Since Equity is a relatively gentle section of the curriculum, it provides an opportunity to maximize your score without feeling like you’ve endured the academic equivalent of dental surgery. Don’t discount it! 😅
We’ve created this Level 1 Equity Cheat Sheet to help speed up your revision of this section.
Our Cheat Sheet series focuses on one specific topic area for each CFA Level.
More Cheat Sheets will be published in the coming weeks, sign up to our member’s list to be notified first.
By referring to the CFA Learning Outcome Statements (LOS), we prioritize and highlight the absolute key concepts and formula you need to know for each topic. With some tips at the end too!
Let’s have a look – bookmark this and check back often to refresh your memory!
- CFA Level 1 Equity: An Overview
- Reading 36: Market Organization and Structure
- Reading 37: Security Market Indexes
- Reading 38: Market Efficiency
- Reading 39: Overview of Equity Securities
- Reading 40: Introduction to Industry and Company Analysis
- Reading 41: Equity Valuation: Concepts and Basic Tools
- CFA Level 1 Equity Tips
CFA Level 1 Equity: An Overview
Equity Investments is an important asset class in finance, with a similar topic weight across all 3 levels of the CFA exams.
Fair warning though, as the topic weights can be somewhat deceptive. While having similar weighting to Economics, Equity Investment topics are more likely to reappear in other topics throughout the curriculum – even if indirectly.
For example, Alternative Investments are considered “alternative” because they are different than Equity (and Fixed Income) and it is difficult to understand these differences without having first acquired a strong understanding of the Equity readings.
CFA Level 1 Equity Investments’ topic weighting is 10%-12%, which means 18-22 questions of the 180 questions of CFA Level 1 exam is centered around this topic.
It is covered in Study Sessions 12-13, which includes Reading 36-41.
Note that the CFA Level 1 Equity section contains 6 readings, but only 3 of these focus exclusively on equities.
Here’s a summary of Level 1 Equity Investments chapter readings:
|36||Market Organization and Structure||An overview of how various types of markets operate and the actors who participate in them|
|37||Security Market Indexes||A helpful summary of how the different types of indexes, how they are constructed, and what they are used for|
|38||Market Efficiency||A discussion on whether market prices reflect the intrinsic value of securities|
|39||Overview of Equity Securities||A qualitative analysis of the features that distinguish equity securities from other asset classes|
|40||Introduction to Industry & Company Analysis||Looks at the qualitative frameworks that are commonly used to analyze equities|
|41||Equity Valuation: Concepts and Basic Tools||This reading, which is the most quantitative, gets into detail about how investors arrive at the valuations that they used when determining whether a stock is trading at an attractive price|
The Equity readings, in a nutshell, are about understanding what makes equities different as an asset class, how to value equities, and how to measure the performance of equity investments.
In short, CFA Level 1 Equity Investments teaches you:
– about the functions and characteristics of a well functioning financial system;
– about market efficiency, behavioural finance and various biases;
– how to value equity with various methods.
Reading 36: Market Organization and Structure
Leveraged positions (buying stock on margin)
Leverage ratio measures the amount borrowed relative to the total value of the asset. It is also the reciprocal of the initial margin (a.k.a. trader’s equity).
Traders receive a margin call when price of equity falls below the maintenance margin requirement.
Execution instructions types for orders
|Market orders||Order is immediately executed at best price available.|
|Limit orders||Sets a minimum price for sell orders, or a maximum price for buy orders. |
However, order may not be executed at all if markets are fast moving or there are insufficient liquidity.
|All-or-nothing orders||Order will only be executed if the entire quantity can be traded.|
|Hidden orders||Large orders that are only known to brokers/exchanges that are executing them, until the trades are executed.|
|Iceberg orders||A small % of a large hidden order is executed first to gauge market liquidity, before the entire order is executed.|
Market order vs limit order
|Market order||Limit order|
|Execution||Executed immediately at best market price||Sets a minimum sell price or a maximum purchase price on orders.|
Types of limit orders:
a) Marketable (aggressively priced) ensures immediate execution:
Limit buy order > best ask, OR
Limit sell order < best bid
b) Making a new market / inside the market:
Best bid < Limit price < Best ask
c) Behind the market:
Limit buy price < Best bid
Limit sell price > Best ask
|Pros||Quick execution||Ensures that price limits are never breached in transaction, more trade price certainty|
|Cons||Trade price uncertainty||Order may not be partially filled, or not executed at all in a volatile market.|
Validity instructions types
|Day orders||Orders that expire if unexecuted by end of day it is submitted.|
|Good-till-cancelled orders||Orders that last until the buy or sell order is executed.|
|Immediate or cancel orders (“fill or kill”)||As per its name, once the order is submitted it has to be immediately executed. If it is not executable immediately, the order is cancelled.|
|Good-on-close (market-on-close)||Order is only executed at the close of trading.|
|Stop orders (stop-loss)||Orders that come with a trigger price, designed to limit losses. |
E.g. stop-sell orders will execute if price is at or below stop/trigger price. Whereas, stop-buy orders will execute if price is at or above stop/trigger price.
