cc-equity investments

8/13/2019 CC-Equity Investments

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Crash Course forEquity Invesment

CFA Level-I Exam

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Equity Investment



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Equity Investment

One-PeriodValuation Model

Infinite PeriodDividend

Discount Models

Earnings MultiplierModel

ConcentrationRatios

Price Indexes &Bias

EstimatingEPS

V0= (D1+P1) /(1+Ke)Be sure to use expecteddividend D1 in calculation.

Q. Analyst expects a stock sellingfor $25 per share to increase to

$30 by year end. The last dividendwas $1, but the analyst expectsnext years dividend to be $1.50.What is the expected holdingperiod yield on this stock?Ans. Yield =($31.50/$25)-1= 26%

PriceMultiples



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Q. Analyst feels that GordonCompany's earnings & dividendwill grow at 25% for two years,after which growth will fall to amarket-like rate of 6%. If theprojected discount rate is 10% &Gordon's most recently paiddividend was $1, value Brown's

stock using the supernormalgrowth (multistage)dividend discount model.Ans.(1.25/1.1) + (1.25/1.1)2+[(1.25)2(1.06)/(0.1- 0.06)]/(1.1)2 = $36.65

Supernormal growth model(multi-stage) DDM: .

Constant growth modelCritical relationship between

ke& gc

Critical assumption of infiniteperiod DDM

Stock continues to paydividends constant growth

rate.Constant growth rate, gcnever changes.kemust be greater than gc

Q. Holding all other factorsconstant, which of the following isexpected to grow at the same rateas dividends in the infinite periodDDM ?Sales.ROE.Stock price.All of the above.Ans.All of the above.

As difference b/w ke& gcwidens, value of Stock falls.

As difference narrows, valueof stock rises.Small changes in differencebetween keand gccause largechanges in stock's value.

Q. Which of the following isstocks P/E ratio based on theDDM?(1-RR)/[k-RR(ROE)]

(1+RR)/[k-RR(ROE)](1+RR)/[k+RR(ROE)](1-RR)/[k+RR(ROE)]Ans. (1-RR)/[k-RR(ROE)] Theearnings multiplier modelcalculate P/E as follows: payout/( kg) Substituting term,payout =1RR, & g=ROE(RR)

V0= D0(1+gc) /(ke- gc)= D1/(ke- gc)

Q. A firm has an constantdividend payout ratio of 60%and an expected future growthrate of 7%. What should thefirms price-to-earning (P/E)ratio be if the required rate ofreturn on stocks of this type is15%

Ans. Using the earningmultiplier model, 0.6/ (0.15 -0.07) = 7.5X

V0= [{D1/(1+ke)} +. +{Dn/(1+ke)

n} + {Pn/(1+ke)n}

Where Pn= Dn+1/(ke- gc)

Equity Investment



Discount Models


ConcentrationRatios

Price Indexes &Bias

EstimatingEPS

PriceMultiples



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

P/E = Price / EPSnearnings can be -ve

mgmt discretioncan distort earningsif n=0, trailing PEif n=1, leading PE

P/BV= Price / Book value

Book value = shareholdersequityBV is cumulative & usually +veBV is more stable than EPSdoes not value human capital

P/Sales = Price/Sales per sharemeaningful for distressed asset

sales not easy to manipulateless volatile compared to P/EP/S ratio does not considercost structures acrosscompanies

P/CF= Price/Cash flow per sharecash flow is difficult to manipulate

P/CF is more stable than P/Eaddresses problem of earningquality

Equity Investment



Discount Models


ConcentrationRatios

Price Indexes &Bias

EstimatingEPS

PriceMultiples



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

Q.An investor is analyzing a f irm that has a historicalearning retention rate of 60%, which is projected tocontinue into the future, & a constant ROE of 15%.

The stocksbeta is 1.2. The nominal risk free rate is8%, & the expected market return is 13%. If theinvestor thinks that next yearsearnings will be $3 pershare, the stocksvalue 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

Equity Investment



Discount Models


ConcentrationRatios

Price Indexes &Bias

EstimatingEPS

PriceMultiples



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Price Weighted: weightedavg. of prices of index stocks,divisor adjusted for splits,biased downward due to splitsof good performers.

