2022 LI Equity

Last Revised: 05/29/2021
Level I - Equity Investments

Readings Page
Market Organization and Structure 2
Security Market Indexes 21
Market Efficiency 35
Overview of Equity Securities 45
Introduction to Industry and Company Analysis 56
Equity Valuation: Concepts and Basic Tools 68
Reviews 86
This document should be used in conjunction with the corresponding readings in the 2022 Level I CFA® Program curriculum.
Some of the graphs, charts, tables, examples, and figures are copyright 2022, CFA Institute. Reproduced and republished with
permission from CFA Institute. All rights reserved.
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1
Market Organization and Structure
a. explain the main functions of the financial system;
b. describe classifications of assets and markets;
c. describe the major types of securities, currencies, contracts, commodities,

and real assets that trade in organized markets, including their distinguishing
characteristics and major subtypes;
d. describe types of financial intermediaries and services that they provide;
e. compare positions an investor can take in an asset;
f. calculate and interpret the leverage ratio, the rate of return on a margin
transaction, and the security price at which the investor would receive a
margin call;
g. compare execution, validity, and clearing instructions;
h. compare market orders with limit orders;
i. define primary and secondary markets and explain how secondary markets
support primary markets;
j. describe how securities, contracts, and currencies are traded in quote-driven,

order-driven, and brokered markets;
k. describe characteristics of a well-functioning financial system;
l. describe objectives of market regulation.
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Main Functions
LOS a
- of the Financial System
- explain
1) Facilitate the transfer of:
- capital between providers and users of capital
- risk between those who don’t want it to those willing
to accept it
2) Price Discovery - rates of return so that I = S
3) Facilitate the efficient allocation of capital
LOS a
1) Facilitate transfers - explain
1) Saving - move money to the future
- requires someone else willing to pay (borrow)
Sources ⇒ individuals, business, gov’t.
2) Borrowing - move money to the present

- requires someone else willing to provide (save)
Sources ⇒ individuals, business, gov’t.
3) Raise Equity Capital - indirect investing

- financial claim on assets
4) Managing Risks - hedging, insurance
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LOS a
1) Facilitate transfers - explain
5) exchange assets (on the spot)
i.e. - forex
6) Information-based trading - speculation
- investors ⇒ expect to earn a return for
bearing risk
- speculators ⇒ expect to earn a return in
excess of the required rate of
return
2) Discovery - capital costs money (rate of return)
- when capital supply > demand for capital , price ↓
- when capital supply < demand for capital , price ↑
LOS a
2) Discovery - when supply = demand (S = I) - explain
⇒ equilibrium interest rate
Caution: there is not one market with one interest

- each market has its own supply & rate
demand dynamics and its own equilibrium
3) Efficient allocation of capital

- capital seeks out the best risk-adjusted return
⇒ 1, 2 & 3 require ⇒ speedy transactions (liquidity)

⇒ low transaction costs
⇒ access to information
⇒ regulation
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Classifications
LOS b
Assets: MBS
- describe
1) financial assets - securities, currencies
2) physical assets - commodities, real assets GLD
Markets can be classified on the basis of

1) the timing of delivery
- spot markets - immediate delivery
- forward/futures markets - some agreed upon
future date
2) who the seller is
Co. $
- issuer - primary market
- investor/holder - secondary market $ $
LOS b
Markets can be classified on the basis of
- describe
3) the maturity of the instruments traded
- money markets - debt maturity < 1 yr.
- capital markets > 1 yr.
4) Types of securities
- traditional - debt, equity, funds
- alternative - private equity, securitized
debt, hedge funds
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Major Types of Securities
LOS c
1) Securities a) Public - exchanges
- describe
b) Private - qualified investors only
① Fixed-Income (Debt)
· Notes · Bonds · Bills · CDs · Repos · MM
② Equities (ownership claims)
· Common Preferred Warrants

- voting rights - higher priority - right to purchase
- entitled to claim stock at a pre-
discretionary dividends - entitled to fixed specified price before
- last claim on dividends (stated as a pre-specified date
assets a yield)
LOS c
1) Securities - describe
③ Pooled Investments (i.e. mutual funds, ABS)
- shares/units represent shared ownership of the
assets held
2) Currencies
- monies issued by national monetary authorities
- trade in foreign currency market (24 hrs./day)
3) Contracts - an agreement between 2 parties to do

something in the future
- value depends on the value of its underlying
(security, index, interest rate)
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LOS c
3) Contracts - may be cash settled or require
- describe
physical delivery
- physical vs. financial contract
- spot vs. forward/future/swap/options contracts
a) Forward (OTC, customizable)
(long) Buyer to buy a specific at a by a

both have an
(short) Seller obligation to sell asset specific certain
price date
b) Futures - a standardized, exchange-traded forward

contract
LOS c
3) Contracts c) Swaps - an agreement to exchange a - describe
series of cash flows at periodic dates over
a period of time (i.e. fixed for floating)
d) Options
Call to buy
a right a specific at a specific by a certain
Put to sell
asset price date
Buyers only the strike expiration

Sellers ➞ obligation underlying price date
e) Others - Insurance
- Credit Default Swaps
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LOS c
4) Commodities - precious/industrial metals, - describe
energy, agriculture, etc…
· spot · Forward/Futures
- buyers/sellers of - hedging/speculating
the physical product - usually close positions prior to
delivery date
5) Real Assets (Direct Investing)
- tangible ⇒ property, factories, equipment
- generally illiquid, high mgmt. costs
Intermediaries
LOS d
- facilitate the matching of providers
- describe
and users of capital and structuring products/services to
satisfy that function
1) Brokers, Exchanges, Alternative Trading Systems (ATS)

Brokers - fulfill orders for clients
- more critical for large-block traders
Exchanges - provide an auction platform

- must print best bid and ask
ATS - no regulatory authority over members

- dark pools ⇒ do not display orders sent to
them
· typically inst. investors, large-block trades
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LOS d
2) Dealers - will hold inventory - describe
- will become contract counterparties
- create liquidity
- can also act as a broker
- Primary Dealers ⇒ can buy/sell with the Central Bank
3) Securitizers - buying assets, placing them in a pool, and

selling securities against them
4) Depository Institutions and Other Financial Corporations

- banks, S&Ls, credit unions
- take deposits - pay interest, lend to borrower, charge
interest
LOS d
5) Insurance Companies
- describe
- create and sell contracts that protect
buyers from risk (auto, fire, theft, life)
- connect buyers with investors, creditors &
reinsurers
i.e. CAT bonds Insurance tornado

sells
creditor Company sells insurance
manages policy holder

6) Arbitrageurs fraud, moral hazard, adverse selection
- trade on mispricing
7) Settlement & Custodial Services (hold securities on behalf

- clearinghouses - arrange for of clients)
final settlement
- act as counterparty for futures contracts
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Positions
LOS e
- long position - benefits from an increase - compare
in price
- owns an asset or has purchased a contract
- short position - benefits from a decrease in price

- sold an asset they do not yet own or has
written a contract
Forwards long position obligated to take delivery asset or

short position obligated to deliver cash
equivalent
LOS e
Options long a call benefit from an - compare
short a put increase in price of the underlying
right obligation
short a call benefit from a drop in price of
long a put the underlying
Swaps - fixed for floating - party that benefits from a

rise in interest rates considered
‘long’
Currency - traded in pairs Buy $100k USD CAD means

I am long $100k USD and
i.e. USD.CAD = 1.3250 short $132.5k CAD
(1)
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LOS e
Short: Contracts - must deliver the - compare
underlying at a pre-determined date for a
pre-determined price
Securities - selling securities you don’t own

- broker arranges a borrow and lends
them to you to sell
- if the borrow cannot be maintained, seller

faces a forced buy-in
- to close a short position, seller initiates

a ‘buy-to-cover’ or ‘buy-to-close’ order
Margin
LOS f
- Levered Positions
- calculate
margin - borrowing funds from your broker - interpret
to buy securities
me margin loan
⇒ interest rate ⇒ ‘call money’ rate

Initial margin
- minimum margin requirements
Maintenance margin
- may be set by regulation,
the exchange, or the clearinghouse
𝐕𝐚𝐥𝐮𝐞 𝐨𝐟 𝐏𝐨𝐬𝐢𝐭𝐢𝐨𝐧
𝐋𝐞𝐯𝐞𝐫𝐚𝐠𝐞 𝐑𝐚𝐭𝐢𝐨: 𝐦𝐚𝐱 𝟏
𝐕𝐚𝐥𝐮𝐞 𝐨𝐟 𝐄𝐪𝐮𝐢𝐭𝐲 𝐥𝐞𝐯𝐞𝐫𝐚𝐠𝐞 =
𝐈𝐧𝐯𝐞𝐬𝐭𝐦𝐞𝐧𝐭 𝐦𝐢𝐧𝐢𝐦𝐮𝐦
𝐑𝐚𝐭𝐢𝐨
𝐦𝐚𝐫𝐠𝐢𝐧
𝐫𝐞𝐪𝐮𝐢𝐫𝐞𝐦𝐞𝐧𝐭
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LOS f
e.g./ 100 shares of ABC @ $30/sh. on - calculate
Sell for $24 @ t1 margin - interpret
-20%
Div. received = 30¢/sh.
-40%
Commission Paid = 10¢/sh.
Leverage Ratio = 2
Call money rate = 6% Sale (100 × 24) 2400
- Comm. (10)
Total ROI?
- Loan (1500)
Purchase (100 × 30) 3000
- Interest (90)
+ Comm. 10 + Dividends 30
3010 830
- Margin Loan 1500
Orig. Inv. 1510 𝟖𝟑𝟎 − 𝟏𝟓𝟏𝟎
𝐑𝐎𝐈 = = −𝟒𝟓%
𝟏𝟓𝟏𝟎
LOS f
Initial Margin - calculate
- interpret
Maintenance Margin ⇒ triggers margin call back up to Initial
margin
- else ‘forced liquidation’
(𝟏 − 𝐈𝐧𝐢𝐭𝐢𝐚𝐥 𝐌𝐚𝐫𝐠𝐢𝐧)
𝐌𝐚𝐫𝐠𝐢𝐧 𝐂𝐚𝐥𝐥 = 𝐏𝟎 ×
(𝟏 − 𝐌𝐚𝐢𝐧𝐭𝐞𝐧𝐚𝐧𝐜𝐞 𝐌𝐚𝐫𝐠𝐢𝐧)
e.g./ P0 = $60, margin = 50%, maintenance margin = 25%

Loan
(𝟏 − . 𝟓) 30
𝟔𝟎 × = 𝟒𝟎
(𝟏 − . 𝟐𝟓) 50%
𝟑𝟎 𝐈𝐧𝐢𝐭. 𝐌𝐚𝐫𝐠𝐢𝐧
Max. 75% = 𝟒𝟎 𝐋𝐨𝐚𝐧
. 𝟕𝟓
(𝟏 − 𝐌𝐚𝐢𝐧. 𝐌𝐚𝐫𝐠𝐢𝐧)
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Order Types
LOS g, h
prices at - compare
prices at which
which dealers Bid Ask they are willing to sell
and traders
are willing to buy spread
400 10.55 2000 × 2000
i.e. 10.55 - 10.62 100 × 600
100 10.53 20 × 20
200 10.51 best best 100
bid ask
1000 10.49 bid ask size size
Execution Instructions: how an order should be filled

1) Market orders - fill immediately at best price
- guaranteed execution, no guaranteed price
2) Limit orders - fill at a specified price or better
- guaranteed price, no guaranteed execution
LOS g, h
To buy - compare
10.70 · limit $ > ask
10.62 Ask
- at least partially
- marketable limit order
filled
58 · bid < limit $ < ask - new price prints

- creates a new market in the market
10.55 Bid · limit $ = bid · all buy orders at

1000 1000
- make the market this price placed
earlier must execute
10.25 · limit $ < bid first
- behind the market - executes only if
(AON - all-or-none) - standing limit orders
price drops
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LOS g, h
Exposure Instructions - display or hide
- compare
- hidden ⇒ only brokers & exchanges see them
- display size ⇒ lower than order
i.e. Buy 10,000, Limit $10.55 , Display size = 500

- also called ‘Iceberg’ order
Validity Instructions - when an order may be filled

Day - expire at end of business (default)
GTC - good-til-cancelled (max typically 6 mos.)
FOK - fill-or-kill
good-on-close (market on close) execute at the
close of trading
LOS g, h
Validity Instructions - compare
stop-loss (long pos.) Buy @ $10, stop @
Stop orders
$9.50
buy-stop (short pos.)
- Sell @ $10, buy-stop @ $10.50
Clearing Instructions - how final settlement should be

arranged
- usually the broker

- applies when using more than 1 broker
- indication of whether a sale is a
long or short sale
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Primary vs. Secondary

LOS i
Primary Issuer Investor - define
first time ⇒ IPO - explain
follow up ⇒ secondary offering
Secondary Investor Investor

- provide liquidity, ensures an efficient
primary market
- sets price for secondary offerings
LOS i
Primary Public Offering - define
Company Investment Investors - explain
Bank
· lines up subscribers (book building)
- may be done as
① Underwriting offer ② Best-efforts offer

- buys the entire issue at - acts as broker only
a negotiated offering price - works on commission
- sell on the IPO ‘bought deal’
- makes the spread
Private Placements - securities not offered to the public

- placed with qualified investors
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Trading
LOS j
Buyers must be able to find Sellers
- describe
- at low cost
Q: when can they trade?

who arranges the trade?
how do they execute the trade?
how do they learn about price?
When?
Call Market: trades occur only at particular times and
VS. Treasury - all bids and asks are balanced to places
determine one price (i.e. quantity bid for = quantity
offered)
- all trades occur at this price
- many continuous trading markets find their opening

price by this method
LOS j
Call Market: - very liquid in session - describe
- illiquid otherwise
Continuous Markets: trades can be arranged and executed

anytime the market is open
Who:
Call - auction process
Continuous - auction process or dealer bid-ask quotes
(e.g. stock exchanges)
Execution: ① Quote-driven markets (price-driven or dealer
market)
- individual dealers ‘make a market’
in specific securities means they are willing
to buy and sell
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LOS j
Execution: ① Quote-driven markets - describe
- customers trade with dealers (dealers trade with
(bonds, spot commodities) dealers)
- referred to as OTC (over-the-counter)
② Order-driven markets (pure auction market)

- exchanges ⇒ buyers/sellers submit bids/offers
Order-matching rules ⇒ rank buy & sell orders based on:

Price precedence - best bid & best ask
Display precedence - display over hidden at same
price
Time precedence - first over others with same
price and display properties
LOS j
Execution: ② Order-driven markets - describe
Trade pricing rules ⇒ 1) Uniform pricing rule - same
price is used for all trades (used by
Call Markets)
2) Discriminatory pricing rule
- the limit price of the order/quote that
arrived first determines the trade price
e.g./
Bid Ask Size New Market
Order to sell arrives:
Size 10.36 300 10.36 300
1400 @ Limit of $10.28
10.34 1200 10.34 1200
300 filled at $10.30
10.32 600 10.32 600
900 filled at $10.28
300 10.30 10.28 200
new standing order of
900 10.28 400 10.26
200 @ 10.28
400 10.26
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LOS j
Execution: ② Order-driven markets
- describe
3) Derivative Pricing Rule - use the
mid-point of the bid-ask from another
market
e.g. POSIT
10.55 - 10.63 ⇒ trades cleared at
$10.59
③ Brokered Markets - brokers arrange trades
among their clients
- usually for very thin markets (unique items)
LOS j
Information: - describe
Pre-trade transparency
- publish real-time data about quotes
and orders
- all exchanges
Post-trade transparency
- publish data about trade prices
after trade occurs (most dealer markets)
- wider spreads, higher transaction costs
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Well-Functioning System
LOS k
⇒ helps - savers
- describe
- borrowers
complete markets
- hedgers
- all the assets/contracts
- asset exchange
exist to satisfy all 4
(spot)
⇒ Features · timely & accurate disclosures (supports
information efficiency)
· liquidity ⇒ minimizes transaction costs

(operationally efficient)
· complete markets
· External/Informational efficiency (prices

respond to changes in fundamental values)
⇒ prices reflect all available information
LOS k
⇒ needs intermediaries who:
- describe
· match buyers & sellers by organizing exchanges,
brokerages, and ATS,
· provide liquidity on demand (make markets)
· create products to match buyers & sellers
(i.e. ABS)
· accept deposits and make loans
· provide insurance
· provide advisory services
· organize clearinghouses (settlement, counterparty)
· safeguard assets (custodial or depository services)
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LOS k
A financial system that is - describe
Operationally efficient
is characterized by securities/assets that

have
Informationally efficient prices
which leads to an economy that is
Allocationally efficient
Regulation
LOS l
· Control fraud by, or deception of, market
- describe
participants Confidence
· Set minimum standards of competence for agents, define

and enforce minimum standards of practice
· promote fairness
· set standards for financial reporting (fair to both user

& provider)
· set minimum capital requirements for financial firms
(reduce costs/disruptions of failure)
· insurance/pension funds have sufficient capital

to honour their long-term commitments
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Security Market Indexes
a. describe a security market index;
b. calculate and interpret the value, price return, and total return of an index;
c. describe the choices and issues in index construction and management;
d. compare the different weighting methods used in index construction;
e. calculate and analyze the value and return of an index given its weighting
method;
f. describe rebalancing and reconstitution of an index;
g. describe uses of security market indexes;
h. describe types of equity indexes;
i. describe types of fixed-income indexes;
j. describe indexes representing alternative investments;
k. compare types of security market indexes.
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Market Index
LOS a
- consists of individual securities that
- describe
represent a given security market,
market segment or asset class a.k.a.
constituent
(most constructed as a portfolio securities
of marketable securities)
- each may have 2 versions depending on how

returns are calculated
① Price Return Index ② Total Return Index

- reflects only prices - assumes reinvestment of
all income received since
inception
LOS a
Uses: - describe
- simple measure to capture performance and
direction of a particular market
- evaluate performance of investment managers

(active)
- construct investment portfolios (passive)
- estimate market/segment risk
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Index Return
LOS b
∑𝐍𝐢'𝟏 𝐧𝐢 𝐏𝐢 VPRI - value of the - calculate
𝐕𝐏𝐑𝐈 = - interpret
𝐃 ‘price return’ index
ni - # of units of security 𝒊
Pi - Price of security 𝒊
depends on
N - # of individual securities in the
the type of
D - value of the divisor index
weighting used
- price a number initially chosen at
- equal inception so that the index has a
- market-cap convenient initial value
- floating-adjusted - divisor changes over time
market-cap so that changes in the index
- fundamental weighting reflect price changes only
LOS b
Single Period Returns - calculate
⇒ Price Return - the %’age change in VPRI 𝟏𝟐. 𝟓𝟎 − 𝟏𝟏 𝟏. 𝟓𝟎 - interpret
= (𝟏𝟏
𝟏𝟏
words
𝑽𝑷𝑹𝑰𝟏 − 𝑽𝑷𝑹𝑰𝟎 𝐩𝐫𝐢𝐜𝐞 𝐕𝐚𝐥𝐮𝐞 𝐚𝐭 𝐭 𝟏 − 𝐕𝐚𝐥𝐮𝐞 𝐚𝐭 𝐭 𝟎
𝐏𝐑 𝐈 = =
𝑽𝑷𝑹𝑰𝟎 𝐫𝐞𝐭𝐮𝐫𝐧 𝐕𝐚𝐥𝐮𝐞 𝐚𝐭 𝐭 𝟎
or/ weighted average of each of the constituent components

𝐍 𝑵
𝑷𝒊 − 𝑷𝒊 𝟎
-
-
𝑷𝒊 − 𝑷𝒊𝟎
𝐏𝐑 𝐢 = 𝟏 - 𝐏𝐑 𝐈 = S 𝐖𝐢 𝐏𝐑 𝐢 = S 𝒘𝒊 V 𝟏 W
𝑷𝒊 𝟎 - 𝑷𝒊 𝟎
- 𝐢'𝟏 𝒊'𝟏
each component = 𝑾𝟏 𝑷𝑹𝟏 + 𝑾𝟐 𝑷𝑹𝟐 + 𝑾𝟑 𝑷𝑹𝟑 + ⋯ + 𝑾𝑵 𝑷𝑹𝑵
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LOS b
Single Period Returns - calculate
⇒ Total Return - price change + all income - interpret
words 𝐕𝐚𝐥𝐮𝐞 𝐚𝐭 𝐭 𝟏 − 𝐕𝐚𝐥𝐮𝐞 𝐚𝐭 𝐭 𝟎

𝑽𝑷𝑹𝑰𝟏 − 𝑽𝑷𝑹𝑰𝟎 + 𝑰𝟏
𝐓𝐑 𝐈 = 𝐭𝐨𝐭𝐚𝐥 + 𝐈𝐧𝐜𝐨𝐦𝐞
𝑽𝑷𝑹𝑰𝟎 =
𝐫𝐞𝐭𝐮𝐫𝐧 𝐕𝐚𝐥𝐮𝐞 𝐚𝐭 𝐭 𝟎
or/ weighted average of each of the constituent components

- 𝐍 𝑵
𝑷𝒊 − 𝑷𝒊𝟎 + 𝑰𝒊 - 𝑷𝒊 − 𝑷𝒊𝟎 +𝑰𝒊
𝐓𝐑 𝐢 = 𝟏 - 𝐓𝐑 𝐈 = S 𝐖𝐢 𝐓𝐑 𝐢 = S 𝒘𝒊 V 𝟏 W
𝑷𝒊 𝟎 - 𝑷𝒊𝟎
- 𝐢'𝟏 𝒊'𝟏
each component = 𝑾𝟏 𝑻𝑹𝟏 + 𝑾𝟐 𝑻𝑹𝟐 + 𝑾𝟑 𝑻𝑹𝟑 + ⋯ + 𝑾𝑵 𝑻𝑹𝑵
LOS b
Multiple Period Return - calculate
- interpret
𝑽𝑷𝑹𝑰𝑻 = 𝑽𝑷𝑹𝑰𝟎 _𝟏 + 𝑷𝑹𝑰𝟏 `_𝟏 + 𝑷𝑹𝑰𝟐 ` … _𝟏 + 𝑷𝑹𝑰𝑻 `
e.g./ Period Return (%) Calculation Ending Value

0 1000(1.0) 1,000
1 5.00 1000(1.05) 1,050
2 3.00 1000(1.05)(1.03) 1,081.50
𝑽𝑻𝑹𝑰𝑻 = 𝑽𝑻𝑹𝑰𝟎 _𝟏 + 𝑻𝑹𝑰𝟏 `_𝟏 + 𝑻𝑹𝑰𝟐 ` … _𝟏 + 𝑻𝑹𝑰𝑻 `

+15
e.g./
36.75
0 1000(0) 1,000
1 5.00 + 1.5% 1000(1.065) 1,065.00
2 3.00 + 2.0% 1065(1.05) 1,118.25
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LOS b
e.g./ 2008 2009 - calculate
PRI 7.5% 8.3% - interpret
TRI 12.6% 13.4%
⇒ equity index created at beg. of 2008, VPRI = VTRI = 1000
VPRI (2008) = 1000 × (1.075) = 1075
VPRI (2009) = 1000 × 1.075 × 1.083 = 1164.225 1075(1.083)
VTRI (2008) = 1000 × (1.126) = 1126
VTRI (2009) = 1126 × (1.134) = 1276.884
Index Construction
LOS c
- similar to constructing and managing
- describe
a portfolio of securities
① target market selection

⇒ asset class (equities, fixed-income, real-estate)
⇒ geographic region (Japan, Mexico, Canada)
⇒ exchange (NY, Toronto, London)
⇒ other characteristics (sector, industry, size)
② security selection
- all or just a sample
- fixed number (S&P500) or variable (TOPIX)
③ Weighting ④ Rebalancing ⑤ Reconstitution
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Index Weighting
LOS d, e
⇒ weighting determines how much of
- compare
each security to include in the index - calculate
① Price Weighting (simplest) - analyze
- called an Average (i.e. DJIA)

.9 𝐏𝐢
𝑾𝑷𝒊 =
𝟗𝟎 ∑𝐍𝐢'𝟏 𝐏𝐢
∑𝐍𝐢'𝟏 𝐏𝐢 𝐈𝐧𝐝𝐞𝐱 𝐕𝐚𝐥𝐮𝐞 =
.1 𝟗𝟎 + 𝟏𝟎 𝐃
typically set
∴ stocks with the highest at inception = N
price will have the
greatest impact on the
return of the index
LOS d, e
- any stock split changes all the - compare
weightings - calculate
- analyze
∴ divisor needs to be adjusted to prevent the split
from changing the value of the index
e.g./ % 2-for-1 on A %
A $55 52.38 27.50 35.48
B 22 20.95 22 28.39
C 8 7.62 8 10.32
D 14 13.33 14 18.07
E 6 5.72 6 7.74
Σ = 105 100% 77.50 100%
D = 5
𝟕𝟕. 𝟓𝟎 𝟕𝟕. 𝟓𝟎
VI = 21 𝟐𝟏 = ⇒ 𝐃= = 𝟑. 𝟔𝟗
𝐃 𝟐𝟏
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LOS d, e
② Equal Weighting ($) - compare
- calculate
𝟏 i.e. $10k - analyze
𝑾𝑬𝒊 =
𝐍 5 components
= $2,000 of each component
𝟐𝟎𝟎𝟎 𝟐𝟎𝟎𝟎
= shares of A , = shares of B, etc…
𝐏𝐀 𝐏𝐁
- select a divisor (D) to give the index a convenient

starting value
i.e. $𝟏𝟎, 𝟎𝟎𝟎

= 𝟏𝟎𝟎𝟎 ⇒ initial value of the
𝟏𝟎
index
LOS d, e
② Equal Weighting - compare
- calculate
+/ - simple - analyze
-/ - securities that represent the largest fraction of
the target market value are underrepresented
- those that constitute a small fraction - overrepresented
- after construction, any price change means weightings

are no longer equal
∴ frequent rebalancing required
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LOS d, e
③ Market-Capitalization Weighting - compare
- calculate
𝑸 𝒊 𝑷𝒊 - divide market-cap
𝑾𝑴 - analyze
𝒊 = of the component by sum of all
∑𝑵
𝒋'𝟏 𝑸𝒋 𝑷𝒋
market caps
- float-adjusted Market-Cap weighting
# of shares available
to the investing public Note: most market-cap
weighted indicies are
float adjusted
LOS d, e
③ Market-Capitalization Weighting - compare
- calculate
+/ - components are held in proportion to
- analyze
their value in the target market Q x P
-/ - components whose price have risen the most (or fallen)
have a greater (lower) weight in the index
- leads to overweighting stocks that may

be overvalued and underweighting stocks
that may be undervalued
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LOS d, e
④ Fundamental Weighting
- compare
- attempts to overcome market-cap - calculate
disadvantages - analyze
- uses a fundamental value as a proxy for size rather
than market cap
𝑭𝒊 i.e. book value
𝑾𝑭𝒊 = Revenues
∑𝑵
𝒋'𝟏 𝑭𝒋
CFO
Earnings, etc…
Market
- results in indicies with ratios of 𝑭𝒊
Value
higher than its market-cap counterpart
- weights favour securities that have decreased in
relative value
LOS d, e
④ Fundamental Weighting - compare
- calculate
e.g./ Stock Market-Cap Earnings Earnings Yield - analyze
A $200M 20M 𝟐𝟎i
𝟐𝟎𝟎 = 𝟏𝟎%
B 800M 20M 𝟐𝟎i
𝟖𝟎𝟎 = 𝟐. 𝟓%
$ 1B 40M
𝑭𝒊 Market
Value
A 20% < 50% - higher yield

B 80% > 50% - lower yield
‘Momentum’ ‘Contrarian’
effect effect
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Rebalancing/Reconstitution
LOS f
① Rebalancing - describe
- weights assigned to constituents at inception
drift from their target weights as prices change
· equal-weighted ⇒ reduce weights of securities

𝟏 that have outperformed, increase weights
𝑾𝑬𝒊 =
𝑵
of securities that have underperformed
𝑷𝒊 · price-weighted ⇒ no need to rebalance since