Reading 37: Security Market Indexes
Index weighting methods
|Price weighting||Weight of each security is determined by dividing its price by the sum of total prices in the index.||
Cons: arbitrary weights
|Equal weighting||Each security is given identical weight at inception.||
Cons: frequent rebalancing needed, and high market cap stocks are underrepresented
|Market-cap weighting||Weight of each security is determined by dividing its market cap by the total market cap of the index.||
Pros: securities held in proportion to value.
Cons: influenced by overpriced securities
|Fundamental weighting||Weight of each security is determined by measures such as book value, P/E, cash flow, revenue etc.||
Pros: biased towards value stocks (value tilt)
Cons: doesn’t consider market value, needs rebalancing.
Reading 38: Market Efficiency
Forms of market efficiency and its implications
|Forms of market efficiency||Past market data||Public info||Private info||Implications|
|Weak-form||✔||✘||✘||Abnormal returns cannot be earned by trading on past price trends. Technical analysis helps maintain weak-form efficient markets.|
|Semi-strong form||✔||✔||✘||Investors cannot achieve risk-adjusted excess returns using important public info. Fundamental analysis helps maintain semi-strong form efficient markets.|
|Strong form||✔||✔||✔||Securities markets are not strong-form efficient as it assumes perfect markets where information is cost-free and available to everyone at the same time.|
Hence, abnormal profits can be made by trading on private information, which regulators try to prevent.
|Loss aversion||Individual’s reluctance to accept/realize a loss or hold on to losers too long (in hope of a comeback), leading to higher risk-taking behaviour|
|Herding||Investors follow what other investors are doing and ignores own private information.|
|Overconfidence||Placing too much confidence in ability to predict|
|Information cascades||An individual copies the trades of other market participants who acted first. The first participant’s action . Related to herding.|
|Representatitveness||Investors base expectations upon past experience, applying stereotypes. If-then heuristic (when investor bases expectations of future on some past/current characteristics. e.g. if A happens, then B will happen)|
|Mental accounting||Keeps track of individual investment’s gains and losses separately, rather than view them as a total portfolio overall.|
|Conservatism||Unwilling to radically readjust from original analysis (often heuristic & much less accurate), only adjusting directionally.|
Hence inability to fully incorporate impact of new information on projections and react slowly.
|Narrow framing||Investors focus on issues in isolation.|
Reading 39: Overview of Equity Securities
Risk of equity securities
- Preference shares have lower risk than common shares because:
- preferred dividends are fixed and they form a larger portion of total return in case of preference shares,
- preference shares rank above common shares in their claim on earnings and net assets (in the event of liquidation).
2. Putable shares have a lower risk than callable or non-callable shares because they can be sold back to the issuer if the stock price falls below a threshold. Hence putable shares have lower dividends.
3. Callable common and preference shares are more risky than their non-callable equivalents because the issuer can buy back the shares at a pre-determined price.
4. Similarly, cumulative shares have a lower risk (and hence lower dividends) than non-cumulative shares as they accrue unpaid dividends.
Reading 40: Introduction to Industry and Company Analysis
Porter’s five forces
- Threat of substitutes
- Customer’s bargaining power
- Supplier’s bargaining power
- Threat of new entrants
- Intensity of rivalry among existing competitors
Industry lifecycle model
|Embryonic||Slow growth, high prices, high failure risk, significant investment required.|
|Growth||Rapidly increasing demand, improved profitability, lower prices, relatively low competition.|
|Shakeout||Slowing growth, intense competition, focus on cost reduction, declining profitability, some failures/mergers.|
|Mature||Little or no growth, industry consolidation, high barriers to entry, strong cashflows.|
|Decline||Negative growth, excess capacity, high competition, weaker firms exit.|
Reading 41: Equity Valuation: Concepts and Basic Tools
Types of equity valuation models
- Present value models: Estimate value as present value of expected future benefits, e.g. dividend discount models, free cash flow to equity models
- Multiplier models: Estimate intrinsic value based on multiple of some fundamental variable. E.g. price to earnings, price to book value, enterprise value (EV) to EBITDA ratios.