Market cap Weighted: baseperiod value increased by %ageincrease in total market value ofindex firms' stock, large cap stockshave greater influence.Float adjusted Market CapWeighted.

Equal Weighted: eitherarithmetic or geometricmean of individual indexstock returns, geometricmean has downward bias.

Q.Stock bonus is most likely to cause downward bias in which of the followingindex weighting schemes?A. Price weightedB. Value weightedC. Equal weighted

Ans. Stock bonus are generally issued by successful companies and hence itreduces their current market price & weightage in price weighted index post ex-bonus date. Hence stock bonus is likely to have downward bias on priceweighted index.

Equity Investment



Discount Models


ConcentrationRatios

Price Indexes &Bias

EstimatingEPS

PriceMultiples




RebalancingThe process ofadjusting the weightsof each security in theindex.ReconstitutionThe process of

changing theconstituent securitiesin an index

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)

Multi-market indices

Ex: MSCI International Equity Index

Sector indices

Ex: consumer goods, energy, finance, health care,

technology

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

Equity Investment



Discount Models


ConcentrationRatios

Price Indexes &Bias

EstimatingEPS

PriceMultiples




EPS1=[sales (EBITDA %)int - depn] (1 - t)Where sales, interest &depreciation are all per shareamounts

Q. Analyst gathered the following financial

information about a firm:Estimated sales per share $200An EBITDA profit margin estimate 20%Estimated depreciation per share $15Interest per share $5If the firms tax rate is 30%, calculate the firmsestimated EPS?Ans.Expected EPS= [(sales)*(EBITDA%) depn -interest](1-t) = [(200)(0.20)15 - 5] (1-0.3) = $14

Equity Investment



Discount Models


ConcentrationRatios

Price Indexes &Bias

EstimatingEPS

PriceMultiples




N-firm concentration ratio is sum of themarket shares of the N largest firms.

Herfindahl index (N-firm or industry) is sum ofthe 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 $200 bn industry have revenuesof $50 bn, $30 bn & $20 bn. Assuming that there are 10 otherequal-size firms in the industry, calculate the 3-firmconcentration ratio & the Herfindahl index for the entire industry.Ans.Three-firm concentration ratio = (50+30+20)/200= 0.50Herfindahl= (50/200)2+(30/200)2+(20/200)2+10(10/200)2= 0.12

Equity Investment



Discount Models


ConcentrationRatios

Price Indexes &Bias

EstimatingEPS

PriceMultiples




Equity investment

FCFE MV vs. BV Enterprise Value

FCFE is a measure of dividend payingcapacityThe entire CFO is not available fordividend distributionCFO needs to be adjusted for FixedCapital Investment and Net Borrowings

FCFE= CFOFCIINV+ Net BorrowingVN=S FCFE

(1+r)t

Enterprise Value =market value of common stock+ market value of debtcash and investments

EV is often used when comparing

companies with significant difference incapital structure

EV/EBITDA where EBITDA is a proxyfor operating cash flow is used verycommonly

Book ValueReflects the historical operating andfinancing decisions of its managementMarket ValueRepresents not only the historicaloperating and financing decisions butalso the collective assessment of thefuture cash flows of the company




Securities Markets& Equity investment

Well Functioning SecurityMarkets

Margin Purchases Margin Calls Forms of EMH

Timely, accurate informationLiquidityInternal Efficiency (Lowestpossible transaction cost)Informational (external)efficiency (prices rapidlyadjust to new information)

For Margin TransactionLeverage Factor= 1/ Margin percentageLevered Return = HPR* leverage Factor

Q. Investor purchase 100 shares of a stock for $55 pershare . 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 marginrequirement of 50%Ans.1. As a 100% cash (equity) transaction, the investorwould had a return equal to $75,00/$5,500)1=36.36%2. With an initial margin of 50%, rest 50% equity in thisposition would be borrowed from the brokerage firm. If theshares were then sold at $75 per share, the position wouldbe worth $4,750(i.e.7,500 - $2,750). In this situation, theinvestor would have return equal to: ($4,750/$2,750)-1=72.72%