𝑾𝑷𝒊 =
∑𝑵
𝒋&𝟏 𝑷𝒋
the weight of each constituent is
determined by price (i.e. target weights drift
as prices change)
𝑸𝒊 𝑷𝒊 · market-cap weighted ⇒ only need to be
𝑾𝑴
𝒊 = 𝑵
∑𝒋&𝟏 𝑸𝒋 𝑷𝒋 rebalanced to reflect M&A and liquidations
LOS f
② Reconstitution - the process of changing - describe
the securities in the index ⇒ keeps the index
representative
· reflect changes in the target market as a

result of bankruptcy, liquidation, M&A, delistings
· reflect judgement of the selection committee
𝑷𝒊
𝑾𝑷𝒊 = 𝑵 Reconstitution results in a change in all the
∑𝒋'𝟏 𝑷𝒋
weightings (price & market-cap)
𝑸 𝒊 𝑷𝒊
𝑾𝑴
𝒊 = 𝑵
⇒ usually announced prior to the reconstitution
∑𝒋'𝟏 𝑸𝒋 𝑷𝒋
date
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Uses
LOS g
· to gauge market sentiment - good
- describe
indicators of the collective option of market
participants
· used as proxies for measuring/modeling returns, systematic
⇒
risk and risk-adjusted performance (𝛃 in CAPM)
· as proxies for asset classes in asset allocation models
- provide the historical data used to model
risk/return of different asset classes
· as a benchmark for actively managed portfolios
· serve as the basis for the creation of investment

products (typically passive)
Index Types
LOS h
1) Broad market indicies
- describe
- represents more than 90% of the selected
market i.e. Russell 3000 ∼ 99% of the market
cap of the US equity
market
2) Multi-market indicies
- consist of security market indicies from
different countries
- different countries/national markets/economic
development groups weighted differently
(e.g. by GDP)
⇒ a fundamental weighting of the
market-cap weighted indicies
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LOS h
3) Sector Indicies
- describe
- represent a particular sector (Consumer Staples,
Utilities, etc.)
- helps assess manager performance (10 broad sectors)
- are returns due to stock
picking or sector allocation
4) Style Indicies
- growth vs. value
- will require more frequent rebalancing
& reconstitution
Fixed-Income Indicies
LOS i
⇒ broader universe of bonds than stocks
- describe
⇒ universe constantly changing (new issues, calls, maturities)
⇒ Duration (price volatility) is constantly changing
Types/ · Issuer (gov’t., gov’t. agency, corporates)

· Type of financing (general obligation, collateralized)
· Currency of payment
· Maturity
· Credit quality (investment grade, high yield, ratings)
· Inflation protection?
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LOS i
⇒ can be categorized as - describe
· Aggregate or broad market indicies
· Market sector indicies
· Style indicies
· Economic sector indicies
· Specialized indicies (e.g. high-yield, inflation-linked,
emerging market)
e.g./
Investment Grade ➞ maturity ➞ credit rating
𝐀𝐀𝐀i 10-yr. gov’t.
𝐀𝐀
Alternative Investments
LOS j
1) Commodity indicies
- describe
- consist of futures contracts on one or
more commodities
⇒ equal, fixed or price weighted (determined by a
committee)
- different weightings ⇒ different exposures

⇒ different risk/return profiles
- index performance may differ from that of the

underlying commodity due to the use of derivatives
rather than the physical commodity
⇒ introduces exposure to rf, 𝚫Fp, roll yield
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LOS j
2) Real Estate/REIT indicies - describe
consist of shares of publicly traded
REITs
appraisal indicies
typically commercial
repeat sales indicies
property
3) Hedge Fund Indicies
⇒ broad global level
⇒ strategy level
⇒ rely on voluntary disclosure
⇒ hedge funds can choose which index to report
performance to (constituents determine the
index)
⇒ poorly performing funds don’t often report
(survivorship bias)
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Market Efficiency
a. describe market efficiency and related concepts, including their importance

to investment practitioners;
b. contrast market value and intrinsic value;
c. explain factors that affect a market’s efficiency;
d. contrast weak-form, semi-strong-form, and strong-form market efficiency;
e. explain the implications of each form of market efficiency for fundamental

analysis, technical analysis, and the choice between active and passive
portfolio management;
f. describe market anomalies;
g. describe behavioral finance and its potential relevance to understanding

market anomalies.
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Market Efficiency
LOS a
- the extent to which market prices
- describe
incorporate available info.
⇒ inefficiency is what justifies active mgmt.
- price efficiency (informative prices)

⇒ ‘price signal’ determine where capital should
be allocated to earn the highest risk-adjusted
return (avoids malinvestment)
- promotes health & sound economic growth
⇒ information efficiency
- assumes information is (timely, complete, correct, and
understandable)
Jobs Jobs
info. ➞ price
_
-
-
-
LOS a
- describe
- asset prices reflect new information
quickly and rationally the unanticipated element
⇒
1 min.-1 hr. consensus FRI

-
-
-
-
-
⇒ prices incorporate all past & present info.
∴ consistent, superior, risk-adjusted returns are not

achievable in an efficient market
passive R > active R

(lower costs)
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Efficient Markets
LOS a
Suppose that a speculative-grade bond issuer announces, just before bond markets - describe
open, that it will default on an upcoming interest payment. In the announcement, the
issuer confirms various reports made in the financial media in the period leading up
to the announcement. Prior to the issuer’s announcement, the financial news media
reported the following:
1) suppliers of the company were making deliveries only for cash payment, reducing
the company’s liquidity
2) the issuer’s financial condition had probably deteriorated to the point that it lacked
the cash to meet an upcoming interest payment
3) although public capital markets were closed to the company, it was negotiating
with a bank for a private loan that would permit it to meet its interest obligations and
continue operations for a least nine months. hope (hope dies last)
If the issuer defaults on the bond, the consensus opinion of analysts is that bondholders
will recover $0.36 to $0.38 per dollar value.
LOS a
1. If the market for the bond is highly efficient, the bond’s market price is most - describe
likely to fully reflect the bond’s value after default:
A. in the period leading up to the announcement

B. in the first trade prices after the market opens on the announcement day
C. when the issuer actually misses the payment on the interest payment day
2. If the market for the bond is highly efficient, the piece of information that bond
investors most likely focused on in the issuer’s announcement was that the issuer:
A. had failed in its negotiations for a bank loan new

B. lacked the cash to meet the upcoming interest payment
C. had been required to make cash payments for supplier deliveries
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Market vs. Intrinsic

LOS b
⇒ Market Value (MV) · price at which an
- distinguish
asset can be bought or sold (i.e. bid-ask)
⇒ Intrinsic Value (IV - fundamental value) - price of an

asset if complete information & understanding
were used (typically PV - future cashflows)
- requires judgment, IV just an estimate
IV < MV - overvalued (Sell, underweight)

20% 10%
IV ≃ MV - fairly valued (Hold, equal weight)
20% 10%
IV > MV - undervalued (Buy, overweight)
LOS b
- describe
1. An analyst estimates that a security’s intrinsic value is lower than its market value.
The security appears to be:
IV < MV
A. undervalued
B. fairly valued
C. overvalued
2. A market in which an asset’s market values are, on average, equal to or nearly equal to
intrinsic value is best described as a market that is attractive for:
A. active investment
B. passive investment
C. both active and passive investment
3. Suppose that the future cash flows of an asset are accurately estimated. The asset
trades in a market that you believe is highly efficient based on most evidence. But
your intrinsic value estimate exceeds market value by a moderate amount. The most
likely conclusion is that you have:
𝐜𝐚𝐬𝐡 𝐟𝐥𝐨𝐰𝐬
A. overestimated the asset’s risk 𝐏𝐕 =
(𝟏 + 𝐫)
B. underestimated the asset’s risk
risk
C. identified a market inefficiency X
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Impediments
te LOS c
Inefficient priva factors Efficient - explain
fewer, few Market Participants more, numerous
narrower Information Availability wider
less, variable Financial Disclosure more, standardized
slow/lagged trans. Limits to Trading speedy transactions
lack of transparency transparency
restrictions no restrictions
Transactions Costs Information - Acquisition Costs

- mispricing would still be classic view return = risk assumed
efficient if within the ∴ info. costs = waste of time
‘bounds of arbitrage’ modern view
(return-info. costs) = risk assumed
Efficiency Taxonomy
LOS d
- contrast
Market Prices Reflect
Forms of Market Past Market Public Private
Efficiency Data Information Information
Weak-form √
Semi-strong form √ √
Strong-form √ √ √
(Eugene Fama, 1970)
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LOS d
Weak-form/ future returns should be independent of - contrast
past returns or patterns
- no serial correlations
- no trading ‘rules’
Proponents of weak-form EMH assert that abnormal

risk-adjusted returns cannot be earned by using
trading rules and technical analysis, which make
investing decisions based on historical security
market data.
LOS d
Semi-strong form/ - encompasses weak-form - contrast
- considerable research support in developed
markets
Proponents of the hypothesis assert that investors

cannot earn abnormal risk-adjusted returns if their
investment decisions are based on important material
information (after it has been made public). They
stress that security prices rapidly adjust to reflect
all public information.
LOS d
Strong form/ · encompasses both weak and semi-strong - contrast
forms
· research rejects the strong-form hypothesis
(i.e. fails to accept) H0
Ha - interesting
Strong-form EMH assumes perfect markets where information

is cost free and available to all. Under strong-form EMH, no one
can consistently achieve abnormal risk-adjusted returns, not
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40
Implications
LOS e
1) Security markets are weak-form eff. - explain
∴ technical analysis will not produce
consistent abnormal risk-adjusted returns
2) Security markets are semi-strong eff.

∴ analysts must consider what is priced in
and how new info. will affect prices
- fundamental analysis facilitates semi-strong EMH
1 + 2) Portfolio Management ⇒ active managers are actually

a waste of money for investors
(The Loser’s Game)
3) Security markets are not strong-form eff.
Market Anomalies
LOS f
① Time-Series Anomalies
- describe
Calendar anomalies
a) January effect - higher returns in equity
markets compared to other months
k b) Turn-of-the-month effect - higher returns on the
l l lac ce
a en
si s
t last trading day and first 3 of next month
per c) Day of week effect - avg. Mon. R < 0, and lower
than other 4
d) Holiday effect - day prior to holiday tends to
have higher returns
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LOS f
① Time-Series Anomalies - describe
Overreaction Anomalies
- investors overreact to the release of
unexpected new information
good news inflate bad news depresses

prices prices
use of a contrarian strategy
Momentum Anomalies
- securities that have outperformed in the
short-run continue to outperform (IBD) - 6pm.
Top 100
LOS f
② Cross-Sectional Anomalies - describe
1) Size effect
- small-cap equities tend to outperform
large-cap equities on a risk-adjusted basis
(not conformed over time)
2) Value effect
- value stocks outperform growth stocks
· market returns
over time (Fama/French)
· MV of equity
(use of 3-factor model for valuation vs.
· BV equity
MV CAPM (1-factor) eliminates this anomaly)
equity
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LOS f
3) Other Anomalies - describe
a) Close-end fund discounts
- to their NAVPS
not - typically not worth the transaction
orted
supp costs
by
stent
consi b) Earnings Surprises
& - prices may be slow to adjust
stent
persi
n ce c) IPOs - if you can get shares at the offer
evide
price
d) Predictability of Returns based on prior
information i.e. economic cycle related
Behavioral Finance
LOS g
- examines investor behavior (observed) - describe
rather than relying on normative assumptions (i.e. rationality)
⇒ investors do not always make efficient

(rational & optional) decisions
- due to cognitive/behavioral biases
① Loss Aversion - tendency to prefer avoiding losses to

acquiring gains
- losses are twice as powerful, psychologically
⇒ can actually lead to ‘loss persistence’

- the unwillingness to actually take a loss
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LOS g
② Herding - investors ignore their own - describe
analysis and make decisions in line with the
direction of the market (can often be rational
to follow)
- correlated strategies, clustered trading
③ Information Cascades - the transfer of information from

those who are the first to act upon it, and
whale
whose decisions influence others (results in
watching
serial correlations, perhaps overreactions to
information)
④ Overconfidence - investors have an inflated view of

their ability to process information
LOS g
- many more - describe
Implications ⇒ for the market - unclear
- even if some investors
exhibit bias, as long as enough do not,
markets will remain efficient
⇒ for the investor

- know thyself
- if you are subject to certain
biases, develop rules to avoid the trap
e.g. Position limits, loss limits, excessive gain/loss

timeouts.
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Overview of Equity Securities
a. describe characteristics of types of equity securities;
b. describe differences in voting rights and other ownership characteristics

among different equity classes;
c. compare and contrast public and private equity securities;
d. describe methods for investing in non-domestic equity securities;
e. compare the risk and return characteristics of different types of equity

securities;
f. explain the role of equity securities in the financing of a company’s assets;
g. contrast the market value and book value of equity securities;
h. compare a company’s cost of equity, its (accounting) return on equity, and

investors’ required rates of return.
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Equity Securities
LOS a, b
- a few global facts ① 𝐄𝐪𝐮𝐢𝐭𝐲 𝐌𝐚𝐫𝐤𝐞𝐭 𝐂𝐚𝐩
~ 50% - describe
𝐆𝐥𝐨𝐛𝐚𝐥 𝐆𝐃𝐏 - long-run
avg.
30% ∼70% ② gov’t. bonds/bills - rr ∼2%

from 1900 - 2011
equity markets - rr ∼4%
70%
∅ 30%
③ equity ownership ∼ 20% - 50% of population
(developed countries) CPP
Company
Debt Equity - residual claim on assets
- liability - cap. gains + div.
- interest
LOS a, b
Common Shares: - describe
- ownership interest in the company (residual claim)
- share in operating performance (cap. app., dividends)
- participate in governance proves (voting rights)
⇒ major corporate decisions (e.g. M&A)
⇒ election of BoD
Statutory voting Cumulative voting

· each share = 1 vote total votes = # of shares ×
# of directors
i.e. 4 directors up for re-election/election
100 for 1 100 shares × 4 directors = 400
total
or = 100 each
votes 400 for 1 votes
100 each total
or = 400
votes
100 each
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LOS a, b
Common Shares: - describe
- different classes each with different ownership
and voting rights, and even different claims on
net assets in liquidation event
i.e. Class A Class B

