Your Cheat Sheet to… CFA Level I: Equity

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By Marc

The Cheat Sheet articles are a series of articles, each focusing on one specific topic of the CFA exam for one specific CFA level. In each Cheat Sheet article, we will cover the basics of what you need to know before diving into the material – what it’s about in a nutshell, how significant is it in the CFA exams, real-life applications, and tips for the CFA exams. You should aim to read each relevant Cheat Sheet article before you start studying the topic to get you to a flying start.

There are many asset classes in which people can invest, but equities (also commonly known as ‘stocks’) are probably the best known. In this article, we look at how equities are covered in the Equity topic of the CFA Level I exam. This is a relatively gentle section of the curriculum, so it provides an opportunity to improve your score without feeling like you’ve endured the academic equivalent of dental surgery.


​What is the weighting of this topic in the CFA exams?
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​10% of the Level I exam is allocated to the Equity topic, so you can expect that 24 of the 240 exam questions will explicitly cover the material presented in the six readings on this topic.

But be warned, these numbers can be somewhat deceptive. Economics is also 10% of the Level I exam. However, the concepts that are covered in the nine readings on Economics are far less likely to reappear in readings on other topics. By contrast, the concepts that are central to understanding the six reading on Equity reappear 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.


What is Equity about, in a nutshell?
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At a very basic level, the funds that companies use to acquire assets are raised by either borrowing (issuing debt) or selling equity (i.e. a stake in the company and entitlement to a share of the profits). From an investor’s perspective, the risks and rewards of lending a company money are quite different than those associated with becoming one of its minority owners. The Equity readings, in a nutshell, are about understanding makes equities different, how to value equities, and how to measure the performance of equity investments.

The Equity section of the Level I CFA curriculum contains six readings, but only three of these focus exclusively on equities. They are:

  • Overview of Equity Securities: a qualitative analysis of the features that distinguish equity securities from other asset classes
  • Introduction to Industry and Company Analysis: a glimpse at the qualitative frameworks that are commonly used to analyze equities
  • 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 other readings that have been included in the equity section are: 

  • Market Organization and Structure: an overview of how various types of markets operate and the actors who participate in them
  • Security Market Indices: a helpful summary of how the different types of indexes, how they are constructed, and what they are used for
  • Market Efficiency: a discussion of whether market prices reflect the intrinsic value of securities

Note that very little of the material in this second group applies exclusively to equities. For example, whether or not markets are efficient is as relevant to bonds as it is to stocks. Indeed, there are sections of these readings that are explicitly about asset classes other than equities, such as the discussion of indices used to measure the performance of hedge funds and other alternative asset classes. However, that does not mean that the material covered in this second group is any less likely to be tested than the material covered in the “pure” equity readings.


Why should I care about this in real life?

​This question can best be answered with the following Venn diagram:

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​The reality is that equity securities and their valuations are almost certainly highly relevant to the day-to-day activities of anyone reading this article. Indeed, some of you may find that much of the content in the Equity readings is not particularly relevant to your job. For example, the Gordon growth model is a key topic in the reading on equity valuation, but is easy to imagine a candidate for the Level I CFA exam who is using highly sophisticated and proprietary equity valuation models and spends none of his or her working hours thinking about the Gordon growth model. 

The point is that, while the curriculum may not matter much in your life outside of the exam room, it is the only thing that matters when you are in the exam room.  You may not agree that the Gordon growth model is the best model to use when valuing a mature company with stable earnings and this may be the right answer to give at work, but what is right at the office and what is correct on the exam are not necessarily the same thing.


Any tips for the CFA exam I should know about?
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​As noted above, the Equity topic is among the more pleasant parts of the Level I CFA, so you may feel comfortable deferring your studies on this topic until you are satisfied with your command of other more complex topics. This is not to say that the equity material is easy and can be taken for granted – just that it contains few, if any, nasty surprises.

Alternatively, you may choose to cover these readings early in your studies so that you can cross a topic with a relatively large exam weighting off your to-do list. This is not a bad idea given that that is a foundational topic with lessons that can be applied to other readings. Ultimately, you are the best judge of which course of study works best for you.

​Whenever you choose to get to the Equity readings, you will encounter no shortage of CFA Institute’s Practice Problems – more than 30 per reading on average. There are also many helpful examples provided within the main body of each reading. This means that you should be able to develop a good idea of what Equity questions will look like on the actual exam. Obviously you won’t know what will be tested specifically, but you can, for example, see that the questions tend to be qualitative (as opposed to quantitative) in nature. 

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:
A. 6.7
B. 10.0
C. 10.6

The correct answer is B.

The forward P/E for a stock is calculated as follows


P0/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%)
= 10.0
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: 

Zee Tan
Author: Zee Tan

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