Equity Investment

© EduPristine For [CFA-I – Equity Investment-MM] (Confidential)

 Mind Map

Equity Investment

Dividend Types of validity

Types of Markets Financial Intermediaries Margin Trading
and Share Repurchases instructions

Spot Market Initial Margin

Broker , Dealer and
Forward Market Maintenance Margin Day order
Exchange
Securitizes Good-till-cancelled
Primary Market Margin Call set off by Immediate or cancelled
Depository Institutions
Secondary Market ▪ Security sale Good on close
Insurance Companies
▪ Deposit of cash Good on open order
Arbitrageurs
Money Market ▪ Deposit additional
Clearing House
Capital Market securities

Traditional Investment
Market
Alternative Investment
Market

Order Driven Market

Price / Quote Driven Market
Brokered Market

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 Mind Map

Equity Investment

Dividend Types of validity

Types of Markets Financial Intermediaries Margin Trading
and Share Repurchases instructions

Dividend Payment
Regular Cash Dividends Stock Splits Reverse Stock Splits Share Repurchases
Chronology

Special ▪ EPS and other per market

▪ Earning yield > Cost of debt
Dividends: Used data decline by half ▪ Declaration Date
Dividend Liquidating then EPS increases
especially by ▪ P/E, Dividend Yield are ▪ Ex-Dividend Date
Reinvestment Dividends: ▪ Earning yield < Cost of Debt
cyclical same ▪ Holder of record date
Plan (DRP): No Company goes then EPS is reduced
companies in ▪ Wealth remains same ▪ Payment Date
floatation costs out of business
periods of strong
earnings
▪ If market price > BVPS then
book value per share
For equal taxation and information content cash dividends = reduces after repurchase
share repurchases ▪ If market price < BVPS then
book value per share
increases after repurchase

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 Mind Map

Equity Investment

Infinite Period
One-Period Price Earnings Price Indexes Estimating Concentration
Dividend
Valuation Model Multiples Multiplier Model & Bias EPS Ratios
Discount Models

V0 = (D1 + P1) /(1 + Ke)

Be sure to use expected dividend
D1 in calculation.

Q:
Analyst expects a stock selling for $25 per
share to increase to $30 by year end. The last
dividend was $1, but the analyst expects next
year's dividend to be $1.50. What is the
expected holding period yield on this stock?
Ans:
Yield =($31.50/$25)-1= 26%

© EduPristine For [CFA-I – Equity Investment-MM] (Confidential) 4

 Mind Map

Equity Investment

Infinite Period
One-Period Price Earnings Price Indexes Estimating Concentration
Dividend
Valuation Model Multiples Multiplier Model & Bias EPS Ratios
Discount Models

Supernormal growth model Critical relationship between Critical assumption

Constant growth model
(multi-stage) DDM k e & gc of infinite period DDM

▪ As difference b/w ke & gc

widens, value of Stock
▪ Stock continues to pay
falls.
dividends constant growth
V0= [{D1/(1+ke)} +…. + ▪ As difference narrows,
V0 = D0(1+gc) /(ke - gc) rate.
{Dn/(1+ke)n} + {Pn/(1+ke)n}] value of stock rises.
= D1/(ke - gc) ▪ Constant growth rate, gc
Where Pn= Dn+1/(ke- gc) ▪ Small changes in
never changes.
difference between ke and
▪ ke must be greater than gc.
gc cause large changes in
stock's value.