- held by investing - held by insiders
public (typically founding family)
0% 100%
60% voting rights 40% voting rights
⇒ Callable - issuer has the right to buy back shares at a

pre-determined call price
⇒ Putable - investor has the right to sell shares back to the

company at a pre-determined put-price
LOS a, b
Preference Shares: (preferreds)
- describe
- do not participate in operating performance
- no voting rights
- receive dividends before common stock
- dividend stated as a yield on par (can be fixed

typically > common yield or variable)
i.e. rate - reset
- dividend still discretionary
- higher priority claim on net assets than common
- can be perpetual, convertible, callable, putable
- prices like debt, pays like equity (i.e. div. vs. int.)
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LOS a, b
Preference Shares: (preferreds)
- describe
Cumulative: · unpaid dividends accrue over time
· must be paid in full before any
common dividends can be paid
Non-cumulative: do not accrue (forfeited permanently)
will have to offer a higher yield
Participating: ① in any increase in dividends if

company profits exceed some level OR/
$15M - $35M if company issues special dividends
30M ② in proceeds from a liquidity event
i.e. 2x partic. on $25 par value = $50 distribution
LOS a, b
Preference Shares: (preferreds) - describe
Non-Participating - stated preferred div. only + par
value
Convertible - to common
- participate in equity participation
usually has a
while getting a higher yield
‘forced conversion’
- common in private equity (i.e. VC)
clause
(typically done so as not to re-price
the common)
forced-conversion - if the common $ > conversion price,
company may force conversion by calling
at low price
⇒ avoids ‘overhanging convertibles’
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Public vs. Private
LOS c
Public ⇒ IPO - secondary markets
- distinguish
Private ⇒ Private Placement - no secondary market
institutional investors (PE/VC)

accredited investors
· not listed on public exchanges

· prices are not market-determined
· highly illiquid
· issuer not required (regulatory) to publish
financial statements
Note: if # of shareholders > 50, classified as a public company
LOS c
Types of Private Investments: - distinguish
1) Venture Capital - seed to growth financing
- VC firm set-up as a limited
partnership
- usually 10-year life
- 3 to 5 yr. investment phase
- YRS-10: Sell, IPO, liquidate
2) LBO/MBO - use of debt to purchase all

group of outstanding shares of a publicly
mgmt. traded company ➞ RJR Nab.
investors
- usually restructured and re-issued
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LOS c
Types of Private Investments: - distinguish
3) Private Investment in Public Equity (PIPE)
GM - $5B - 10%
- restricted stock usually at a
GS - $5B - 10%
- preferreds discount
Advantages of Private Equity:
- management focused more on long-term value
creation
- inefficient markets ⇒ higher risk-adjusted
returns
- lower company costs due to lack of - filing requirements
- listing fees
- regulatory costs
Non-Domestic Equity
LOS d
⇒ Companies are able to issue shares in
- describe
international markets
- wider shareholder base
- lower cost of capital
⇒ Investors gain access to foreign companies

- diversify risk away from ‘domestic only’ exposure
Restrictions still exist

- limit amount of control foreign investors have
over domestic companies
- give domestic investors the opportunity to own
the shares of foreign companies conducting business
in the domestic market
- reduce volatility of capital in/out-flows
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LOS d
- reducing these restrictions tend to lead - describe
to improved equity market performance
⇒ Increased number of companies have issued shares in

markets outside their home country
- dual-listing
Benefits/ · improves awareness about the company’s

products/services
· enhances liquidity (of the shares)
· increases corporate transparency
(need to meet a greater number
of filing requirements)
LOS d
Methods/ - describe
① Direct Investing
- buy/sell directly in foreign market
· purchase price, sale price, gains/losses
& dividends in foreign currency
(exchange rate risk)
· must be familiar with trading,
clearing & settlement regulations of
the foreign market
· may lead to less transparency & more
volatility (or vice versa)
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LOS d
Methods/ - describe
② Depository Receipts
- trades like an ordinary share on a local
exchange
- represents an economic interest in a
foreign company
Domestic Market
Buyer
deposits may not be
dom. $
1-for-1
shares
Foreign Domestic Domestic
Bank issues Exchange
Co.
receipts
Seller
· transfer agent · all divs. in dom. $
· custodian dom. $
LOS d
Methods/ - describe
sponsored ⇒ foreign company has a direct involvement

in the issuance of receipts
- investors in DRs have the same rights as
direct owners
Level 1 1 ADR - trade OTC
Level 2 & 3 - must register with SEC
- follow regulatory guidelines
Rule 144A - QIBs (private placements)
unsponsored ⇒ foreign company has no direct involvement in

the issuance of receipts
MM108293137.
- the depository has the rights of ownership,

not the investor
52
LOS d
Methods/ - describe
in
GDR - global depository receipt - issued by depository US D
bank outside both issuer’s home country and the U.S.
- except for
ADR - American depository receipt P.P.
- denominated in USD and trade like common shares
in the U.S.
③ Global Registered Shares - ordinary shares that are

quoted and traded in different currencies on
different stock markets
high withholding T4
i.e. BOM
on TSX in CAD + on NYSE in USD
TD
④ Basket of Listed Depository Receipts (BLDR)

(i.e. ETF)
Risk and Return

LOS e
- 2 main sources of return in any one period
- compare
1) capital gains (𝑷𝒕 − 𝑷𝒕8𝟏 ) + 𝑫𝒕
2) dividends 𝑹𝒕 =
𝑷𝒕8𝟏
- for DRs and direct foreign investments s
ns. fee
3) currency gains/losses no tra v.
. re-in
immed isc.
RIP) 5% mkt. d
- over multiple periods (D 3 -
4) dividend (reinvestment) (compounding effect)
(does not have to be same co.)
Risk ⇒ therefore refers to the uncertainty of the

above future returns and cash flows
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53
LOS e
⇒ Preferreds are less risky than common - compare
- Pref. Div. known and fixed (generally) (Dt)
- dividend accounts for a large portion of the
(less uncertainty about future CFs) Pref. sh. Rt
- Pref. receive div. & distributions before common

- rank behind all debt. (up to par)
- Cumulative less risky than Non-Cumulative
⇒ Common shares - large part of Rt made up to (Pt - Pt-1)

- Putable less risky than Callable/Non-Callable
- Callable more risky than Non-Callable
⇒ Public Less risky than Private
Financing a Company
LOS f, g
- companies issue equity to raise - explain
(A = L + E)
capital (for many reasons/uses) - distinguish
- ultimate goal of mgmt. is to increase the

BV of the company and maximize the MV of its
equity
direct
control BV = A - L ∴ increase Ret. Earn.
indirect
MV = # of shares × P0
control
primarily determined by investor’s
expectations about the amount,
timing and uncertainty of future
cash flows
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54
LOS f, g
⇒ Accounting Return on Equity - explain
𝐍𝐈𝐭 𝐍𝐈𝐭 - Pref. Div. - distinguish
𝐑𝐎𝐄𝐭 = =
𝐀𝐯𝐠. 𝐁𝐕𝐄𝐭 (𝐁𝐕𝐄𝐭 + 𝐁𝐕𝐄𝐭8𝟏 )i
𝟐
Note: NI ⇒ total net income available to common shareholders
(i.e. Net Income - Preferred Dividends)
NI rises faster than BVE
ROEt can increase if
NI falls slower than BVE
- Price-to-Book Ratio P0 - higher ratio indicates that the

𝐌𝐕𝐄𝐭 ⁄𝐬𝐡. 𝐌𝐕𝐄𝐭 market is pricing in higher
=
𝐁𝐕𝐄𝐭 ⁄𝐬𝐡. 𝐁𝐕𝐄𝐭 future growth opportunities
LOS h
ROE - the rate of return earned by a - compare
company on its equity capital
- uses accounting net income (s.t. estimates, methods)
- can be managed ➞ issue debt to buy back shares
decreases equity ⇒ BVE ↓
Intrinsic Value ⇒ PV (expected future cash flows)
discounted at the ‘required rate of

return’
Cost of Equity ⇒ the discount rate needed to equate

the expected future cash flows with the
offering price
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55
Introduction to Industry and Company Analysis
a. explain uses of industry analysis and the relation of industry analysis to

company analysis;
b. compare methods by which companies can be grouped;
c. explain the factors that affect the sensitivity of a company to the business
cycle and the uses and limitations of industry and company descriptors such
as “growth”, “defensive”, and “cyclical”;
d. describe current industry classification systems, and identify how a company

should be classified, given a description of its activities and the classification
system;
e. explain how a company’s industry classification can be used to identify a

potential “peer group” for equality valiation;
f. describe the elements that need to be covered in a thorough industry

analysis;
g. describe the principles of strategic analysis of an industry;
h. explain the effects of barriers to entry, industry concentration, industry

capacity, and market share stability on pricing power and price competition;
i. describe industry life cycle models, classify an industry as to life cycle stage,
and describe limitations of the life-cycle concept in forecasting industry
performance;
j. describe macroeconomic, technological, demographic, governmental, and

social influences on industry growth, profitability, and risk;
k. compare characteristics of representative industries from the various

economic sectors; MM108293137.
l. describe the elements that should be covered in a thorough company

analysis.
56
LOS a (1p) Uses of Industry Analysis - explain
LOS b, c (3.5p) Approaches to Identifying Similar Companies - compare

- explain
LOS d (5p) Industry Classification Systems - describe
- identify
LOS e (4p) Constructing a Peer Group - explain
LOS f, g (3p) Describing/Analyzing an Industry and - describe

Principles of Strategic Analysis
LOS h (7.5) Barriers to Entry - explain
LOS i (4.5p) Industry Life Cycle - describe, classify
LOS j (6.5p) External Influences on Industry - describe
LOS k (3p) Industry Comparison - compare
LOS L (4p) Company Analysis - describe
Page 1
LOS a
1/ Understand a company’s business environment - explain
- provides context for a company analysis ➞ growth opportunities
and threats, competitive dynamics, business risks
2/ Identify active equity investment opportunities (over) (under)

- top-down approach identifies industries with positive, negative or
neutral outlooks for growth and profitability
(equal)
- investors can attempt to outperform (absolute basis or relative
to a benchmark) by correctly timing sector/industry rotation
3/ portfolio performance attribution

- addresses the source of portfolio returns
- the contribution to returns from the choice of
MM108293137.
industries/sectors in the portfolio

identified by industry classification systems
57
Page 2
1) By product/service supplied/ (GICS, ICB) LOS b, c
- compare
- companies placed in industries based on their
- explain
principal business activity (source of the majority of
its revenues/earnings)
- sector - a group of related industries
2) By business cycle sensitivity
cyclical non-cyclical
correlated with overall economy relatively independent of the
high demand in expansions business cycle
low demand in contractions relatively stable demand over the
typically have high operating business cycle
leverage (high FC, low VC) non-discretionary goods/services
durable/discretionary goods (Utilities, food/beverage, Health Care)
(auto, industrials, housing)
Page 3
2) By business cycle sensitivity LOS b, c
- compare
growth cyclical ➞ companies growing rapidly but still very
- explain
business cycle sensitive
non-cyclical
defensive growth
- revenues/profits least affected - specific demand drivers that
by fluctuations in economic override broad economic factors
activity - generate growth regardless of phase
(staple consumer goods, basic of the business cycle
services, rates of return determined (e.g. Netflix)
by regulation)
terms cyclical/non-cyclical is not binary, but continuous

- all companies are cyclical relative to the economy to
some degree
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58
Page 4
2) By business cycle sensitivity LOS b, c
cyclical - compare
non-cyclical - explain
economic downturns affect all companies
- also, different countries and regions progress through the various stages
of the business cycle at different times
international companies with weak domestic economies may

have strong foreign market economies
- complicates establishing industry benchmark values (growth rates,
ratios)
3) By statistical similarities low 𝒓𝟐
- based on correlations of past returns high high high

- cluster analysis (based on financial 𝒓𝟐 𝒓𝟐 𝒓𝟐
or operating characteristics)
low 𝒓𝟐
Page 5
3) By statistical similarities LOS b, c
- produce non-stable groups across time - compare
- relies on historical data ➞ may not be representative - explain
of future relationships
- subject to Type I/II errors
LOS d
Commercial Industry Classification Systems/
- describe
GICS - global industry classification standard - identify
- classified based on principal business activity
Sector ➞ Industry group ➞ Industry ➞ Sub-Industry

(11) (24) (69) (158)
equal ICB - Industry Classification Benchmark

here - classified onMM108293137.
the basis of primary revenue source
Industry - Supersector - Sector - Sub-sector

(11) (20) (45) (173)
59
Page 6
both GICS and ICB recognize the same top-level LOS d
broad groupings - describe
- identify
1. Materials - building materials, chemicals, forest products
2. Consumer Discretionary - auto, apparel, hotel
3. Consumer Staples - food/beverage, personal care products
4. Energy - exploration, production, refining, services to
5. Financials - banking, insurance, asset mgmt.
6. Health Care - biotech, pharma, medical devices
7. Industrials - heavy machinery, aerospace/defense
8. Real Estate - REITs, REOCs
9. Information Technology - electronic entertainment, internet services, tech.
consulting
10. Communication Services/Telecom - fixed line/wireless, video gaming
11. Utilities - electric, gas, water
Page 7
LOS e
Peer group ➞ a group of companies engaged in similar - explain
business activities whose economics and valuations
are influenced by closely related factors
1. GICS/ICB to quickly identify the public companies operating in

the same industry
2. Review the subject’s annual report to identify any mention of
competitors
3. Review industry trade publications to identify comparables
4. Confirm that all comparable companies identified have similar
primary business activities
the higher the proportion of revenue and operating profit
derived from similar business activities, the more
meaningful the comparison
- the more similar the demand environment, the better the
comparison
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60
Page 8
Peer group ➞ companies with limited lines of business can LOS e
be categorized easily - explain
➞ companies with multiple divisions may be included in
more than 1 category
- can be a distinction between a company’s industry and its

peer group
LOS f, g
- describe
macro
industry
variables
structure
affecting
the industry Porter’s
5-forces
Page 9
Principles of Strategic Analysis/ LOS f, g
- describe
analysis of the competitive environment must be
informed by the structural attributes of an industry
the context in which the company operates
Porter’s 5-forces model ➞ 5 determinants of the attractiveness of an

industry
threat of new entrants
availability of substitute products low = attractive
bargaining power of suppliers (high profitability)
bargaining power of customers high = unattractive
Intensity of rivalry
61
Page 10
barriers to entry: higher/stronger barriers reduce competition LOS h
- low barriers reduce pricing power and drive - explain
return on invested capital to its required return (economic
profit = 0)
- disruptive technologies are a threat
- fintech vs. traditional payment clearing
- barriers to entry ≠ barriers to success

- entering may be easy but success may be hard
- high barriers to entry often create high barriers to exit - can make
industries prone to overcapacity (retail malls)
Industry concentration: more concentration, less price competition (generally)

- neither has
a scale 11% 7% 2%
50% 50% ➞ etc.
advantage
miniscule
- intense scale advantages
rivalry over all the smaller players
Page 11
Industry concentration: fragmented, tend to be highly price LOS h
competitive - explain
- makes strategy co-ordination difficult (i.e. tacit co-ordination)

