CFA Level 1 — Equity

Intuition-First Study Guide · All 8 Readings

Every concept explained in plain English · Likely exam questions after every topic · Common traps flagged

Reading 39

Market Organization and Structure

How financial markets are built, why they exist, and the mechanics of trading — orders, margins, and short selling.

📌 Big Picture

This reading is foundational infrastructure. The CFA exam uses it to test whether you know how a real trade actually works — order types, margin calls, short selling P&L, and the difference between various market structures. The margin call calculation and short-selling profit formula are consistently tested numerically. Know them cold.

Functions of the Financial System Exam

The financial system serves six core functions that the exam may ask you to identify or categorise:

Function	What It Means	Example
Saving	Allow individuals to move wealth to the future	Purchasing Treasury bonds
Borrowing	Allow entities to move future income to the present	Corporate debt issuance
Raising equity capital	Companies sell ownership stakes for growth capital	IPO or rights offering
Risk management	Transfer risk to those willing to bear it	Buying put options, swaps
Price discovery	Markets aggregate dispersed information into prices	Stock exchange continuous trading
Liquidity provision	Allow assets to be converted to cash quickly	Market makers standing ready to trade

Market Types and Classifications Critical

Primary Market

New securities are sold for the first time. Proceeds go to the issuer. Examples: IPOs, seasoned equity offerings (SEOs), rights offerings, private placements.

Secondary Market

Previously issued securities trade between investors. Proceeds go to the seller, not the issuer. Provides liquidity and price discovery. Example: NYSE, NASDAQ.

Quote-Driven (Dealer) Markets

Dealers post bid and ask prices and stand ready to trade from their own inventory. Provides continuous liquidity. Example: OTC bond markets, FX dealers.

Order-Driven Markets

Buyers and sellers submit orders; a matching system pairs them. No dealer is required. Includes call markets (batch) and continuous markets. Example: most major equity exchanges.

Broker markets (agency markets) are distinct from dealer markets. A broker acts as an agent for a client and charges a commission — the broker does NOT take a position. A dealer takes a position and profits from the spread. Confusing agent vs principal is a classic exam trap.

Order Types Critical

Order Type	Execution Rule	Price Certainty	Execution Certainty
Market Order	Execute immediately at best available price	None — you get whatever the market gives	High (almost certain to fill)
Limit Order	Execute only at a specified price or better	High — worst price is your limit	Low (may not execute if price not reached)
Stop (Loss) Order	Becomes a market order once stop price is touched	None once triggered	Moderate
Stop-Limit Order	Becomes a limit order once stop price is touched	Partial (limit sets worst price)	Low (may not execute)
Marketable Limit Order	Limit set at or through current market price	Good — limit sets floor/ceiling	High

A buy limit order at $50 means: "I will buy, but only if I can get it at $50 or cheaper." A sell limit order at $55 means: "I will sell, but only at $55 or higher." Limit orders protect you from price but not from missing the trade. Stop orders protect you from price moves continuing against you — but once triggered, you're back to a market order and have no price guarantee.

🎯 Likely Exam Question

An investor places a sell stop order at $40 for a stock currently trading at $45. What happens if the price falls to $39?

The order is triggered at $40 and becomes a market sell order. It will execute at the best available bid, which could be $39 or lower — not necessarily $40. Stop orders do not guarantee execution at the stop price; they simply activate the order. If the ask falls through $40 with no trades exactly at $40 (gapping), execution might be at $38 or $37. This is why stop orders are imperfect for loss protection.

Margin Trading Critical

Buying on margin means borrowing from a broker to finance part of a purchase. The investor puts up equity (initial margin) and borrows the rest.

\[ \text{Leverage Ratio} = \frac{\text{Value of Position}}{\text{Equity}} = \frac{1}{\text{Initial Margin \%}} \]

\[ \text{Margin Call Price (Long)} = P_0 \times \frac{1 - \text{Initial Margin}}{1 - \text{Maintenance Margin}} \]

🎯 Likely Exam Question (Numerical)

An investor buys 200 shares at $50 on 40% initial margin. The maintenance margin is 25%. At what price will the investor receive a margin call?