Types of Orders Companys sensitivity to theBusiness Cycle




Margin call triggers pricesMargin 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 is60% & the maintenance margin requirement is 20%, at which price will you get amargin callAns.$20(1-0.6)/(1-0.2) = $10



Margin Purchases Margin Calls Forms of EMHTypes of Orders Companys sensitivity to theBusiness Cycle




Market order:

Order placedat currentmarket rate

Limit order:

Order can onlybe executed atthe limit priceor lower for buyorder

Market if touched

order: order whichis executed as amarket order whena pre-specifiedprice is reached

Stop loss order:Order to buy orsell a stock oncethe price of thestock reaches aspecified price

Discretionary

order: marketorder whoseexecution maybe delayed atthe brokersdiscretion

Time-of-day

order: orderwhich isexecuted at aparticularperiod of day

Open order:

order which is ineffect untilexecuted or untilthe end of thetrading

Fill-or-kill

order: orderthat must beexecutedimmediately ornot at all







Weak form: Currentstock prices fullyreflect availablesecurity market info.Volume info/ pastprice dont relate tofuture direction of

security prices.Investor cant achieveexcess returns usingtech analysis

Semi-strong form:Security pricesinstantly adjust tonew publicinformation. Investorcant achieveabnormal returns

using fundamentalanalysis

Strong form: Stockprices fully reflect allinformation from public &private sources.Assumes perfectmarkets in which allinformation is cost free &

available to everyone atthe same time. Even withinside info, investor cantachieve excess returns

CyclicalProfits strongly correlated with thestrength of the overall economyDefensive/Stable

Revenues and profits are least affectedby fluctuations in overall economicactivityGrowthInclude industries with specific demanddynamics that are so strong that theyoverride the significance of broadeconomic or other external factors






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Question 1

All of the following are characteristics of a good market except

A. Information asymmetryB. Price Continuity

C. Internal Efficiency




Answer 1

A.

Characteristics of a good market include a) information symmetry b) price continuity c)internal efficiency.




Question 2

Cluster analysis groups companies:

A. Operating in the same regionB. Having correlated returns

C. In the same industry




Answer 2

B

Cluster analysis is done by grouping companies whose past returns correlations arehigh




Question 3

An investor buys 100 shares of a company at 50% margin for $42. The shares fall to

$35 in the next few days. What is his rate of return on the investment? Instead if thestock had risen to $50 what will be his rate of return

A. -16.67%; 19.05%

B. -33.33%; 38.10%

C. -33.33%;19.05%




Answer 3

B.

The cost of the purchase will be $42 * 100 = $4,200 since the investor has a 50%margin, his equity will be $2,100. When the stock rises to $50. The value of his equitywill be $2,900 giving him a return of 38.10%. If the stock falls to $35 his equity falls to$1,400 and he has a negative return of -33.33%.




Question 4

The correlation between US Investment grade bonds and Emerging Markets and

between S&P 500 and Russell 3000 is most likelyUS Investment Grade vs. Emerging Markets S&P 500 vs. Russell 3000

A. Low Low

B. Low High

C. High Low



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Answer 4

B.

The correlation between US Investment-grade bonds and the emerging markets is verylow while the correlation between S&P 500 and the Russell 3000 will be very high.



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Question 5

The most likely classification for the following indices will be

Price Index Weighted IndexA. S&P 500 Dow Jones

B. S&P 500 NikkeiDJ

C. Dow Jones S&P 500



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Answer 5

C.

The Dow Jones is a price index while the S&P 500 is a value-weighted index



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Question 6

The price of stock XYZ fell from $100 to $20. Stock XYZ was a constituent of an index

but after the stock fall, its market cap reduced many folded and thus needed to bereplaced in the index. Which of the following must take place for companys XYZ to bereplaced by companys ABCs stock?

A. Rebalancing

B. Reconstitution

C. Both Rebalancing and ReconstitutionThis files has expired at 30-Jun-13


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Answer 6

C.

Not only the constituents of the index must change, but their weights as well



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Question 7

An investor makes the following statement, While testing the weak-form of EMH the

returns from a trading rule must be calculated excluding any transaction chargesbecause they tend to skew the returns when the returns are negative.