- small gains in market share can be meaningful at small prices
∴ competition for share intense (larger players have less to gain

by destructive price behavior)
- firms act individualistically
(larger firms are more tied to the fortunes of the industry as a whole)
(exhibit #8)
Industry capacity: limited capacity ➞ demand > supply ➞ more pricing power
excess capacity ➞ supply > demand ➞ weak pricing power
- capacity is fixed in the short term but variable in the long term
- capacity cycles in waves ➞ tight to loose
62
Page 12
Industry capacity: LOS h
- if new capacity is physical, longer lead times for - explain
capacity to come online - market will be tight for sometime
- once overcapacity is reached ➞ will exist for an extended

period
- if capacity is financial/human capital ➞ companies can
ramp up capacity much quicker
Market share stability: stable market shares indicate less competitive

industries
- unstable market shares often indicate highly
competitive industries with little pricing power
- market shares are affected by: barriers to entry

frequency of new product introductions
product differentiation
Page 13
Price Competition: industries for which price is a large LOS h
factor in customer purchase decisions tend to - explain
be more competitive than industries in which customers

value other attributes more highly
LOS i
Life-Cycle Models/
- describe
Mature
Decline - classify
Shakeout
Embryonic Growth
Embryonic: slow growth, high prices, significant investment, high risk

- low customer awareness, low volumes
- tend to be private companies, Angel or VC financial
63
Page 14
Life-Cycle Models/ LOS i
Growth: new customers enter the market increasing - describe
demand, profitability improves, sales grow - classify
rapidly, lower prices as a result of scale, low levels

of competition (market share gains come from industry
growth vs. each other), high threat of new entrants
- focus on top-line revenue growth + reinvestment
Shakeout: demand growth slows, competitive pressures begin to grow
as market share gains begin to come at the expense of
others, capacity outweigh demand which puts downward
pressure on price
- focus on cost reduction and building brand loyalty
Maturity: little/no growth in demand, industry in consolidation,
companies become more price strategic, high barriers to
entry, efficient cost structures, positive cash flows, dividends
present
Page 15
Life-Cycle Models/ LOS i
Maturity: focus on incremental innovations, industry at - describe
risk from radical innovation (usually from outside) - classify
Decline: negative growth, excess capacity, price competition, industry

exit
- technological substitution, social changes, global comp.
- mgmt. behavior should be consistent with where a company is relative

to its industry’s life cycle
i.e. companies in a growth industry should be focused on growth

- mature companies in mature industries should typically not
be acting like a growth company
Limitations/ - technological change may accelerate the life cycle

(i.e. growth ➞ decline)
- regulatory changes ➞ deregulation (mature ➞ growth)
➞ regulation (growth ➞ decline)
64
Page 16
Limitations/ LOS i
social changes/demographics (growth ➞ decline) - describe
or (mature ➞ growth) - classify
- more challenging to apply to rapidly changing industries

- not all companies in an industry experience similar performance
i.e. not all companies in a growth industry are growth
companies
cyclical (business cycle related) LOS j

1/ Macroeconomic - describe
structural (permanent changes)
impact on pos. up low loose low
revenues GDP, interest rates, credit availability, inflation

and profits neg.
down high tight high
Page 17
2/ Technological Influences/ LOS j
- new products may replace older products - describe
- new products may also change the way other industries
operate
new ways of organizing, new way of producing
3/ Demographic Influences/ size

population age distribution
gender distribution
- growing and young ➞ positive for growth

- stable and aging ➞ negative for profitability
4/ Government Influences/ taxes, subsidies, regulation
5/ Social Influences/ how people value work/leisure

money/wealth
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health/wellness
ethics/fairness
65
Page 18
6/ Environmental Influences/ LOS j
consumer perception climate, animal rights, - describe
government regulation sustainability, biological infection
floods
resource shortages, supply chain disruptions fire
weather
Company analysis: LOS L

financial position - describe
products/services
offensive - growth
competitive strategy
defensive - maintaining share
1) low-cost strategy - low cost producer/provider
- gain market share with lower prices
- may be defensive to protect market position, or offensive

to increase market share, may even be predatory
Page 19
competitive strategy - describe
1) low-cost strategy - requires tight cost control, efficiency of assets

and operations
2) Differentiation strategy - unique g/s in terms of quality, type, or

distribution (valued by customers)
- justify a premium price
- requires strong market research, creative and inventive
people
- elements covers: Overview of company
Relevant industry characteristics
Analysis of demand for company’s g/s
Analysis of supply characteristics, including an analysis of
Explanation ofMM108293137.
the company’s pricing environment costs
In-depth financial analysis
66
Page 20
- describe
Corporate Profile
- governance arrangements
Industry characteristics
Demand Pricing Supply

analysis analysis analysis over time and
Financial ratios and metrics across companies
(activity, liquidity, solvency, profitability)
- Dupont decomposition
Spreadsheet Modelling: useful tool, but built on assumptions

- model complexity ≠ forecast precision
MM108293137.
67
Equity Valuation: Concepts and Basic Tools
a. evaluate whether a security, given its current market price and a value
estimate, is overvalued, fairly valued, or undervalued by the market;
b. describe major categories of equity valuation models;
c. describe regular cash dividends, extra dividends, stock dividends, stock

splits, reverse stock splits, and share repurchases;
d. describe dividend payment chronology;
e. explain the rationale for using present value models to value equity and
describe the dividend discount and free-cash-flow-to-equity models;
f. calculate the intrinsic value of a non-callable, non-convertible preferred

stock;
g. calculate and interpret the intrinsic value of an equity security based on the
Gordon (constant) growth dividend discount model or a two-stage dividend
discount model, as appropriate;
h. identify characteristics of companies for which the constant growth or a

multistage dividend discount model is appropriate;
i. explain the rationale for using price multiples to value equity, how the price
to earnings multiple relates to fundamentals, and the use of multiples based
on comparables;
j. calculate and interpret the following multiples: price to earnings, price to an

estimate of operating cash flow, price to sales, and price to book value;
k. describe enterprise value multiples and their use in estimating equity value;
l. describe asset-based valuation models

MM108293137.and their use in estimating equity
value;
m. explain advantages and disadvantages of each category of valuation model.
68
IV versus MV
LOS a
- goal is to identify mispriced securities - evaluate
(i.e. IV ≠ MV)
IV - intrinsic value/fundamental value

MV - market value
< - overvalued + 10% - 20% tighter
IV = MV - fairly valued
bands
> - undervalued - 10% - 20%
· also depends
on the confidence of the inputs ⇒ more confidence
· also depends on the expected time frame of

convergence of IV and MV
Valuation Models
Page 2
- 3 major categories of valuation model LOS b
1) Present Value Models (discounted cash flow) - describe
- present value of the future benefits to be
received from the security
- either future dividends paid (dividend discount model)
or future cash available to pay dividends (FCFF/FCFE)
2) Multiplier Models - market value or Enterprise Value

multiples
- price is some multiple of some fundamental variable
e.g./ P/E or P/S (stated on a forward basis based on an
estimate, or on a trailing basis based on observed values)
3) Asset based valuation models

(estimated value of Assets) - (estimated value of
Liabilities + est. value
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of Pref. shares)
69
Dividends & Repurchases

Page 3
· Dividend - a distribution paid to shareholders
LOS c
based on the number of shares owned - describe
- regular cash dividend - paid at regular intervals
- extra or special dividend - paid by a company that does
not pay at regular intervals or as a supplement
➞ not a legal obligation ➞ they are discretionary

➞ declared/authorized by the BoD
· Stock Dividend - bonus issue of shares - additional shares

issued (typically 2% - 4%) instead of cash
- not relevant for valuation
· Stock Splits/Reverse Stock Splits - no economic effect

↓ ↓
increase # of shares decrease # of shares
e.g. 2-for-1 (P0/sh. ↓) e.g. 1-for-10 (P0/sh. ↑)
Page 4
· Share Repurchase - an alternative to cash LOS c
dividends - describe
- company uses cash to buy back its own stock
Transaction:
Treasury Stock $ ➞ a contra-equity account
PPE
Cash $ - Accum.Dep.
these shares are not considered for dividends, voting or

computing EPS
Reasons for:
a) signaling a belief that their shares are undervalued
b) flexibility on amounts and timing
c) tax efficiency (deliver capital gains vs. dividends)
d) nullify the effect of employee stock options
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70
Dividend Payment Chronology

Page 5
dividends are stock begins trading
LOS d
now contractual without the dividend - describe
Declaration Ex-Dividend
Date Date
-
-
May 29 Sept 28 Sept 29 Oct 21
Holder of Payment
Record Date Date
- settlement = T + 2 ∴ to be a shareholder of record on

Sept. 29, must buy the stock by close of Sept. 27
$10 cum-dividend
stock ‘opens’ lower
date
by the amount of
9.75
the dividend
9.50
-25¢ +25¢
Sept. 28
Present Value Models

LOS e
⇒ Save today to have more tomorrow
- explain
(defer consumption) (future benefits) - describe
to have
∴ Value
present value of future
today
benefits
Simplest PV model ⇒ Dividend Discount Model (DDM)
: V0 - value of share today
𝐃𝐭
𝐕𝟎 = S Dt - expected dividend in year t
(𝟏 + 𝐫)𝐭
𝐭'𝟏 r = required rate of return
usually estimated using CAPM

𝑽𝟎 𝒕𝟏
MM108293137.
= 𝐫𝐟 + 𝛃(𝐫𝐄 − 𝐫𝐟 )
71
: LOS e
𝐃𝐭 - explain
𝐕𝟎 = S ⇒ why use ∞
(𝟏 + 𝐫)𝐭 - describe
𝐭'𝟏
- holding period, t = 1
𝐃𝐭 𝐏𝐭 𝐃𝐭=𝟏 𝐏𝐭=𝟏
𝐕𝟎 = + where 𝐏𝐭 = +
(𝟏 + 𝐫) (𝟏 + 𝐫)
𝐭 (𝟏 + 𝐫) (𝟏 + 𝐫)
so at t = 2
𝐃𝐭 𝐃𝐭=𝟏 𝐏𝐭=𝟏 𝐃𝐭=𝟐 𝐏𝐭=𝟐
𝐕𝟎 = + + where 𝐏𝐭=𝟏 = +
(𝟏 + 𝐫) (𝟏 + 𝐫)𝟐 (𝟏 + 𝐫)𝟐 (𝟏 + 𝐫) (𝟏 + 𝐫)
and at t = 3
𝐃𝐭 𝐃𝐭=𝟏 𝐃𝐭=𝟐 𝐏𝐭=𝟐 and so on…
𝐕𝟎 = } + + ~+
(𝟏 + 𝐫) (𝟏 + 𝐫)𝟐 (𝟏 + 𝐫)𝟑 (𝟏 + 𝐫)𝟑
t = n
𝐧
𝐃𝐭 𝐏𝐧
𝐕𝟎 = •S €+• ‚ ⇒ terminal stock value
(𝟏 + 𝐫)𝐭 (𝟏 + 𝐫)𝐧
𝐭'𝟏
LOS e
e.g./ YR1 YR2 YR3 - explain
Div. 2.00 2.10 2.20 - describe
P3 = 20
r=10% 𝟐. 𝟎𝟎 𝟐. 𝟏𝟎 𝟐. 𝟐𝟎 𝟐𝟎
𝐕𝟎 = + + +
Find V0 (𝟏. 𝟏𝟎) (𝟏. 𝟏𝟎)𝟐 (𝟏. 𝟏𝟎)𝟑 (𝟏. 𝟏𝟎)𝟑
= 𝟏. 𝟖𝟏𝟖 + 𝟏. 𝟕𝟑𝟔 + 𝟏. 𝟔𝟓𝟑 + 𝟏𝟓. 𝟎𝟐𝟔

= $𝟐𝟎. 𝟐𝟑
V0 depends directly on dividends expected to

be received and indirectly on the (dividends
subsequent to the end of the holding period)
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72
LOS e
e.g./ D0 = $4
- explain
g = 20% (expected growth rate in the
- describe
dividend for one year)
rf = 6%
rE = 11% What is V0?
𝒕=𝟏
𝛃 = 1.2 𝐃𝐭 𝐏𝐭 Dt = D0(1 + g)
𝐕𝟎 = +
est. P1 = $15.40 (𝟏 + 𝐫) (𝟏 + 𝐫) = 4(1.2)
𝟒. 𝟖𝟎 𝟏𝟓. 𝟒𝟎 = 4.80
= +
(𝟏. 𝟏𝟐) (𝟏. 𝟏𝟐)
r = rf + 𝛃(rE - rf)
= 𝟒. 𝟐𝟗 + 𝟏𝟑. 𝟕𝟓 = .06 + 1.2(.11 - .06)
= 𝟏𝟖. 𝟎𝟒 = .06 + 1.2(.05)
= .06 + .06
= .12
LOS e
- FCFE ⇒ free cash flow to equity - explain
- describe
reflects dividend paying capacity
(useful for non-dividend paying stocks)
CFO - (CFInv + Net Borrowings)
CAPEX
Usually CAPM
: Recall 𝐫 = 𝐫𝐟 + 𝛃(𝐫𝐄 − 𝐫𝐟 )
𝐅𝐂𝐅𝐄𝐭 economic
𝐕𝟎 = S
(𝟏 + 𝐫)𝐭 or/ r = rf + risk premium judgement
𝐭'𝟏
gov’t. company’s
Dt bond yield
bond
MM108293137.
73
Preferred Shares
LOS f
- non-callable, non-convertible
- calculate
(perpetual)
𝐃𝟎 Recall: dividend
𝐕𝟎 = PV of a perpetuity stated as a fixed
𝐫
yield
𝟓. 𝟓𝟎
e.g./ $100 par value @ 5.5% , r = 6% 𝐕𝟎 = = 𝟗𝟏. 𝟔𝟕
. 𝟎𝟔
e.g./ maturity at time n ⇒ same as a bond

𝐧
𝐃𝐭 𝐅𝐕 e.g. $20 par value @ 6% semi
𝐕𝟎 = S + maturing in 6 years, r = 8%
(𝟏 + 𝐫)𝐭 (𝟏 + 𝐫)𝐧
𝐭'𝟏
FV = 20
PMT = .60 CPT PV = $18.12
n = 12
I/Y = 4
LOS f
e.g./ Non-Callable, Non-Convertible, Perpetual - calculate
Par value = $100 @ 4.75%
Credit Rating = Ba1/BB, required return on BB = 7.5%
𝐃𝟎 𝟒. 𝟕𝟓 What if the
IV = ? 𝐕𝟎 = = = $𝟔𝟑. 𝟑𝟑
𝐫 . 𝟎𝟕𝟓 shares were
callable?
e.g./ Retractable Term Preferred Shares

FV = 25
Par value $25 @ 5% quarterly n = 34
retractable in 34 quarters at par PMT = (25 x .05)/4
r = 15.5% = 0.3125
I/Y = 𝟏𝟓. 𝟓@𝟒 = 𝟑. 𝟖𝟕𝟓
CPT PV = $12.71
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Gordon Growth Model