Step 1: Margin call price = P₀ × (1 − Initial Margin) / (1 − Maintenance Margin)
= $50 × (1 − 0.40) / (1 − 0.25)
= $50 × 0.60 / 0.75
= $50 × 0.80 = $40.00

Verification: At $40, position = 200 × $40 = $8,000. Loan = 200 × $50 × 60% = $6,000. Equity = $8,000 − $6,000 = $2,000. Margin % = $2,000 / $8,000 = 25% = maintenance margin. ✓

Short Selling Critical

Short selling involves borrowing shares from a broker, selling them, hoping the price falls, then buying them back at a lower price to return to the lender.

\[ \text{Profit on Short} = P_{\text{short}} - P_{\text{cover}} - \text{Dividends Paid} - \text{Borrowing Costs} \]

\[ \text{Margin Call Price (Short)} = P_{\text{short}} \times \frac{1 + \text{Initial Margin}}{1 + \text{Maintenance Margin}} \]

🎯 Likely Exam Question (Numerical)

An investor shorts 100 shares at $80, with 50% initial margin and 30% maintenance margin. At what price will a margin call occur?

Margin call price = $80 × (1 + 0.50) / (1 + 0.30) = $80 × 1.50 / 1.30 = $80 × 1.1538 = $92.31

Intuition: the price RISES above the short price triggering a call — the short seller is losing money as the price climbs, and the broker wants more equity to cover the exposure.

Short sellers must pay any dividends declared on the borrowed shares to the lender. So if a stock pays a $2 dividend while you are short, your P&L is reduced by $2 per share. Forgetting to subtract dividends from short-selling profit is a common mistake.

Market Characteristics and Execution Quality

Good markets have five key characteristics:

Liquidity — the ability to trade in size quickly without large price impact
Transparency — pre-trade (quotes) and post-trade (transactions) information available
Assurity of completion — confidence that a counterparty will settle
Operational efficiency — low transaction costs (commissions, spreads, market impact)
Informationally efficient — prices reflect all available information (leads into Reading 41)

Reading 40

Security Market Indexes

How indexes are built, what they measure, and why the weighting method changes everything.

📌 Big Picture

Index construction is a surprisingly deep topic. The CFA exam regularly tests your ability to calculate index returns under different weighting methods, and to identify the biases of each. Price-weighted and equal-weighted calculations appear most often numerically. Know the differences, their advantages, disadvantages, and what type of bias each introduces.

Index Weighting Methods Critical

Method	Weight Determined By	Key Bias / Flaw	Example
Price-Weighted	Share price (higher price = higher weight)	Biased toward high-priced stocks, not high-value companies. Stock splits distort the index.	DJIA, Nikkei 225
Equal-Weighted	Same weight for every stock	Biased toward small caps (requires constant rebalancing). Over-rebalancing costs.	Value Line Index
Market-Cap Weighted	Market capitalisation (price × shares)	Overweights overvalued stocks (momentum bias). Most popular method.	S&P 500, MSCI
Float-Adjusted Market Cap	Free-float market cap (exclude insider/strategic holdings)	Slightly reduced momentum bias vs full market cap	Most modern global indexes
Fundamental-Weighted	Fundamental metrics (earnings, book value, dividends, revenue)	Value tilt; no momentum bias. More complex to maintain.	FTSE RAFI indexes

\[ \text{Price-Weighted Index} = \frac{\sum P_i}{\text{Divisor}} \]

\[ \text{Market-Cap Weighted Return} = \sum w_i \times R_i \quad \text{where } w_i = \frac{P_i \times Q_i}{\sum P_j \times Q_j} \]

🎯 Likely Exam Question (Numerical)

A price-weighted index has three stocks: Stock A ($60), Stock B ($30), Stock C ($10). The divisor is 3. What is the index level? If Stock A then splits 2-for-1, what is the new divisor to maintain the same index level?

Initial index = ($60 + $30 + $10) / 3 = $100 / 3 = 33.33

After 2-for-1 split, Stock A price = $30. New sum = $30 + $30 + $10 = $70.
New divisor = $70 / 33.33 = 2.10 (rounded)

This is why the DJIA's divisor is a small decimal number (currently around 0.15) — decades of adjustments for splits and changes have eroded it.

Index Rebalancing and Reconstitution

Rebalancing

Adjusting weights back to target weights. Equal-weighted indexes require frequent rebalancing (after any price change, weights drift). Market-cap-weighted indexes self-rebalance (weights change automatically with prices).

Reconstitution

Adding/removing securities from the index based on criteria (market cap, liquidity, sector). Causes price pressure on additions (everyone must buy) and selling pressure on deletions. Creates an "index effect."

