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LEVEL 1 REVIEW EQUITIES

STUDY SESSION 13:

Study session 13 in the CFA Level 1 curriculum begins the material on equity investments with three readings (46-48) in equity
market structure and efficiency. The material is almost completely conceptual and any student of finance will already have seen it. If
you are new to the industry, spend a little time to get the vocabulary and concepts. The topic area is only worth about 10% of your
first exam but is extremely important in the other two tests.

Market Organization & Structure

This is almost entirely a vocabulary lesson on the market and participants. It is important that you know the information for general
knowledge but it is not as testable as some of the other readings. The key terms are good for flashcards with a quick rundown until
you’ve got them.

Understand how to calculate returns on leveraged positions, maintenance margin requirement and the margin call price. If a buyer
will receive a margin call when the value of equity drops below 25% of the maintenance margin requirement, with an initial stock
price of $20 leveraged with 60% margin: the margin call price is ($8 +Price – $20) / Price = $16

Pay special attention to the information on orders as you will need it for attribution analysis in the Level 3 exam and it is highly
testable in the first exam.

Security Market Indices

The differences and calculations for the indices (price-weighted, equal-weighted, market cap, and fundamentally-weighted) are
important information and have shown up on the exam. It’s really not difficult information, just understand how they are
constructed and how to calculate returns.

They construction and limitations of alternative asset indices shows up several times in the curriculum, so spend some time on this
section. Pay special attention to the possible biases within each index.

Market Efficiency

The efficient markets theory is a huge concept in the industry and for the exams. You do not necessarily need to know all the data
and details that support it, but you should know the implications of each level of efficiency. Understand what it means for technical
analysis and transaction costs in trading.

The Institute does not ask you to take a position on the efficient market hypothesis but regardless of how you believe the markets
behave, when you are taking the exam the curriculum is the ultimate truth. Know that there is considerable evidence supporting the
semi-strong form of efficiency and some evidence to support the strong form.

The list of market anomalies is testable vocabulary and can be fun to read through. Again, mostly a flashcard exercise until you can
recognize the terms and their basic idea.
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STUDY SESSION 14:

Study session 14 in the CFA Level 1 curriculum concludes the equity topic area with three readings (49-51) on valuation of equity
securities. The topic area is arguably one of the single most important in the entire curriculum. It is worth 10% of your Level 1 exam,
about 25% of your Level 2 test and 10% of your last exam. As with most of the curriculum throughout the first exam, you will need a
strong base to be able to move into deeper detail for the other exams.

Overview of Equity Securities

This is a very basic reading and almost entirely conceptual. Look for the list material and any comparisons with other types of
investments, i.e. the differences between debt and equity.

Understand the differences between common and preferred shares like: payment order of dividends, distribution of net assets in a
liquidation, and voting rights.

The characteristics of a depository receipt and the types of ADRs is important. You probably won’t need the full detail on types of
ADRs but remember that Level II and III are traded on the exchanges. Level I ADRs are subject to limited reporting requirements and
only trade on the OTC market. Regulation S depository receipts are not subject to registration requirements and are only privately
placed.

Understand the basic return and risk characteristics of equities, pay attention to standard deviation.

The material on ROE, the cost of equity and investors’ required rates of return is probably the most important in the reading. These
will be fundamental concepts across the three exams. Understand how to use the DuPont formula to analyze the sources of changes
in a company’s ROE.

Introduction to Industry and Company Analysis

I am struck with a sense of déjà vu because the same concepts reappear so many years. You will revisit industry and company
analysis in both the Level 2 and 3 exams. I know you are tired of studying and trying to find time as it is but spending a little extra
time on the Level 1 curriculum to absolutely master the material will pay off big time in the next two years.

Understand the differences between cyclical and non-cyclical companies like stability of demand for products/services and variability
in profits due to fixed costs. Understand the basic differences between the sectors, i.e. basic product category and demand stability.
If it helps, you might try looking at the fact sheet to the Select Sector SPDRs ETF funds which provide descriptions of each sector.
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Porter’s Five Forces Framework is something you will see again so you need to understand it in detail. Understand each of the five
forces and how it relates to industry analysis. Beyond the exam, the concept is pretty well known in the business world and you’ll
need to know it sooner or later.

Greater rivalry (competition) within the industry means lower profitability as companies compete on price and brand
identification.

The higher the threat of new entrants the lower profitability will be as companies lower prices to avoid attracting
competitors. Barriers to entry like high capital expenses or regulation important here.

The lower the threat of substitutes the higher the profitability as companies can exercise more control on prices. Pay
attention to switching costs for consumers.

Bargaining power of buyers is relative to the number of consumers and relative size of each for the product.

Bargaining power of suppliers is relative to the number of suppliers for an input and how easily it is to switch suppliers.
The Industry Life Cycle model is also pretty testable so understand the stages (embryonic, growth, shakeout, mature, and decline)
and characteristics of each.

Equity Valuation: Concepts and Basic Tools

Understand the differences and advantages/limitations of each of the three major categories of valuation models:

1) Present value or DCF models provide an intrinsic value estimate of the shares as the sum of future cash flows.

a) Understand the Gordon growth model and its assumptions, i.e. growth remains constant indefinitely, dividends grow at a
constant rate, and the growth rate is less than the required rate of return. A multi-stage DDM is necessary when growth is
not constant.
b) Pay attention to the FCFE model and how it can be used on non-dividend paying stocks

2) Market multiple models estimate value through a multiplier with earnings, sales, enterprise value or asset-values. These can be
applied on a trailing or forward basis.

a) These are fairly easy to understand but you need to know the limitations, i.e. the multiples are based on trailing (past) data
and may not be a good predictor of the future, the multiples reflect relative valuation compared to peers or the index but
not intrinsic value.
b) Understand the difference between the trailing multiple (past data) and the justified (forward) multiple which is based on
forecasted data.
Enterprise value is the market cap plus market value of preferred and debt minus any cash and short-term investments. It reflects
the real economic value of the company and is helpful when comparing companies with different capital structures.