Q: Q: Q: Q:
Analyst feels that Gordon Company's earnings & A firm has an constant dividend Which of the following is stock's P/E Holding all other factors constant,
dividend will grow at 25% for two years, after which payout ratio of 60% and an ratio based on the DDM? which of the following is expected to
growth will fall to a market-like rate of 6%. If the expected future growth rate of ▪ (1-RR)/[k-RR(ROE)] grow at the same rate as dividends
projected discount rate is 10% & Gordon's most 7%. What should the firm's ▪ (1+RR)/[k-RR(ROE)] in the infinite period DDM ?
recently paid dividend was $1, value Brown's stock expected price-to-earning (P/E) ▪ (1+RR)/[k+RR(ROE)] ▪ Sales
using the supernormal growth (multistage) ratio be if the required rate of ▪ (1-RR)/[k+RR(ROE)] ▪ ROE
dividend discount model. return on stocks of this type is Ans: ▪ Stock price
Ans: 15%. (1-RR)/[k-RR(ROE)] The earnings ▪ All of the above
(1.25/1.1) + (1.25/1.1)2 + [(1.25)2(1.06)/(0.1- 0.06)] Ans: multiplier model calculate P/E as Ans:
/(1.1)2 = $36.65 Using the earning multiplier follows: payout /( k – g) Substituting All of the above.
model, 0.6/ (0.15 - 0.07) = 7.5X term, payout = 1 – RR, & g = ROE(RR)

© EduPristine For [CFA-I – Equity Investment-MM] (Confidential) 5

 Mind Map

Equity Investment

Infinite Period
One-Period Price Earnings Price Indexes Estimating Concentration
Dividend
Valuation Model Multiples Multiplier Model & Bias EPS Ratios
Discount Models

P/E multiple P/BV multiple P/Sales multiple P/CF multiple

P/Sales = Price/Sales per

P/BV= Price / Book value share
P/CF= Price/Cash flow
Book value = ▪ Meaningful for distressed
P/E = Price / EPSn per share
shareholder's equity asset
▪ Earnings can be –ve ▪ Cash flow is difficult to
▪ BV is cumulative & ▪ Sales not easy to
▪ Mgmt discretion can manipulate
usually +ve manipulate
distort earnings ▪ P/CF is more stable than
▪ BV is more stable than ▪ Less volatile compared
▪ If n = 0, trailing PE P/E
EPS to P/E
▪ If n = 1, leading PE ▪ Addresses problem of
▪ Does not value human ▪ P/S ratio does not
earning quality
capital consider cost structures
across companies

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 Mind Map

Equity Investment

Infinite Period
One-Period Price Earnings Price Indexes Estimating Concentration
Dividend
Valuation Model Multiples Multiplier Model & Bias EPS Ratios
Discount Models

P0/E1= (D1/E1)/ (k-g)

= Payout ratio /(k-g)

Q:
An investor is analyzing a firm that has a historical
earning retention rate of 60%, which is projected to
continue into the future, & a constant ROE of 15%.
The stock's beta is 1.2. The nominal risk free rate is
8%, & the expected market return is 13%. If the
investor thinks that next year's earnings will be $3
per share, the stock's value is closest to:
Ans:
g = 0.6*0.15 = 9%, k = 0.08 + 1.2 (0.13-0.08) = 14%,
P0 = ($3*0.4) / (0.14-0.09) = $24

© EduPristine For [CFA-I – Equity Investment-MM] (Confidential) 7

 Mind Map

Equity Investment

Infinite Period
One-Period Price Earnings Price Indexes Estimating Concentration
Dividend
Valuation Model Multiples Multiplier Model & Bias EPS Ratios
Discount Models

Market cap Weighted: Base period value

Price Weighted: Weighted avg. of prices of Equal Weighted: Either arithmetic or
increased by %age increase in total market
index stocks, divisor adjusted for splits, biased geometric mean of individual index stock
value of index firms' stock, large cap stocks
downward due to splits of good performers. returns, geometric mean has downward bias.
have greater influence.

Q:
Stock bonus is most likely to cause downward bias in which of the
following index weighting schemes?
A. Price weighted
B. Value weighted
C. Equal weighted
Ans:
Stock bonus are generally issued by successful companies and hence it
reduces their current market price & weightage in price weighted index
post ex-bonus date. Hence stock bonus is likely to have downward bias
on price weighted index.