Types of Indexes Exam

Indexes exist for virtually every asset class. The exam may test whether you can identify which index type is most appropriate for a given purpose:

Index Type	What It Measures	Unique Feature
Equity	Stock market performance by region/sector/style	Style indexes: growth vs value; market cap: large/mid/small cap
Fixed Income	Bond market returns	More complex: must handle maturity, coupons, and credit quality changes
Commodity	Price changes of raw materials	Usually futures-based (not spot); roll yield is a component of return
Real Estate	Property market returns	REIT indexes are liquid; appraisal-based indexes are lagged and smoothed
Hedge Fund	Alternative manager performance	Self-reporting bias, survivorship bias; not investable benchmarks

Hedge fund index data suffers from survivorship bias (failed funds aren't in the index) and self-selection bias (only funds that want to report do so). Hedge fund indexes overstate average performance. This is a classic exam trick question.

Uses of Security Market Indexes

Gauges of market sentiment — broad market direction
Proxies for market portfolio — used in CAPM as the market portfolio
Benchmarks for portfolio performance — active managers compared to index
Model portfolio for index funds/ETFs — passive investing vehicles
Measure of systematic risk (beta) — regression of stock returns vs index returns

Reading 41

Market Efficiency

When do prices already "know" everything? The three forms, anomalies that challenge them, and what it all means for investors.

📌 Big Picture

Market efficiency is one of the most conceptually tested topics in equity. The exam rarely asks you to calculate anything here — instead it tests whether you can correctly identify which form of efficiency is violated by a scenario, whether a strategy can earn excess returns in a given market, and how behavioral finance anomalies challenge the EMH. Know the three forms and their tests cold.

The Efficient Market Hypothesis (EMH) Critical

The EMH states that security prices fully reflect all available information. In an efficient market, no investor can consistently earn risk-adjusted excess returns (i.e., alpha) using that information set.

Form	Information Reflected in Prices	What Doesn't Work	What Can Still Work
Weak Form	All past market data (prices, volume, trading patterns)	Technical analysis (chart reading)	Fundamental analysis, insider info
Semi-Strong Form	All publicly available information (incl. financial statements, news, macro data)	Technical analysis + Fundamental analysis	Insider information (trading on it)
Strong Form	All information — public AND private (insider)	Everything, including insider trading	Nothing — no one can outperform

Think of efficiency like an information funnel. Weak form: prices already reflect the past. Semi-strong: prices already reflect the past AND today's news. Strong form: prices reflect even what the CEO whispers over dinner. Most real markets are somewhere between weak and semi-strong. Strong form is mostly a theoretical benchmark.

Tests of Market Efficiency Exam

Form Being Tested	Test / Evidence	Result
Weak Form	Serial correlation tests (autocorrelation of returns)	Generally no significant autocorrelation — supports weak form efficiency
Weak Form	Filter rules / technical trading rules	After transaction costs, technical strategies do not consistently outperform
Semi-Strong	Event studies (earnings announcements, M&A)	Prices adjust rapidly — no sustained drift after most events (supports semi-strong)
Semi-Strong	Mutual fund performance persistence	Most actively managed funds underperform after fees — supports semi-strong
Strong Form	Insider trading studies	Corporate insiders DO earn excess returns — strong form does NOT hold

Market Anomalies (Challenges to EMH) Critical

Anomaly	Description	CFA Explanation / Caveat
Calendar Effects	January Effect (small caps outperform in Jan); Day-of-week effects	May be data-mined; largely disappears after publication
Momentum Effect	Recent winners tend to outperform in the short run (3–12 months)	Risk-based explanation? Or behavioral overconfidence?
Value Effect	Low P/E, low P/B stocks outperform growth stocks long-term	Could be compensation for higher risk (distress risk) — not necessarily a market inefficiency
Small-Cap Effect	Small-cap stocks outperform large-caps historically	Partly explained by higher liquidity risk and data mining
Overreaction / Reversal	Extreme past losers outperform over 3–5 years (long-run reversal)	Behavioral: investors overreact to bad news, creating cheapness
Post-Earnings Drift	Stocks drift after earnings surprises for weeks/months	Strong challenge to semi-strong efficiency

The CFA curriculum distinguishes between genuine anomalies and findings that may simply reflect: (1) inadequate adjustment for risk, (2) data mining/snooping bias, (3) transaction costs that eliminate the profit, or (4) anomalies that disappear after publication. Don't assume all "anomalies" refute the EMH — the exam tests this nuance.