LOS g
- allows for growth/change of the
- calculate
dividend over time - interpret
⇒ Gordon Growth - assumes dividends grow indefinitely
at a constant rate
(non-cyclical, mature companies)
:
𝐃𝟎 (𝟏 + 𝐠)𝐭 (𝟏 + 𝐠) (𝟏 + 𝐠)𝟐 (𝟏 + 𝐠):
𝐕𝟎 = S = 𝑫𝟎 „ + + ⋯ + …
(𝟏 + 𝐫)𝐭 (𝟏 + 𝐫) (𝟏 + 𝐫)𝟐 (𝟏 + 𝐫):
𝐭'𝟏
⇒ r strictly greater than g
infinite geometric series

𝐃𝟎 (𝟏 + 𝐠) 𝐃𝟏
𝐕𝟎 = = sums to (𝟏 + 𝐠)
𝐫−𝐠 (𝐫 − 𝐠)
(𝟏 − 𝐠)
LOS g
e.g./ D0 = $5
𝐃𝟎 (𝟏 + 𝐠) 𝟓(𝟏. 𝟎𝟒) - calculate
g = 4% 𝐕𝟎 = = = $𝟏𝟑𝟎/𝐬𝐡. - interpret
𝐫−𝐠 . 𝟎𝟖 − . 𝟎𝟒
r = 8%
PV of a growing perpetuity
𝐃𝟎
- if g = 0 , 𝐕𝟎 = PV of a perpetuity
𝐫
how do we get g?
g = div. growth rate
g = b × ROE
b = earnings retention rate
(1 - DPR)
ROE = return on equity
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LOS g
- calculate
- interpret
IV = ? with
r = 19%
𝐃𝟎 (𝟏 + 𝐠)
𝐕𝟎 =
D0 = 2.28 r = .19 g = ? 2.28 = 1.35(1 + g)4 𝐫−𝐠
𝟐. 𝟐𝟖(𝟏. 𝟏𝟒) = g = .14

𝐕𝟎 = = $𝟓𝟏. 𝟗𝟖 ∴ share price of $38.91 undervalued
. 𝟏𝟗 − . 𝟏𝟒
𝟐. 𝟐𝟖(𝟏. 𝟏𝟑)
𝟐. 𝟐𝟖 if g = 13% 𝐕𝟎 = = 𝟒𝟐. 𝟗𝟒
if g = 0 𝐕𝟎 = = $𝟏𝟐 . 𝟏𝟗 − . 𝟏𝟑
. 𝟏𝟗
∴ g adds $39.98 to V0 if g = 13% 𝟐. 𝟐𝟖(𝟏. 𝟏𝟑)
𝐕𝟎 = = 𝟑𝟔. 𝟖𝟏
r = 20% . 𝟐 − . 𝟏𝟑
LOS g
- calculate
- interpret
strictly
15.8
15.9
19%
- model is extremely sensitive to changes in

both r and g
· as r ➞ g, P0 ↑ dramatically, hence the requirement

that g must be strictly less than r
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assumptions: LOS g
- calculate
1) Dividends are the correct
- interpret
metric for valuation purposes
2) g is forever ⇒ perpetual and never changes
3) r is also constant over time
4) g is strictly less than r
- alternatives
a) modify the model (for varying patterns of
growth)
b) use a cash flow measure
other than dividends (for non-dividend
paying stocks)
c) use some other approach
LOS g
e.g./ D5 = 4.00 (expected) - calculate
g = 6% (t5 onwards) - interpret
r = 10%
4.00 4.00(1.06)....
0 5 6 7 g = 6%
r = 10%
𝐃𝟓 (𝟏 + 𝐠) 𝟒. 𝟎𝟎(𝟏. 𝟎𝟔)
𝐕𝟓 = = = $𝟏𝟎𝟔
𝐫−𝐠 . 𝟏 − . 𝟎𝟔
𝟒. 𝟎𝟎
(𝟏. 𝟏)𝟓 𝟒
𝐕𝟒 ˆ. 𝟏 − . 𝟎𝟔‰
𝟏𝟎𝟔 𝐕𝟎 = =
(𝟏 + 𝐫)𝟒 (𝟏 + 𝐫)𝟒
(𝟏. 𝟏)𝟓
= 𝟐. 𝟒𝟖𝟒 + 𝟔𝟓. 𝟖𝟏𝟖 = 𝟔𝟖. 𝟑𝟎 = 𝟔𝟖. 𝟑𝟎
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LOS g
- Multistage DDM - calculate
- interpret
2-stage: makes use of 2 growth rates
high g low g
𝐠𝐬 𝐠𝐋
2 - initial finite - perpetuity
1 period
Vn use Gordon Growth
use DDM + terminal
V0 value
model to estimate Vn
𝐧
𝐃𝟎 (𝟏 + 𝐠 𝐬 )𝐭 𝐕𝐧 𝐃𝐧=𝟏
𝐕𝟎 = S + 𝐕𝐧 =
(𝟏 + 𝐫) 𝐭 (𝟏 + 𝐫)𝐧 𝐫 − 𝐠𝐋
𝐭'𝟏
𝐃𝐧=𝟏 − 𝐃𝟎 (𝟏 + 𝐠 𝐬 )𝐧 (𝟏 + 𝐠 𝐋 )
LOS g
e.g./ D0 = $5.00 - calculate
gs = 10%/a for 3 years - interpret
gL = 5%/a subsequent
r = 15% D3 = 5.00(1.1)3
g = 10%
g = 5%
-
0 1 2 3 4 -5
5.00
𝟓(𝟏. 𝟏) 𝟓(𝟏. 𝟏)𝟐 r = 15%
𝐕𝟎 = +
𝟏. 𝟏𝟓 (𝟏. 𝟏𝟓)𝟐
𝟑
𝐃𝟑 (𝟏 + . 𝟎𝟓) 𝟓. 𝟎𝟎(𝟏. 𝟏)𝟑 (𝟏. 𝟎𝟓)
𝟓(𝟏. 𝟏) 𝟔𝟗. 𝟖𝟕𝟕𝟓 𝐕𝟑 = =
+ + . 𝟏𝟓 − . 𝟎𝟓 . 𝟏𝟓 − . 𝟎𝟓
(𝟏. 𝟏𝟓) 𝟑 (𝟏. 𝟏𝟓)𝟑
= 𝟔𝟗. 𝟖𝟕𝟕𝟓
= $𝟓𝟗. 𝟔𝟖 (90 Sec)
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Model Appropriateness
LOS h
- constant growth - stable growth
- identify
- maturity phase
g < (1 - DPR)ROE
- non-cyclical
- dividend paying company
- multi-stage DDMs - rapidly growing companies

FCFE
growth fairly young company
3-stage DDM ⇒ transition just entering growth
maturity stage
transition older companies out of

2-stage DDM ⇒ growth stage or a
maturity
revitalized company
Price Multiples
LOS i, j
- ratios that compare the share price - explain
with some sort of monetary flow or value - calculate
earnings book value - interpret
sales
cash flow
𝐏𝟎 𝐏i = 𝐏𝟎 𝐏i = 𝐏𝟎 𝐏i = 𝐏𝟎
𝐏𝐄 = 𝐁 𝐁𝐕i 𝐒 𝐒𝐚𝐥𝐞𝐬i 𝐂𝐅 𝐅𝐂𝐅i
𝐄𝐏𝐒
𝐬𝐡. 𝐬𝐡. 𝐬𝐡.
(or OCF/sh.)
- denominators may be based on trailing values

or forward values
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LOS i, j
Price-to-Earnings (P/E)
+ - explain
- - calculate
- easy to use · useless if EPS < 0, - interpret
- most common measure if earnings are volatile

- strongly correlated to long-term · earnings are an accounting
returns measure
+ Price-to-Sales (P/s)
-
- not influenced by actg. choices - rev. recognition issues
- better metric if EPS < 0 still apply
- ignores cost structure
LOS i, j
Price-to-Cash Flow (P/CF)
+ - explain
- - calculate
· more of an economic measure - interpret
- ignores non-cash
· more difficult to manipulate
revenues
· tends to be less volatile than EPS
· more reliable over long-term
+ Price-to-Book Value (P/BV)

-
· more stable measure - ignores relative asset
· can be used even if EPS < 0 size in comparisons
· appropriate for firms in
- book value ≠ market value
distress
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LOS i, j
< undervalued - explain
Ratio = specified fairly valued - calculate
> value overvalued - interpret
EPS
.96
.84 𝟑𝟔
.72 Σ = 3.12 𝐏𝐄𝐭𝐭𝐦 = = 𝟑𝟎𝐱
𝟏. 𝟐𝟎 (overvalued)
.60
.48
.36 𝟑𝟔
Σ = 1.20 𝐏𝐄𝐟 = = 𝟏𝟏. 𝟓𝟑𝐱
.24 𝟑. 𝟏𝟐
.12 (undervalued)
actual estimated Q
YR1
Target Price = 15 × 3.12 = $46.80
industry P/E = 15 Strong - ‘Buy’
P0 = $36.00
LOS i, j
𝐃𝟏
Recall 𝐕𝟎 = - explain
𝐫−𝐠 - calculate
- interpret
𝐃𝟏
Let’s assume that V0 = P0 , then 𝐏𝟎 =
𝐫−𝐠
𝐃𝟏i
Divide P0 & D1 by EPS 𝐏𝟎i 𝐄𝐏𝐒 DPR
𝐄𝐏𝐒 = 𝐫 − 𝐠
𝐃𝐏𝐑
justified = 𝐏i =
𝐄 𝐫−𝐠
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LOS i, j
𝐏i = 𝐃𝐏𝐑 So, P/E is positively related - explain
𝐄 𝐫−𝐠
to - calculate
① DPR - questionable however
- interpret
called the - higher DPR, lower retention
‘justified P/E’ rate, lower re-investment
(i.e. justified by the (dividend displacement of
fundamentals) earnings)
② g ⇒ (1 - DPR)ROE
∴ P/E is positively
related to ROE
…and negatively related to r.
LOS i, j
- Based on comparables - explain
multiple 1 - calculate
Company multiple 2 versus Benchmark value - interpret
multiple 3 (i.e. compared to) of the multiple(s)
etc.…
Rationale: · a closely matched

‘Law of one Price’ individual stock
typically · avg. multiple of a
- identical assets
called peer group or industry
should sell for the
‘comps’ · avg. multiple derived
same price
from trend or time-series
analysis
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LOS i, j
e.g./ Company P/S - explain
A .14 ⇒ A appears - calculate
B .26 undervalued ‘Relative’ to its - interpret
C .32 peers
or/
D .48
E .64 ⇒ E appears overvalued
‘Relative’ to its peers
e.g./ Year
2016 2015 2014 2013 2012
P/E 11.2 13.6 15.2 16.1 15.8
appears undervalued ‘Relative’ to its

historical trend
Enterprise Value Multiples

LOS k
- rather than estimate the value of - describe
equity, estimate the value of the enterprise
(𝐏𝟎 × # 𝐨𝐟 𝐬𝐡𝐚𝐫𝐞𝐬) + 𝐌𝐕(𝐏𝐫 ) + 𝐌𝐕(𝐃𝐞𝐛𝐭) − 𝐂𝐚𝐬𝐡
MV(equity)
cost of a takeover
· most useful when
comparing companies with
significant differences in capital structure
Note: EV may be difficult

e.g./ 𝐄𝐕)
𝐄𝐁𝐈𝐓𝐃𝐀 to calculate for companies
whose debt is not publicly traded
83
Asset-Based Valuation
LOS L
- uses MVs of a company’s A & L to
- describe
determine the value of the company as a whole
- more frequently used with:

· private companies
· companies with few/no intangibles or
off-book assets (i.e. reputation)
· companies with high proportion of CA & CL
· companies being liquidated
· financial companies
Not suitable for · companies whose MV of A & L are

difficult to determine or have a significant
amount of intangible assets
1. Using DDM,
E find V0 (r = 10%)
✓
E 𝐃𝟏
𝐕𝟎 = 𝐃𝟎 = (𝟏 + 𝐠)
E 𝐫−𝐠
E
E
𝟑. 𝟏𝟎 = 𝟐. 𝟒𝟑(𝟏 + 𝐠)𝟓
Œ𝟑. 𝟏𝟎i𝟐. 𝟒𝟑 − 𝟏 = 𝐠
𝟓
= 𝟒. 𝟗𝟗𝟎𝟕%
~𝟓%
𝐃𝟎 (𝟏 + 𝐠)
= 𝟐. 𝟒𝟑(𝟏. 𝟎𝟓) = 𝟐. 𝟓𝟓
② Find IV assuming avg. PEttm is
appropriate. 𝐏 (𝟏𝟑. 𝟐 + 𝟏𝟔. 𝟒 + 𝟏𝟓. 𝟐 + 𝟏𝟒)i
i𝐄 = 𝟒 = 𝟏𝟒. 𝟕 𝟐. 𝟓𝟓
𝐈𝐕 = 𝟒. 𝟎𝟎 × 𝟏𝟒. 𝟕 = $𝟓𝟖. 𝟖𝟎 (U) 𝐕𝟎 = = $𝟓𝟏. 𝟎𝟎
. 𝟏 − . 𝟎𝟓
84
Asset-Based Valuation
= MV MV(A) = 5000 +
= MV 15000 + 30000
+ 55000 = 105,000
x 1.1 = MV
= MV MV(L) = 3,000 + 17,000

= MV + 25,000 = 45,000
= MV
1000 shares
MV(A) - MV(L) = 105,000
20% - 45,000
DDM ⇒ $51 P0 = $50.80 60,000
P/E ⇒ $58.80 𝟔𝟎, 𝟎𝟎𝟎
𝐕𝟎 = = $𝟔𝟎
𝟏𝟎𝟎𝟎
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REVIEWS
MM108293137.
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Market Organization & Structure
saving Review - 1
Functions of Financial System/ capital
borrowing
1) Facilitate transfer of risk
- providers/users of capital ➞ indiv., bus., gov’t.
- information-based trading (speculator return > req. r)
2) Price Discovery - what is the price of risk
3) Facilitate the efficient allocation of capital
- hedging, insurance
- capital seeks out best risk-adjusted return
- requires/ · speedy transactions

· low transaction costs
· access to information
· regulation
Review - 2
Assets/ - financial assets - stock, bonds, currencies
- physical assets - commodities, real estate
Markets classified by/ spot

1) timing of delivery forward/futures
primary
2) who the seller is
secondary
money mkt.
3) the maturity of the instruments traded
capital mkt.
traditional (debt, equity)
4) types of securities
alternative (private equity, securitized
debt)
Securities/
① Fixed-Income (notes, bills, bonds, CDs, Repos, MM)
② Equities (common, preferred, warrants)
③ Pooled Investments (mutual funds, ABS)

