ROE exceeds the required return; if $ROE = r$ then $P/B = 1$.

20. What is the difference between a price multiple based on fundamentals and one based on the method of comparables?

    A fundamentals-based multiple is derived from a valuation model (e.g., DDM) giving a justified value driven by growth, payout, and required return. The comparables method compares a stock's actual multiple to those of similar firms or a benchmark to judge relative over-/under-valuation, using the law of one price.

21. Define the price-to-sales (P/S) ratio and give one advantage over P/E.

    $$P/S = \frac{\text{Market value of equity}}{\text{Total sales}} = \frac{\text{Price per share}}{\text{Sales per share}}$$ Advantage: sales are less easily manipulated than earnings and are always positive, so P/S is usable even for firms with negative or zero earnings.

22. Define the enterprise value (EV) and the EV/EBITDA multiple, and state why EV/EBITDA is useful.

    $$EV = \text{Market value of equity} + \text{Market value of debt} - \text{Cash and short-term investments}$$ $$EV/EBITDA = \frac{EV}{\text{EBITDA}}$$ It is useful for comparing firms with different capital structures and can be applied when earnings (or EPS) are negative, since EBITDA is more often positive.

23. What is the price/earnings-to-growth (PEG) ratio and how is it interpreted?

    $$PEG = \frac{P/E}{g}$$ where $g$ is the expected earnings growth rate (in percentage points). It standardizes P/E for growth; lower PEG suggests more attractive (cheaper per unit of growth) valuation, though it assumes a linear P/E–growth relationship.

24. What are the two broad categories of equity valuation models besides present-value (DDM) and multiplier (price-multiple) models?

    (1) Asset-based valuation models, which estimate equity value as the market/fair value of assets minus the value of liabilities; and (2) enterprise-value / multiplier models based on measures like EV/EBITDA. (The four categories are present-value, multiplier, asset-based, and enterprise-value models.)

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Equity Investments flashcards FAQ