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Top 9 Formulas for the CFA Level 1

Exam
Posted on October 12, 2015 by josephhogue

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! " # $
Peeling back the cover on your CFA Level 1 books can be a shock at first. Thousands of pages
and hundreds of formulas sit in front of you and can seem overwhelming.

Before you freak out, it’s not really so bad. While formulas become crucial on the CFA level 2
exam and its quantitative focus, the formulas on the first exam are much more about learning
relationships and the process. Learn the ‘why’ of the formula and you’ll remember how to work it
on the exam easily.

I thought I would cover some of the most important formulas in the CFA level 1 exam and how to
approach the mountain of equations. Practice problems and flash cards are going to be your best
friends. There’s really no substitute for working formulas over and over again for remembering
them on the exam. Write out practice problems of the most difficult and most important formulas
and then practice them daily until you can do them easily.

Equation #1: Future Value of a Single Cash Flow

The future value of cash flows is not a difficult formula and one that you’ll do on your financial
calculator but it’s really a building block to a lot of the more difficult formulas for time value of
money. Make sure you understand this basic formula and what the different notations mean.

FVN=PV(1+r)N
i.e. if your savings account earns interest at a 5% rate and you have $100 deposited, how much
will it be worth in 20 years?

FV20=$100(1+.05)20
=$265.33

Equation #2: NPV and IRR

Both NPV and IRR are also found easily with the calculator but they pop up many times in
conceptual questions so you really need to understand the idea behind each. Remember that a
key assumption of IRR is that cash flows are reinvested at that rate, which may not be realistic.
Also, if there are multiple cash outflows, there will be multiple IRRs or none at all. There may be a
conflict between NPV and IRR when projects are mutually exclusive or when there are multiple
cash outflows. In this case, NPV is preferred.

Using the calculator is relatively easy,

The initial project cost or investment is a negative (outflow) as CF0

CO1 through x are the stream of cash flows and entered as a positive (inflow)
If cash flows are an equal amount, you can enter them as F (frequency)

Press the NPV button and enter the interest rate

Down arrow
CPT NPV
For IRR, just press the IRR button and CPT

Equation #3: Sharpe Ratio

The Sharpe Ratio is a measure for adjusting risk across investments and measuring return on the
same scale. While bonds may offer a much lower rate, are they a better or worse investment than
stocks given their lower volatility? It’s a pretty easy calculation and you’ll see it come up in all three
exams so make sure you can remember it quickly.

Sharpe ratio = (Asset Return – Risk Free Rate) / Asset Standard Deviation

Equation #4: Capital Asset Pricing Model

There are a lot of flaws in the CAPM and it’s used more in academics but it is still a very useful
formula and will appear throughout the CFA exams. Beyond the formula, you should pay attention
to drawbacks of using the CAPM.

Ra = rf + Ba (rm-rf)

The required return (Ra) is the amount of return required given a specific asset’s additional risk
relative to the market and the risk free rate. You multiple an asset’s beta (Ba) by the difference
between the expected return on the market (rm) and the risk free rate (rf). You then add back in
the risk free rate.
The difference between the market’s expected return and the risk free rate is called the market
premium, the additional return required for taking on market risk.

Equation #5: DuPont Analysis of ROE

DuPont analysis breaks down the return on equity (ROE) into three components, profit margin –
asset turnover – equity multiplier.

ROE = (Net Income/Sales)*(Sales/Assets)*(Assets/Equity)

Which becomes (Net Income/Equity) in its simplest form.

The formula provides another layer of analysis on which to compare company profitability. It’s not
enough to be able to say that one company has a high return on its shareholder equity but you
need to know the source of the return.

Equation #6: Dividend Discount Models

The Gordon Growth Model (GGM) is arguably one of the most used formulas in the curriculum. It
is a single-stage model, assuming that dividends will grow at a constant rate into perpetuity. The
general formula is:

Price = Div0 (1+growth) / (Rce – growth)

An important note is that the required return must be higher than the growth rate in dividends to
use the formula. This is not usually a problem in single-stage models because the long-term
growth rate will probably be fairly low. Be ready to calculate some of the data points on the exam
(like finding the discount rate through CAPM or the growth rate through ROE and the payout
ratio).

The GGM is not appropriate when the company is experiencing super-normal growth for a period
before it slows to perpetual growth. For this scenario, you need one of the multi-stage models.

Equation #7: Weighted Average Cost of Capital

Understanding and calculating the WACC is another foundational concept that you will need to
master. The concept is pretty intuitive, a firm’s cost of capital (spending) is a weighted average of
the cost from each source (debt or equity). Debt is normally less expensive and tax shielded but
can be risky at high amounts.

WACC = E/V * Re + D/V * Rd * (1-Tc)

The WACC is equal to the percentage of financing from equity (E/V) times the cost of equity (Re)
plus the percentage of financing from debt (Rd) times the cost of debt, adjusted for the tax shield.

Use the market value of debt or equity when available. Remember, the company’s capital
structure may change over time so it is preferable to use target weights instead of current market
value weights.

Equation #8: Free Cash Flows

FCF models acknowledge that investors have a right to all cash flows from a company and not
just those paid out as dividends. Free cash flows are the cash generated from operations after
that needed for continued operations is deducted.

The advantage is that FCF compared to dividend models is that FCF can be calculated regardless
if the company pays a dividend. FCF models are also appropriate for investors that may be able
to exercise a control premium on the company. The major disadvantage is in valuing those
companies with high capital expenditures, making free cash flow negative at times.

Free cash flow is shown two different ways, Free Cash Flow to Equity and Free Cash Flow to the
Firm, each appropriate to two different ownership perspectives. FCFF is the cash flow from
operations after capital expenditures that is available to both levels of ownership (debt and equity).
FCFE is that left over after paying debt holders, since they have a prior claim.

Free Cash Flow to the Firm (FCFF) is the cash flow available to all capital providers (debt
and equity) and equals:

Net income + Net noncash Charges (depreciation and amortization) – Investment in working
capital – Investment in Fixed capital + after tax interest expense

Free Cash Flow to Equity (FCFE) is the cash flow available to common shareholders and
equals:

Net income + Net noncash Charges (depreciation and amortization) – Investment in working
capital – Investment in Fixed +/- net borrowing

Notice that FCFE is FCFF except without adding back interest expense and taking net
borrowing into account.
Understand how to arrive at FCFE or FCFF with CFO

FCFF = CFO + INT (1-t) – invest fixed capital

FCFE= CFO – invest fixed capital +/- net borrowing

Equation #9: Turnover Ratios

The last formula is actually a series of ratios but all relatively easy to remember. These are the
turnover ratios: accounts receivable, inventory turnover, number of days receivables, number of
days payable and number of days inventory. You’ll use these to calculate the net operating cycle
and all individual ratios are fair game on the exam.

The most important thing here is to remember that when you are combining income statement
data and balance sheet data, you need to use an average of the balance sheet data. For
example, the inventory turnover ratio is the cost of goods sold (income statement) divided by the
average inventory from the current and previous period balance sheet.
Most of these formulas are not difficult and are pretty intuitive if you just think through them for a
moment. You’ll need that deep understanding of what is going on in the formula more than you’ll
need the formula itself. Make sure you have this conceptual mastery and you’ll have no trouble on
the CFA level 1 exam.

‘til next time, happy studyin’

Joseph Hogue, CFA

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Follow @finquiz 187 followers

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