- Asset-based valuation models: Estimate value of equity as fair value of assets less fair value of liabilities.
Dividend payment chronology
- Declaration date: Company declares the dividend
- Ex-dividend date: Cutoff date on or after which buyers of a stock are not eligible for the dividend. Also the first date where the stock trades without dividend.
- Holder-of-record date: A record of shareholders who are eligible to receive dividend is made, usually 2 days after ex-dividend date.
- Payment date: dividend payment made to shareholders
Dividend discount model (DDM)
Intrinsic value = PV of future dividends + PV of terminal value
Gordon growth model
Gordon growth model assumes dividends grows forever at a constant rate.
where g = dividend growth rate
= earnings retention ratio x ROE
= (1- dividend payout ratio) x ROE
Multistage dividend discount model (DDM)
Preferred stock valuation
For valuation of perpetual, non-callable, non-convertible preferred share with constant dividend:
- Price to earnings ratio (P/E)
2. Price to book ratio (P/B)
3. Price to sales ratio (P/S)
4. Price to cashflow ratio (P/CF)
5. Enterprise value
Enterprise value is an alternate measure for equity which measures the market value of a firm’s debt and equity. It can be viewed as the cost of taking over a company.
EV = Market value of debt + Market value of equity + Market value of preferred stock – cash and short term investments
EV/EBITDA multiple is useful for comparing companies with different capital structures, to evaluate the cost of a takeover and for analyzing loss making companies.
That said, a limitation of EV method is that market value of debt can be hard to estimate.
CFA Level 1 Equity Tips
Master Equity Investments to maximize your score
As noted above, the Equity topic is among the more “pleasant” parts of the Level 1. This is not to say that the Equity Investments material is easy and can be taken for granted – just that it contains few(er) nasty surprises.
Given it’s relative ease compared to its topic weight for CFA Level 1, mastering this topic is a good return on investment, don’t skip it!
Don’t forget to practice quantitative Equity questions too
While it is reasonable to expect that the majority of Equity questions will be qualitative, don’t assume that the questions that do require calculations will be simple.
It is therefore important to become familiar with your calculator – specifically, the features that allow you to determine the present value of a series of cash flows.
It is also important to develop a fluency with the formulae associated with these readings. By “fluency,” I mean knowledge of a formula beyond being able to recite it from memory, such as the ability to rearrange or restate it in order to solve for a given variable.
For example, know how to use the Gordon growth model to solve for the long-term growth rate or required return, not just the present value. Such fluency is also required in order to answer the following example question:
A company has recently paid a dividend of $1.20 per share. Analysts expect the company to maintain its 40% retention rate and increase its dividend per share dividend at an annual rate of 3.0% indefinitely. If the market requires a 9.0% return on equity, the forward price-to-earnings (P/E) ratio for the company’s stock is closest to:
The correct answer is B.
The forward P/E for a stock is calculated as followsP0/E1 = (D1/E1)/(r – g) where P0 = current stock price
E1 = next period’s earnings per share
D1 = next period’s dividends per share
r = required rate of return
g = dividend growth rate
Note that D1/E1 is the dividend payout ratio, which is calculated as one minus the retention ratio (or 1 – b).We can restate the above formula as follows
P0/E1 = (1 – b)/(r – g) = (1 – 40%)/(9% – 3%)
It is possible to disregard the value of next period’s dividend and earnings per share because, having restated the formula, all that matters is their ratio relative to each other and we know that this will not change because we are told that the company is expected to maintain its retention rate (and therefore maintain its payout ratio).
More Cheat Sheet articles will be published over the coming weeks. Get ahead of other CFA candidates by signing up to our member’s list to get notified.
Meanwhile, here are other related articles that may be of interest:
- CFA Level 1 Cheat Sheets series: Quant Methods | Economics | Corporate Finance | Fixed Income | FRA | Derivatives | Ethics | Alt Investments | Portfolio Management
- CFA Level 1: How to Prepare and Pass CFA in 18 Months
- CFA Level 1 Tips: Top 10 Advice from Previous Candidates
- 18 Actionable Ways to Improve Your Study Memory
- How to Study Effectively: Proven Methods that Work for CFA, FRM and CAIA
- The Ultimate Guide to CFA Practice Questions