A.Correct. Transaction costs increase the losses when the returns are negative.

B.Incorrect. Transaction costs involved in implementing the trading rule should beincluded.

C.Incorrect. Transaction costs are public information and they should be included in

the calculations.This files has expired at 30-Jun-13


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Answer 7

B.

Transaction charges should be included while testing the weak-form hypothesis.



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Question 8

An investor who does not have access to superior analyst should least likely

A. Invest in mid cap stocksB. Diversify the portfolio

C. Minimize transaction costs



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Answer 8

A.

An investor without superior analysis skills should diversify and minimize thetransaction costs.



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Question 9

Corporate insiders, professional money managers and stock exchange specialists are

most likely to be tested for which form of the EMHA. Strong-form Hypothesis

B. Semi-strong form Hypothesis

C. Weak form Hypothesis



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Question 9

A.

Corporate insiders, professional money managers, security analysts and stockexchange specialist represent a group of investors who represent the strong-form ofEMH. They have information which might not be available to the lay investor and themeans to act on it.



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Question 10

Karen makes the following statementA stock with a relatively low PEG will

experience above- average rates of return as compared to a stock with relatively higherPEG ratio.

She also states thatThe risk-adjusted returns for smaller firms are greater than forlarger firms. She is most likely correct regarding

PEG ratio Small-firm

A. Correct Correct

B. Incorrect IncorrectC. Incorrect Correct



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Answer 10

A.

Karen is correct regarding both the statements.



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Question 11

Capital Markets are not always efficient. The least likely reason for a market to be fully

efficient isA. Cost of Information

B. Costs of Trading

C. Cost of Insider Information



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Answer 11

C.

The limitations for capital markets to be completely efficient areA. Cost of information

B. Cost of trading and

C. Limits of arbitrage.



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Question 12

Karen and Carl are arguing on the limitations of arbitrage opportunities. Karen states

that arbitrageurs are agents. They manage other peoples money; hence they may belimited by their mandates and so may not be able to take advantage of every arbitrageopportunity. Carl states that arbitrageurs are never limited by the amount of capital thatthey can invest in a mispricing. Both of them are most likely

A. Both the statements are correct

B. Only one statement is correct

C. Both the statements are incorrectThis files has expired at 30-Jun-13


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Answer 12

B.

Arbitrageurs are limited by the amount of money that they can invest in an anomaly. Ina rising market investors want to take advantage of the available opportunity ratherthan searching for mispricing that may give small returns.



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Question 13

Ashley Williams argues that in Neo-Classical growth theory the long-term growth rate

of GDP depends upon the savings rate. However Wayne Brady states that accordingto the neo-classical theory the long-term level of GDP depends on the countrys savingrate. Ashley and William are respectively

Ashley Wayne

A. Correct Incorrect

B. Incorrect Correct

C. Incorrect IncorrectThis files has expired at 30-Jun-13


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Answer 13

B.

The Neo-classical growth theory states that the long-term level of the GDP depends onthe countrys saving rate but the growth rate of GDP is independent of the countryssaving rate.



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Question 14

Zadobe Corp. has sustained modest but rapidly increasing growth rates. It also hasshown high profit margins as it has very few competitors in the industry. Bulsoft Inc.has high growth rates but these rates are stagnating. It is also facing increasedcompetition from new competitors and price cutting due to increased capacity. Both thecompanies respectively are most likely in which stage of the industry cycle.

Zadobe Corp Bulsoft Inc.

A. Mature Stage Growth Stage

B. Shakeout Stage Mature stageC. Growth stage Shakeout stage



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Answer 14

C.

Zadobe is in a rapidly accelerating hence in growth stage while Bulsoft is in ashakeout stage.



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Question 15

According to Porter if a company is maintaining industry leadership through cost cuttingand low-cost production. The company is most likely following which of the followingcompetitive strategies

A. Cost leadership

B. Differentiation

C. Focus



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Answer 15

A.

A company following a cost-leader ship strategy is trying to capture the market sharethrough cost-cutting.



