A Complete Guide to the CFA Equity Investments Topic
Of the many degrees and credentials a financial professional can hold, the designation of CFA charterholder could be considered the ‘gold standard.’ Many candidates even waive graduate school in favor of the CFA exams due to the rigorously focused Candidate Body Of Knowledge (CBOK) that must be learned to pass all three levels. Though the exams get more difficult, the opportunity for the self-development of investment skills and knowledge is unparalleled by any equivalent qualification. But, let’s not mince words; it is hard.
The CFA Candidate Body Of Knowledge (CBOK) represents “the core knowledge, skills, and abilities generally accepted and applied by investment professionals globally.” This prestigious body of knowledge has been the collaborative work of thousands of investment professionals. And it has been continuously evolving since the original Institute of Chartered Financial Analysts (ICFA) began the CFA credentialing program in 1959.
CFA Study Sessions for All Levels
The outline for the three 2018 CFA Exam Study Sessions can be found in its full glory here. This article, though, is going to focus on the equity investment topics for the three different exams. We’ll take a look at how the core subject is broken down and weighted according to each CFA level.
CFA Level 1
Subject 6 of 10: Equity Investments
- A. Types of Equity Securities and Their Characteristics
- B. Equity Markets: Characteristics and Institutions
- C. Equity Market Indexes and Benchmarks
- D. Valuation of Individual Equity Securities
- E. Fundamental Analysis (Sector, Industry, Company)
- F. Equity Market Valuation and Return Analysis
- G. Equity Portfolio Management Strategies
Exam Weight: 10%
(CFAInstitute)
These core asset classes form the foundation of the equity investment study infrastructure which you will continue in Levels 2 and 3. Much of what you should take away from studying these areas includes equity investment calculation, portfolio construction, and being able to use security market indexes. At Level 1, you should also cover three of the main equity valuation approaches (these are present value, multiplier, and asset-based models).
CFA Level 2
Equity Valuation
Exam Weight: 15-25%
(CFAInstitute)
At Level 2, your studies need to include:
- Being able to use equity valuation skills to solve everyday problems
- Financial modeling including how to develop forecasts with balance sheets, income, and cash flow statements
- Being able to employ other analysis methods for calculating a firm’s intrinsic value (for the difference between market value and intrinsic value read my blog post here)
CFA Level 3
Equity Investments
Exam Weight: 5-15%
Portfolio Management and Wealth Planning
Exam Weight: 40-55%
(CFAInstitute)
As equity portfolio management is considered to play a pivotal role in achieving investment goals and success it weighs heavily in the final CFA exam. During your studies for this exam, you should be focusing on managing equity assets within an investment portfolio. You should also be adept at using the three major approaches (passive, active, and semi-active) to construct equity portfolios at this juncture.
Equity Valuation Models
As you can see, being able to practically handle equity valuation is crucial to CFA charterholder success—along with the requisite 48 months of “acceptable professional work experience.” (Check out my #1 study tip for the CFA exams here.)
There are three significant types of equity valuation models that you will need to wrap your head around over the course of your studies, these are:
- Present Value Models/Discounted Cash Flow (DCF) Models: These models estimate the value of an asset by its expected income stream. The asset’s price is calculated according to the sum of expected dividends (Dividend Discount Model (DDM)) or expected free cash flows (free-cash-flow-to-equity models).
- Multiplier Models/Market Multiple Models: These models determine an asset’s value according to the absolute or relative multiples of a company’s financial ratios. Price-earnings ratio is a popular multiple; others also include book value, sales, and cash flow per share. Other multiples are based on the enterprise value (EV), e.g., EV/EBITDA, EV/EBIT, and EV/ Unlevered free cash flow (UFCF). These multiples are common when valuing private firms.
- Asset-Based Valuation Models: These models estimate the fair value of a stock based on the calculation of a company’s assets minus its liabilities and preferred stock. As the company’s assets and liabilities will be at book value, analysts adjust these figures to a fair value. In theory, the final fair value of a business will be equal to the sum of the value of the company’s assets.
These are the essential methods you need to evaluate modern equity investments on both the CFA exam and in real-life. Many of the CFA exam questions will be on analyzing companies practically.
Here’s an example below:
A company’s ROE is 10%, and the required return on equity is 9%. Everything else remains the same.
If there is a decrease in a company’s payout rate, a stock’s value—estimated by the constant growth dividend discount model (DDM)—will most probably:
- A. Decrease
- B. Increase
- C. Either increase or decrease
Practice Makes Perfect
As the example question demonstrates, the exams test your practical equity valuation application to ensure you are able to choose the correct answer with the correct methodology. The CFA exam assesses what valuation methods you know such as DCF and DDM, as well multiple valuations including P/E and P/B. Without these skills, you will struggle. Get ahead and get equipped with the practical equity valuation know-how to achieve success on your CFA exams. (And don’t forget to check out my #1 study tip for passing the CFA exams here too!)
The A Stotz Investment Research Valuation Master Class provides full coverage of these methods in detail. The Valuation Master Class can aid you in:
- Understanding the mechanism and differences of the various valuation methods available to you
- Learning to evaluate a company using multiple valuation techniques
- Learning about valuation sensitivity to certain assumptions by using sensitivity analysis
The course encompasses all the practical knowledge and application you need for each of the three CFA exams. So, what are you waiting for? Sign up today to take your first step to becoming a Valuation Master.
Answer: Increase