© EduPristine For [CFA-I – Equity Investment-MM] (Confidential) 8

 Mind Map

Equity Investment

Infinite Period
One-Period Price Earnings Price Indexes Estimating Concentration
Dividend
Valuation Model Multiples Multiplier Model & Bias EPS Ratios
Discount Models

Major type of equity indices:

Broad market indices:
Typically constitutes more than 90% of the entire market
(eg: Shanghai Stock Exchange Composite Index, Russell 3000).
Rebalancing:
Multi-market indices:
The process of adjusting the weights of each security in the
Ex: MSCI International Equity Index.
index.
Sector indices:
Reconstitution:
Ex: consumer goods, energy, finance, health care, technology.
The process of changing the constituent securities in an index.
Style indices:
Market capitalization: Large cap, midcap, small cap.
Volume/growth classification: based on P/B, P/E, dividend yields.
Market capitalization and Value/growth.

© EduPristine For [CFA-I – Equity Investment-MM] (Confidential) 9

 Mind Map

Equity Investment

Infinite Period
One-Period Price Earnings Price Indexes Estimating Concentration
Dividend
Valuation Model Multiples Multiplier Model & Bias EPS Ratios
Discount Models

EPS1 = [sales (EBITDA %) – int - depn] (1 - t)

Where sales, interest & depreciation are all
per share amounts

Q:
Analyst gathered the following financial information about a firm:
▪ Estimated sales per share $200
▪ An EBITDA profit margin estimate 20%
▪ Estimated depreciation per share $15
▪ Interest per share $5
If the firm's tax rate is 30%, calculate the firm's estimated EPS?
Ans:
Expected EPS = [(sales)*(EBITDA%) – depn - interest](1-t)
= [(200)(0.20) – 15 - 5] (1-0.3)
= $14

© EduPristine For [CFA-I – Equity Investment-MM] (Confidential) 10

 Mind Map

Equity Investment

Infinite Period
One-Period Price Earnings Price Indexes Estimating Concentration
Dividend
Valuation Model Multiples Multiplier Model & Bias EPS Ratios
Discount Models

N-firm concentration ratio is sum of the market

shares of the N largest firms.

Herfindahl index (N-firm or industry) is sum of

the squared market shares. Herfindahl < 0.1 is
competitive industry, >0.18 is concentrated. 1/
Herfindahl is equivalent number of equal-size
firms.

Q:
The three largest firms in a $200bn industry have revenues
of $50bn, $30bn & $20bn. Assuming that there are 10 other
equal-size firms in the industry, calculate the 3-firm
concentration ratio & the Herfindahl index for the entire
industry.
Ans:
Three-firm concentration ratio = (50+30+20)/200 = 0.50
Herfindahl = (50/200)2 + (30/200)2 + (20/200)2 +
10(10/200)2
= 0.12

© EduPristine For [CFA-I – Equity Investment-MM] (Confidential) 11

 Mind Map

Equity Investment

FCFE MV vs. BV Enterprise Value

Enterprise Value = Market capitalization +

Book Value: Market value of preferred stock + Market
▪ FCFE is a measure of dividend paying
▪ Reflects the historical operating and value of debt – Cash and investments
capacity.
financing decisions of its management.
▪ The entire CFO is not available for
▪ EV is often used when comparing
dividend distribution.
Market Value: companies with significant difference in
▪ CFO needs to be adjusted for Fixed
▪ Represents not only the historical capital structure
Capital Investment and Net Borrowings.
operating and financing decisions but also
the collective assessment of the future ▪ EV/EBITDA where EBITDA is a proxy for
FCFE= CFO – FCIINV + Net Borrowing
cash flows of the company. operating cash flow is used very
commonly

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 Mind Map

Securities Markets & Equity Investment

Well Functioning Company's Sensitivity

Margin Purchases Margin Calls Types of Orders Forms of EMH
Security Markets to the Business Cycle

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 Mind Map

Securities Markets & Equity Investment

Well Functioning Company's Sensitivity

Margin Purchases Margin Calls Types of Orders Forms of EMH
Security Markets to the Business Cycle