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Question 16

The following two statements most likely represent which of Porters five forces thatshape an industry:

Statement 1: Defense contractors require very specific components in their hardware.There are very few companies who can provide the components with the requiredspecifications.

Statement 2:The brokerage industry is very competitive. New players are alwaysentering the industry and there are very low exit costs.

Statement 1 Statement 2A. Supplier Power Competitors

B. Buyers Power Substitutes

C. Supplier Power New Entrants



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Answer 16

C.

The defense industry is an example of suppliers power due to its stringentspecifications. Statement 2 gives an example of the threat of new entrants to theprofitability of incumbents in the industry.



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Question 17

An analyst states that, A cyclical stock is a high beta stock while a cyclical company isgreatly influenced by the economy. These are generally commodity stocks. Theanalyst is most likely

A. Correct regarding both the statements

B. Correct regarding only one statement

C. Incorrect regarding both the statements



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Answer 17

A.

Both the statements are correct.



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Question 18

In the country of Silverland drug chains have grown at a very high rate for the last fiveyears. However during the last few quarters aggressive price cuts have reduced profitmargins. However the industry is expected to consolidate and prices are expected tostabilize. The industry is most likely

A. Pioneering

B. Mature

C. Declining



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Answer 18

B.

In a mature industry profits are squeezed and the industry is consolidating with stableprices.



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Question 19

The value of the preferred stock of Company A is $92.45. If the dividend is $7.5 peryear. The promised yield is closest to

A. 8.15%

B. 8.11%

C. 8.25%



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Answer 19

B.

Promised Yield = Dividend / Price = $7.5 / $92.45 = 8.11%.



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Question 20

Equity valuation can be approached through two techniquesDiscounted Cash Flowand Relative Valuation. The closest classification of the various techniques

DCF Relative Valuation

A. P/CF P/E

B. P/S PV of Operating CF

C. PV of FCFF P/BV



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Answer 20

C.

Free Cash Flow to the Firm is a DCF approach to valuation while Price to Book Valueis a Relative Valuation technique.



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Question 21

Company A reinvests all of its retained earnings in the business. The companymanagement believes that this is the most appropriate source of funding as it keepsleverage low which can be very beneficial in a cyclical industry. The least likely methodof analyzing the company

A. Dividend Discount Model

B. Price to Earnings model

C. PV of Free CF to Equity



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Answer 21

A.

DDM models are used for companies which make regular dividend payments with afixed dividend payout ratio.



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Question 22

Ashley an analyst with a broking firm makes the following statement, The relativevaluation technique is useful while comparing companies that are similar in terms ofindustry, size and risk. However a DDM model can also be used for companies that donot pay dividends during a high growth period, but otherwise pay regular dividends.She is most likely

A.Correct regarding the DDM model but incorrect regarding the relative valuationtechnique.

B.Correct regarding both the DDM model and the relative valuation technique.C.Correct regarding the relative valuation technique but incorrect regarding the DDM

model.



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Answer 22

C.

DDM models can only be used for companies with regular payout ratios.



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Question 23

Company A pays 50% of its earnings to its shareholders. Their ROE is 20% while therequired rate of return is 14%. Next years earnings are $4. The value of their stock isclosest to

A. 200

B. 50

C. 100



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Answer 23

B.

Constant growth rate(g) = ROE*Payout ratio = 0.20*0.5 = 0.10Next Years dividend (D1)= 4*.5 =2

Required rate (k)=14%

P = D1/(k-g)

= 2/(0.14-0.10)

= 50 This files has expired at 30-Jun-13


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Question 24

An analyst has gathered some information about stock, which is provided below:

Expected market returns: 15%Risk free rate: 8%

Beta of the stock: 1.13

Current market price: Rs 75

9 month price target: Rs 87

Which of the following is most likely to be true about stock valuation?

A. Stock is undervalued

B. Stock is overvalued

C. Stock is fairly valued



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Answer 24

A.

The correct answer is Stock is undervaluedKe=8%+1.13*(15%-8%) = 15.9% for 1 year

Interest rate for 9 months = 15.9 *0.75 = 11.93%

V0=87/1.1193

= 77.73


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