MM108293137.
87
· Currencies - forex Review - 3

· Contracts - a financial contract between 2 parties
financial asset
underlying
physical asset
- some cash settled, some physical settlement
a) Forwards
Buyer both have an to buy a specific at a specific by a
Seller obligation to sell asset price certain
b) Futures - exchange-traded forwards (standardized) date
c) Swaps - an exchange of cash flows
d) Options
Call to buy a specific at a specific by a certain
a right
Put to sell asset price date
Sellers ➞ an obligation
e) Others - Insurance, Credit Default Swaps
Review - 4
· Commodities - spot
hedging
- forward/futures
speculation
generally illiquid
· Real Assets - property, factories, equipment
high mgmt. costs
⇒ Intermediaries/
1) Brokers, Exchanges, ATS (Alternative Trading Systems)
best bid and ask dark pools - do not display
order sent to them
2) Dealers - hold inventory
- act as market makers (create liquidity)
- Primary Dealers (can buy/sell w/ Central Bank)
3) Securitizers
4) Depository Institutions/Other Financial Corporations

- banks, credit unions
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(deposit taking)
5) Insurance Companies
88
⇒ Intermediaries/ Review - 5
6) Arbitrageurs
7) Settlement & Custodial Services - hold securities on
behalf of clients
⇒ Positions/ long - benefits from an increase in price
short - benefits from a drop in prices
long - takes delivery
· forward/future
short - delivers
· options long - buy a call or put
short - sell a call or put
· swaps - party that benefits from a rise in rates = long
· Currencies - traded in pairs, long one, short the other
⇒ Levered Positions/ margin = me , loan = broker

- interest rate on loan = ‘call money’ rate
⇒ Levered Positions/ Review - 6

Initial margin
- margin requirements
maintenance margin
𝐕𝐚𝐥𝐮𝐞 𝐨𝐟 𝐏𝐨𝐬𝐢𝐭𝐢𝐨𝐧 𝐦𝐚𝐱
𝐋𝐞𝐯𝐞𝐫𝐚𝐠𝐞 𝐑𝐚𝐭𝐢𝐨 = 𝟏
𝐕𝐚𝐥𝐮𝐞 𝐨𝐟 𝐄𝐪𝐮𝐢𝐭𝐲 𝐥𝐞𝐯𝐞𝐫𝐚𝐠𝐞 =
𝐦𝐢𝐧𝐢𝐦𝐮𝐦
𝐏𝐨𝐬𝐢𝐭𝐢𝐨𝐧 𝐑𝐚𝐭𝐢𝐨
𝐦𝐚𝐫𝐠𝐢𝐧
𝐫𝐞𝐪𝐮𝐢𝐫𝐞𝐦𝐞𝐧𝐭
𝟏 − 𝐈𝐧𝐢𝐭𝐢𝐚𝐥 𝐌𝐚𝐫𝐠𝐢𝐧
𝐌𝐚𝐫𝐠𝐢𝐧 𝐂𝐚𝐥𝐥 = 𝐏𝟎 × • ‚
𝟏 − 𝐌𝐚𝐢𝐧𝐭𝐞𝐧𝐚𝐧𝐜𝐞 𝐌𝐚𝐫𝐠𝐢𝐧
e.g./ P0 = $60 margin = 50% maintenance margin = 25%

𝟏 − .𝟓
𝐂𝐚𝐥𝐥 = 𝟔𝟎 • ‚ = 𝟔𝟎ˆ. 𝟓i. 𝟕𝟓‰ = 𝟒𝟎
𝟏 − . 𝟐𝟓
⇒ Order Types/ Execution Instructions
Bid - Ask buy on the Ask
1) Market
sell on the Bid
spread MM108293137.
2) Limit - specified price
89
Review - 7
⇒ Order Types/ market - guaranteed execution, but not price
limit - guaranteed price, but not execution
x x x x x
Bid Ask
make the create a marketable
to Buy: behind the
market limit order
market new market
standing limit all earlier orders
order at the bid executed
first
⇒ Exposure Instructions/ display or hide, or display a certain size
⇒ Validity Instructions/ when an order is to be filled
Day = default
GTC = good-til-cancelled
FOK = fill-or-kill
good-on-close = market order on close
Review - 8
⇒ Validity Instructions/
stop loss (stop a long pos.)
Stop orders
buy stop (stop a short pos.)
⇒ Clearing Instructions/ applies when using more than 1 broker

⇒ Primary Market/ IPOs Issuer Investor
underwriting offer - Inv. Bank buys entire issue
- sells to market (spread = income)
best efforts offer - acts as a broker only
(commission = income)
⇒ Secondary Market/ Investor - Investor
⇒ Private Placements/ securities not offered to the public
⇒ Call Markets/ trades occur only at particular times & places
- all bids/asks balanced to determine one
price - all trades occur at this price
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⇒ Continuous Market/ anytime trading when mkt. is open Review - 9

- auction market or dealer market
⇒ Quote-Driven Markets/ dealer markets (dealer supplies both

(OTC) bid & ask)
⇒ Order-Driven Markets/ pure action markets
(exchanges)
· order matching rules/

· price precedence - best bid & best ask
· display precedence - displayed over hidden at same price
· time precedence - first over others w/ same
price & display
· trade pricing rules/ uniform pricing - Call Mkt.
discriminatory pricing (auction Mkt.)
Review - 10
· derivative pricing rule/ · mid point of bid-ask from
another market
⇒ Brokered Markets/ brokers arrange trades (unique items)
⇒ Trade Information/ pre-trade transparency - bid/ask known before

trade
post-trade transparency - prices known after
trades executed
⇒ Well-functioning financial system/

· timely & accurate disclosures (information efficiency)
· liquidity (operational efficiency)
· complete markets - assets/contracts exist to
satisfy savers, borrowers, hedgers, asset
exchanges
· external information efficiency
- prices reflect all information
+ financial intermediaries + regulation

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Security Market Indicies
Review - 1
Index ⇒ constituent securities representing a given
security market (or asset class)
- 2 versions ① Price Return - reflects only prices
② Total Return - reinvestment of all income
uses/ · evaluate performance (active mgrs.)

· construct investment portfolios (passive)
· estimate market risk
∑𝐍𝐢'𝟏 𝐧𝐢 𝐏𝐢
𝐕𝐏𝐑𝐈 = a number chosen at inception
𝐃 value of
so the index has a nice
divisor
price initial value - divisor changes
return over time so that
fundamental
price changes in index
weightings reflect price
equal
market-cap changes only
float adjusted market cap
𝑽𝑷𝑹𝑰𝟏 − 𝑽𝑷𝑹𝑰𝟎 Review - 2

⇒ Returns/ · Single Period 𝐏𝐑 𝐈 =
𝑽𝑷𝑹𝑰𝟎
𝐍 𝑵
or weighted average of 𝑷𝒊 − 𝑷𝒊 𝟎 𝑷𝒊 − 𝑷𝒊 𝟎
𝐏𝐑 𝐢 = 𝟏 ⇒ 𝐏𝐑 𝐈 = S 𝐖𝐢 𝐏𝐑 𝐢 = S 𝒘𝒊 V 𝟏 W
each component : 𝑷𝒊 𝟎
𝐢'𝟏 𝒊'𝟏
𝑷𝒊 𝟎
each component
𝑵
𝑽𝑷𝑹𝑰𝟏 − 𝑽𝑷𝑹𝑰𝟎 + 𝑰𝟏 𝑷𝒊 − 𝑷𝒊𝟎 + 𝑰𝒊
⇒ Total Return/ 𝐓𝐑 𝐈 = or 𝐓𝐑 𝐢 = 𝟏 = S 𝒘𝒊 𝑻𝑹𝒊
𝑽𝑷𝑹𝑰𝟎 𝑷𝒊𝟎
𝒊'𝟏
(VPRI = VTRI at inception)
· Multiple Period Returns/
𝑽𝑷𝑹𝑰 = 𝑽𝑷𝑹𝑰𝟎 _𝟏 + 𝑷𝑹𝑰𝟏 `_𝟏 + 𝑷𝑹𝑰𝟐 ` + ⋯ + _𝟏 + 𝑷𝑹𝑰𝑻 ` · if no

MM108293137. income
𝑽𝑻𝑹𝑰 = 𝑽𝑻𝑹𝑰𝟎 _𝟏 + 𝑻𝑹𝑰𝟏 `_𝟏 + 𝑻𝑹𝑰𝟐 ` + ⋯ + _𝟏 + 𝑻𝑹𝑰𝑻 `
𝐕𝐏𝐑𝐈𝐓 = 𝐕𝐓𝐑𝐈𝐓
92
Review - 3
⇒ Index Construction/ ① target market selection
asset class, geography, sector, industry, size?
② security selection - all or a sample?
- fixed or variable
③ weightings ④ Rebalancing ⑤ Reconstitution
how much of each security to include
① Price weighting (simplest) 𝐏𝐢 𝐈𝐧𝐝𝐞𝐱 ∑𝐍𝐢'𝟏 𝐰𝐢 𝐏𝐢

𝑾𝑷𝒊 = 𝐍 =
(called an average, not an Index) ∑𝐢'𝟏 𝐏𝐢 𝐕𝐚𝐥𝐮𝐞 𝐃
adjusted for
② Equal weighting 𝐖𝐢𝐄 = 𝟏i𝐍
splits
e.g./ $10k in 5 stocks
$2000 into as soon as a
weighting = 𝟏i𝟓 = .2 ⇒
each stock price changes, no
longer have equal
- may under/over represent securities
weighting
Review - 4
⇒ Index Construction/ ③ market-cap weighted Index
𝑸 𝒊 𝑷𝒊
④ float-adjusted 𝑾𝑴
𝒊 = 𝑵
∑𝒊'𝟏 𝑸𝒊 𝑷𝒊
# of shares - most market-cap indicies
available to the are float adjusted
investing public
· components are held in proportion to their value

· components whose prices have risen the most have
a greater weight overweight overvalued stocks
may
underweight undervalued stocks
⑤ Fundamental weighting
BV
𝑭𝒊 Contrarian effect - will overweight
𝑾𝑭𝒊 = Rev.
∑𝑵
𝒊'𝟏 𝑭𝒊 undervalued stocks
CFO
- underweight overvalued stocks
Earnings
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Review - 5
⇒ Rebalancing/ weights drift over time
𝐖𝐢𝐄 = 𝟏i𝐍 · equal weighting - reduce weights of components
that have outperformed, increase ones that
𝑷𝒊
𝑾𝑷𝒊 = have underperformed
∑𝑵
𝒊'𝟏 𝑷𝒊 · price weighting - no need to rebalance
𝑸 𝒊 𝑷𝒊 · market cap weighting - only need rebalancing
𝑾𝑴
𝒊 = 𝑵
∑𝒊'𝟏 𝑸𝒊 𝑷𝒊 to reflect M&A and liquidations
⇒ Reconstitution/ · changing the securities in the index

· results in a change in all weightings
· reflect changes in target market, bankruptcy, M&A
⇒ Uses of Indicies/ gauge market sentiment, a proxy for measuring

risk & returns, proxies for asset classes, a benchmark for
active managers, basis for the creation of investment products
Review - 6
⇒ Types/ 1) Broad market Index
2) Multi-market Index - indicies from different
countries (e.g. countries by GDP)
3) Sector Indicies
growth
4) Style Indicies
value
⇒ Fixed-Income Indicies/ · aggregate/broad market

· market sector
· style
· economic sector
· specialized
⇒ Alternative Investments/ ① Commodities - futures contracts

② Real Estate/REIT Index
appraisal
repeat sales
③ Hedge Fund Index - rely on voluntary
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94
Market Efficiency
- the process by which the markets incorporates info. Review - 1
- price efficiency - informative prices (avoids malinvestment)

- prices incorporate all past & present info.
- general conclusion/ consistent superior risk-adjusted returns

are not achievable passive R > active R
⇒ Market Value (MV) - price at which asset can be bought or sold
⇒ Intrinsic Value (IV) - price of asset if complete information

and understanding were used
IV < MV - overvalued IV > MV - undervalued
IV ≃ MV - fairly valued
+/- 10%
Review - 2
⇒ Impediments to efficiency/
- few market participants

- lack of information availability
characteristics
- less financial disclosure
of private
- trading is limited
markets
- lack of transparency
- restrictions risk
classic view (return =
⇒ Information Acquisition Costs/ assumed
modern view (return - Info. = risk
⇒ Forms of Efficiency/ costs assumed
Past Data public info. private info.
weak √
semi-strong √ √
strong √ √ √
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Review - 3
⇒ Weak form/ future returns independent of past returns
- technical analysis useless
- no abnormal risk-adjusted returns based on past prices
⇒ Semi-strong form/ no abnormal risk-adjusted returns based

on public information
- both technical & fundamental analysis useless
- must consider what is priced in (only unanticipated
information affects prices)
⇒ Strong/ research rejects strong-form hypothesis
⇒ Time-Series Anomalies/
Calendar January
- all lack turn-of-the month (last day + first 3)
persistence Day of the week (avg. M. r. < 0)
Holiday effect (day prior)
Review - 4
⇒ Time-Series Anomalies/
Overreaction/ investors overreact to unexpected info.
(use of a contrarian strategy)
Momentum/ securities that have outperformed in
the short-run continue to outperform
⇒ Cross Sectional Anomalies/

1) size effect - small cap tend to outperform large cap
equities on a risk-adjusted basis
2) Value effect/ value stocks outperform growth
stocks over time
(3-factor model eliminates this effect)
Other Anomalies/ · closed-end fund discount

none supported by · earnings surprises
persistent & · IPOs economic
consistent evidence · Predictability of Returns based on prior info. cycle
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96
Review - 5
⇒ Behavioral Finance/ investors do not always act
rationally due to cognitive/behavioral biases (+ emotional)
① Loss Aversion/ tendency to avoid taking losses

- leads to ‘loss persistence’
② Herding/ ignore personal analysis and make decisions

in line with the direction of the market
③ Information Cascades/ serial correlation - acting on

actions of someone who acted on information
④ Overconfidence/ inflated view of their ability
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Overview of Equity Securities
⇒ Common Shares/ · ownership interest (residual claim) Review - 1
· voting rights (governance)

Statutory voting cumulative voting
1 vote/sh. # shares × # directors
· return - cap. gains, dividends
· dual-class shares (ownership & voting differences)
· Callable/Putable
⇒ Preferred Shares/ · no voting rights