▪ Timely, accurate information ▪ For Margin Transaction

▪ Liquidity ▪ Leverage Factor= 1/ Margin percentage
▪ Internal Efficiency ▪ Levered Return = HPR* Leverage Factor
(Lowest possible transaction
cost)
▪ Informational (external) Q:
efficiency (prices rapidly Investor purchase 100 shares of a stock for $55
adjust to new information per share. Compute the investor's return if the
stock is sold for $75 per share and the transaction
was…
1. 100% financed by investor
2. A margin purchase with an initial margin
requirement of 50%
Ans:
1. As a 100% cash (equity) transaction, the
investor would had a return
=$75,00/$5,500) – 1
= 36.36%
2. With an initial margin of 50%, rest 50% equity in
this position would be borrowed from the
brokerage firm. If the shares were then sold at
$75 per share, the position would be worth
$4,750(i.e.7,500 - $2,750). In this situation, the
investor would have return =($4,750/$2,750) – 1
= 72.72%

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 Mind Map

Securities Markets & Equity Investment

Well Functioning Company's Sensitivity

Margin Purchases Margin Calls Types of Orders Forms of EMH
Security Markets to the Business Cycle

▪ Initial margin is the initial amount the investor can borrow.

▪ Maintenance margin is the amount an investor needs to maintain after the trade has
been done.
▪ Margin call triggers prices.
▪ Margin Purchase = P0*(1 - Initial margin %) / (1 - Maintenance margin %)
▪ Short Sell = P0*(1 + Initial margin %) / (1 + Maintenance margin %)

Q:
Assume you bought a stock for $20 per share. If the initial margin requirement is 60%
& the maintenance margin requirement is 20%, at which price will you get a margin
call?
Ans:
$20 (1 - 0.6) / (1 - 0.2) = $10

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 Mind Map

Securities Markets & Equity Investment

Well Functioning Company's Sensitivity

Margin Purchases Margin Calls Types of Orders Forms of EMH
Security Markets to the Business Cycle

Market If Touched
Stop Loss Order: Discretionary Open Order:
Limit Order: Order Order: Order Time-of-Day Fill-or-Kill Order:
Order to buy or sell Order: Market Order which is in
Market Order: can only be which is executed Order: Order Order that must be
a stock once the order whose effect until
Order placed at executed at the as a market order which is executed executed
price of the stock execution may be executed or until
current market rate limit price or lower when a pre- at a particular immediately or not
reaches a delayed at the the end of the
for buy order specified price is period of day at all
specified price broker's discretion trading
reached

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 Mind Map

Securities Markets & Equity Investment

Well Functioning Company's Sensitivity

Margin Purchases Margin Calls Types of Orders Forms of EMH
Security Markets to the Business Cycle

Strong Form: Stock prices fully reflect all

Weak Form: Current stock prices fully reflect
Semi-Strong Form: Security prices instantly information from public & private sources.
available security market info. Volume info/ past
adjust to new public information. Investor can't Assumes perfect markets in which all
price don't relate to future direction of security
achieve abnormal returns using fundamental information is cost free & available to everyone
prices. Investor can't achieve excess returns
analysis. at the same time. Even with inside info, investor
using tech analysis.
can't achieve excess returns.

© EduPristine For [CFA-I – Equity Investment-MM] (Confidential) 17

 Mind Map

Securities Markets & Equity Investment

Well Functioning Company's Sensitivity

Margin Purchases Margin Calls Types of Orders Forms of EMH
Security Markets to the Business Cycle

Company's sensitivity to the Business Cycle

Cyclical:
Profits strongly correlated with the strength of the
overall economy.

Defensive/Stable:
Revenues and profits are least affected by fluctuations
in overall economic activity.

Growth:
Include industries with specific demand dynamics that
are so strong that they override the significance of
broad economic or other external factors.

© EduPristine For [CFA-I – Equity Investment-MM] (Confidential) 18

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