· usually stated dividend (before common div.)
(still discretionary)
· higher priority of claims
· can be perpetual, convertible, callable, putable
· prices like debt
· Cumulative/ unpaid dividends accrue over time
(may also be non-cumulative)
Review - 2
⇒ Preferred Shares/ in increases in divs. if profit
· participating over some level
proceeds of a liquidity event
· convertible - typically ‘forced conversion’ clause
⇒ Public/ - secondary market
⇒ Private/ · not listed, private placement, prices not market determined

· highly illiquid (inefficient market)
1) Venture Capital
2) LBO/MBO - leveraged/mgmt. buyout
3) PIPE - private investment in public equity
· restricted stock
Adv./ · focus on long-term value creation

· higher risk-adjusted return
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Review - 3
· companies can list in international markets
- more filing requirements
· investors can buy in international markets
- typically limits on foreign ownership
· Direct Investing ⇒ price + Divs. ➞ forex risk

· Depository Receipts - foreign company deposits shares
with Domestic Bank
issues receipts in domestic
currency on exchange
L1 - OTC · Sponsored · foreign company directly involved
L2 & 3 - exch. · investors have ownership rights
· Unsponsored · foreign company not involved

· depository has rights of ownership
Review - 4
· GDR - global depository receipt - issued outside
home country of company and outside U.S.
· ADR - American depository receipt - issued in U.S.
⇒ Global Registered Shares/ ordinary shares traded on different

exchanges in different currencies
⇒ Risk & Return/ 1) capital gains (𝐏𝐭 − 𝐏𝐭8𝟏 ) + 𝐃𝐭

𝐑𝐭 =
2) dividends 𝐏𝐭8𝟏
3) currency gains/losses
4) reinvestment of dividends (Total Return)
· Book Value = A - L 𝐍𝐈𝐭 𝐍𝐈𝐭

𝐑𝐎𝐄𝐭 = =
· Market Value = # of shares × P 𝐀𝐯𝐠. 𝐁𝐕𝐄𝐭 (𝐁𝐕𝐄𝐭 + 𝐁𝐕𝐄𝐭8𝟏 )i
𝟐
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Review - 5
· Price-to-Book 𝐌𝐕𝐄𝐭i · higher ratio
𝐬𝐡. = 𝐌𝐕𝐄𝐭 · overvalued
𝐁𝐕𝐄𝐭i 𝐁𝐕𝐄𝐭
𝐬𝐡. or/ higher growth
opps. priced in
· Intrinsic Value (IV)
PV (expected future cash flows)
· Cost of Equity 𝐫𝐞 = 𝐫𝐟 + 𝛃(𝐑 𝐦 − 𝐫𝐟 )
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LOS a - explain/ Review - 1
1/ Understand a company’s business environment (context)

2/ Identify active equity investment opportunities
- top-down approach ➞ sector rotation strategies
3/ Portfolio Performance Attribution ➞ source of return
sector industry stock
identified by GICS/ICB
LOS b, c - compare/explain/
Groupings: 1/ By product/service supplied - principal business activity
2/ By business cycle sensitivity
- cyclical - correlated with bus. cycle, high op. leverage

- durable/discretionary goods
- non-cyclical - relatively independent of the business cycle

- non-discretionary goods/services
Review - 2
LOS b, c - compare/explain/
Groupings: 2/ By business cycle sensitivity
Defensive - consumer staples, basic services

Growth - generate growth regardless of phase of bus. cycle
- different countries and regions progress through various stages of the

business cycle at different times
3) by statistical similarities - based on correlations of past
returns
- produce non-stable groups across time
LOS d - describe/identify/
GICS - Global Industry Classification Standard
Sector - Industry group - Industry - Sub-Industry
- classified based on principal business activity
ICB - Industry Classification Benchmark
Industry - Super sector - Sector - Sub-sector
- classified based on primary revenue source
101
Review - 3
LOS d - describe/identify/
11 Broad sectors ➞ Materials Consumer Discretionary Utilities
Consumer Staples Energy Health Care
Financials Real Estate Industrials IT
Communication Services/Telecom
LOS e - explain/ Peer groups ➞ a group of companies engaged in similar

business activities whose economics and valuations
are influenced by closely related factors
- the more similar the demand environment and the higher the
proportion of revenue and op. profit derived from similar
business activities, the more meaningful the comparison
- companies with multiple divisions may be included in more than

one category
Review - 4
LOS f, g - describe
external influences: Porter’s 5 forces
Demographic Bargaining power of buyers low = attractive
Government Bargaining power of suppliers
Macroeconomic Threat of new entrants high
Technology Threat of substitutes =
Social Industry Rivalry unattractive
Environmental
LOS h - explain/
low - little pricing power (highly competitive)
Barriers tendencies, not
high - greater pricing power laws
- often create high exit barriers
Concentration more - less price competition (tacit competitive co-ordination)

less - fragmented - higher levels of price competition
- strategy co-ordination is difficult
- small gains in market share can be
meaningful at small sizes
102
LOS h - explain/ Review - 5

limited d > S ➞ more pricing power
Industry capacity
excess S > d ➞ less pricing power
- adding physical capacity has longer lead times
Market share stability stable - less competitive industries

unstable - highly competitive industries with
frequent little pricing power
innovations
Price Competition - if price is a large factor in purchase decisions, such
industries tend to be more competitive
LOS i - describe, classify/

demand Maturity
Shakeout Decline
Embryonic
Growth
time
Review - 6
LOS i - describe, classify/
Embryonic - slow growth, high prices, low volumes

Growth - increasing demand, prices drop, still low competition
- focus on top-line revenue growth + reinvestment
Shakeout - demand growth slows, prices under pressure, competitive
pressures grow
- focus on cost reduction and building brand loyalty
Maturity - little/no demand growth, consolidation underway, companies more
price strategic
- focus on incremental innovation
Decline - negative growth, excess capacity, price competition, exit
Limitations/ tech. change may accelerate the life cycle

regulatory change affect the life cycle
deregulation: mature ➞ growth
regulation: growth ➞ decline
social changes/demographics (growth ➞ decline or mature ➞ growth)
103
Review - 7
LOS j - describe/ External Influences
cyclical - business cycle related
1/ Macroeconomic
structural - permanent changes
impact on up low loose low

pos.
revenues and GDP, interest rates, credit availability, inflation
profits neg.
down high tight high
2/ Technological incremental = stability

radical = disruptive
3/ Demographic - young/growing ➞ positive for growth
- stable/aging ➞ negative for profitability
4/ Government - taxes, subsidies, regulation
5/ Social - values
6/ Environmental - climate, animal rights, sustainability, biological infection
Review - 8
LOS L - describe/ Company analysis
1/ low-cost strategy - low cost producer

- may be defensive, offensive, predatory
2/ differentiation strategy - unique g/s in terms of quality, type

or distribution
Spreadsheet modelling ➞ model complexity ≠ forecast precision
104
Equity Valuation
Review - 1
IV - Intrinsic Value MV - Market Value
< - overvalued
IV = MV + 10 - 20%
fairly valued
> undervalued
- 10 - 20%
- must consider expected time frame of convergence

⇒ Valuation Models/
dividends
1) Present Value Models
cash flow
2) Multiplier Models - MV or EV
3) Asset-based valuation
⇒ Present Value Models/ :
𝐃𝐭
1) Dividend Discount Model ⇒ 𝐕𝟎 = S
(𝟏 + 𝐫)𝐭
𝐧 𝐭'𝟏
𝐃𝐭 𝐏𝐧
𝐕𝟎 = S + 𝒓𝒆 = 𝐫𝐟 + 𝛃(𝐑 𝐦 − 𝐫𝐟 )
(𝟏 + 𝐫)𝐭 (𝟏 + 𝐫)𝐧
𝐭'𝟏
(usually)
explicit forecast terminal
period value
Review - 2
⇒ Present Value Models/
2) FCFE · free cash flow to equity
(useful for non-dividend paying stocks)
CFO - FCInv + Net Borrowings
0
𝐅𝐂𝐅𝐄𝐭 CAPEX judgement
𝐕𝟎 = E
(𝟏 + 𝐫)𝐭 𝐫 = 𝐫𝐟 + 𝛃(𝐑 𝐌 − 𝐫𝐟 ) or r = rf + risk premium
𝐭&𝟏
gov’t. company’s bond

bond yield
⇒ Preferred Shares/ 𝐕 = 𝐃𝟎
𝟎
𝐫 (perpetuity)
- div. stated as a yield (stable)
⇒ Gordon Growth Model/ - assumes divs. grow indefinitely at a
constant rate
(g < r) 𝐃𝟎 (𝟏 + 𝐠) 𝐃
𝐕𝟎 = = 𝟏i𝐫 − 𝐠 - a growing perpetuity
𝐫−𝐠
sensitive to changes in r & g
105
Review - 3
⇒ Gordon Growth DDM/ 1) Divs. are correct metric for
assumes valuation
2) g is forever
3) r is constant
4) g < r g - (1 - DPR)ROE = RR ROE

⇒ Multi-Stage DDM - uses 2 growth rates
𝐠𝐬 high g low g (perpetuity) 𝐠𝐋
(Initial growth period)
𝐧
𝐃𝟎 (𝟏 + 𝐠 𝐬 )𝐭 𝐕𝐧 𝐃𝐧=𝟏 𝐃𝐧2𝟏 = 𝐃𝟎 (𝟏 + 𝐠 𝐬 )𝐧 (𝟏 + 𝐠 𝐋 )
𝐕𝟎 = S + 𝐕𝐧 =
(𝟏 + 𝐫)𝐭 (𝟏 + 𝐫)𝐧 𝐫−𝐠 𝐃𝐧=𝟏
𝐭'𝟏
- rapidly growing companies

growth
transition
2-stage 3-stage transition
maturity
maturity
Review - 4
⇒ Price Multiples/
⇒ P/E - easy to use, most common 𝐏
𝐏𝐄 = 𝟎i𝐄𝐏𝐒
- useless if E < 0
⇒ P/S - not influenced by actg. measures 𝐏i = 𝐏𝟎
𝐒 Ž𝐒𝐚𝐥𝐞𝐬
- ignores cost structure i𝐬𝐡.
⇒ P/CF - less volatile than EPS 𝐏i = 𝐏𝟎
𝐂𝐅 Ž𝐅𝐂𝐅i
- ignores non-cash revenues 𝐬𝐡.
⇒ P/BV - more stable, appropriate for 𝐏i 𝐏
𝐁𝐕 = 𝟎Ž𝐁𝐕
firms in distress i𝐬𝐡.
⇒ Justified P/E/ - denominator may be
𝐃𝟏
- assume V0 = P0, then 𝐏𝟎 = based on trailing values or
𝐫−𝐠
forward values
𝐏𝟎i 𝐃𝟏 /𝐄𝐏𝐒 𝐃𝐏𝐑
𝐄𝐏𝐒 = 𝐫 − 𝐠 𝐏𝐄 =
𝐫−𝐠
106
Review - 5
⇒ Justified P/E/ 𝐃𝐏𝐑 P/E positively related to:
=
𝐫−𝐠 ① DPR
· higher DPR, lower RR, ② g = RR(ROE)
lower reinvestment …and negatively related to r
(dividend displacement of earnings)
⇒ Comparables/ Company vs. closely matched stock

peer group/industry multiple
- rationale - ‘Law of One avg. historical trends
Price’
⇒ Enterprise Value/ (𝐏𝟎 × # 𝐨𝐟 𝐬𝐡𝐚𝐫𝐞𝐬) + 𝐌𝐕(𝐏𝐫 ) + 𝐌𝐕(𝐃𝐞𝐛𝐭) − 𝐂𝐚𝐬𝐡
- most useful for comparing companies with sig. diff. in
capital structure
e.g. 𝐄𝐕i
𝐄𝐁𝐈𝐓𝐃𝐀
Review - 6
⇒ Asset Based Valuation/
- use MV of A & L to determine value of company
for/ · private companies
· companies with no/few intangibles
· high proportions of CA & CL
· companies being liquidated
· financial companies
107

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Level I - Equity Investments

Market Organization and Structure 2

Security Market Indexes 21

Overview of Equity Securities 45

Introduction to Industry and Company Analysis 56

Equity Valuation: Concepts and Basic Tools 68

© markmeldrum.com. All rights reserved.

Market Organization and Structure

a. explain the main functions of the financial system;

b. describe classifications of assets and markets;

c. describe the major types of securities, currencies, contracts, commodities,

d. describe types of financial intermediaries and services that they provide;

e. compare positions an investor can take in an asset;

g. compare execution, validity, and clearing instructions;

h. compare market orders with limit orders;

j. describe how securities, contracts, and currencies are traded in quote-driven,

k. describe characteristics of a well-functioning financial system;

l. describe objectives of market regulation.

2) Price Discovery - rates of return so that I = S

3) Facilitate the efficient allocation of capital

2) Borrowing - move money to the present

3) Raise Equity Capital - indirect investing

4) Managing Risks - hedging, insurance

Caution: there is not one market with one interest

3) Efficient allocation of capital

⇒ 1, 2 & 3 require ⇒ speedy transactions (liquidity)

Markets can be classified on the basis of

Major Types of Securities

② Equities (ownership claims)

· Common Preferred Warrants

3) Contracts - an agreement between 2 parties to do

a) Forward (OTC, customizable)

(long) Buyer to buy a specific at a by a

b) Futures - a standardized, exchange-traded forward

Buyers only the strike expiration

- tangible ⇒ property, factories, equipment

- generally illiquid, high mgmt. costs

1) Brokers, Exchanges, Alternative Trading Systems (ATS)

Exchanges - provide an auction platform

ATS - no regulatory authority over members

3) Securitizers - buying assets, placing them in a pool, and

4) Depository Institutions and Other Financial Corporations

i.e. CAT bonds Insurance tornado

manages policy holder

7) Settlement & Custodial Services (hold securities on behalf

- short position - benefits from a decrease in price

Forwards long position obligated to take delivery asset or

Swaps - fixed for floating - party that benefits from a

Currency - traded in pairs Buy $100k USD CAD means

Securities - selling securities you don’t own

- if the borrow cannot be maintained, seller

- to close a short position, seller initiates

⇒ interest rate ⇒ ‘call money’ rate

e.g./ P0 = $60, margin = 50%, maintenance margin = 25%

Execution Instructions: how an order should be filled

58 · bid < limit $ < ask - new price prints

10.55 Bid · limit $ = bid · all buy orders at

- display size ⇒ lower than order

i.e. Buy 10,000, Limit $10.55 , Display size = 500

Validity Instructions - when an order may be filled

Clearing Instructions - how final settlement should be

- usually the broker

Primary vs. Secondary