Behavioral Finance and Biases

Behavioral finance explains why investors behave irrationally and why prices can deviate from fundamental value. Key biases tested:

Bias	Description	Market Effect
Loss Aversion	Losses felt more painfully than equivalent gains	Disposition effect (hold losers, sell winners)
Overconfidence	Investors overestimate their own ability	Excessive trading, momentum
Representativeness	Extrapolate recent patterns as if permanent	Overreaction, momentum, then reversal
Anchoring	Over-weight initial price/value reference points	Slow price adjustment to new information
Herding	Follow the crowd even against private information	Bubbles and crashes
Availability Bias	Weight recent or memorable events too heavily	Overpricing of recently salient stocks

🎯 Likely Exam Question

A portfolio manager announces that she uses a strategy based on past price patterns to identify stocks to buy. Under which form of market efficiency would her strategy be expected to generate excess returns?

Neither semi-strong nor strong form. Her strategy could only generate excess returns if markets are not even weak-form efficient. Since weak form efficiency states that past price data is already reflected in prices, technical analysis based on price patterns has no edge in a weak-form efficient market. The correct answer is: her strategy would only work in a market that is not even weak-form efficient.

Reading 42

Overview of Equity Securities

What equity actually is, every flavour of share type, how private equity works, and the real link between ROE and stock value.

📌 Big Picture

This reading is the definitional foundation of the equity section. The exam tests whether you know the exact features of different share types — especially preference shares — and can distinguish them. Convertible vs callable vs putable preference shares are a favourite test target. The return components and ROE decomposition are also high-probability exam topics.

Common Shares (Ordinary Shares) Exam

Common shares represent a residual claim on a company's assets and earnings after all other obligations are settled. Key features:

Voting rights — elect the board; one vote per share (statutory voting) or cumulative voting (concentrate votes on one director candidate)
Residual claim — last in line in liquidation (after creditors and preference shareholders)
Limited liability — maximum loss is the amount invested
Participation in earnings — dividends at board discretion; no guaranteed payment

Statutory Voting

Each share gets one vote per director position. E.g., 100 shares voting on 3 directors = 100 votes per seat. Favours large shareholders.

Cumulative Voting

Shares × seats = total votes, which can be concentrated on one candidate. E.g., 100 shares × 3 seats = 300 votes on one director. Favours minority shareholders.

Preference Shares (Preferred Stock) Critical

Preference shares have a fixed dividend claim ahead of common shares, but no voting rights. They sit between debt and equity in the capital structure. The exam heavily tests the various types:

Type	Key Feature	Who Benefits
Cumulative	Missed dividends accumulate; must be paid before any common dividend	Investor — protects against deferred dividends
Non-Cumulative	Missed dividends are lost permanently; no back-pay obligation	Issuer — not on the hook for missed payments
Participating	Receives fixed dividend PLUS shares in residual earnings if common dividend exceeds a threshold	Investor — upside participation
Convertible	Can be converted into common shares at a preset conversion ratio	Investor — captures equity upside
Callable	Issuer can redeem at a preset price before maturity	Issuer — can refinance if rates fall
Putable	Investor can force redemption at a preset price	Investor — downside protection

Convertible preference shares are like a bond with an equity option embedded. When the stock price rises above the conversion price, the preference share value is driven by the common share price. When the stock falls below, the preference share behaves like a bond. This is the classic "floor + participation" structure.

Preference shares are NOT debt — they are equity on the balance sheet. Dividends on preference shares are paid from after-tax earnings (unlike interest on debt, which is tax-deductible). Classifying preference share dividends as "interest expense" is a common mistake.

Private Equity Exam

Equity securities that are not listed on public exchanges. The main forms:

Stage	Type	Description
Startup / Early	Venture Capital (VC)	Funding for early-stage companies with high growth potential; high risk, high potential return; illiquid
Growth / Mature	Private Equity (PE)	Buying established companies (often via LBOs), improving operations, then exiting via IPO or sale
Distressed	Distressed Investing	Buying debt or equity of troubled companies at steep discounts; complex restructuring expertise required

Private equity investors can't just sell on an exchange when they want to exit. They need a planned exit strategy — typically an IPO, a sale to a strategic buyer (trade sale), or a secondary buyout (sell to another PE firm). This illiquidity is why PE investors demand a return premium over public equity.

Return Components of Equity Formula

\[ \text{Total Return} = \text{Dividend Yield} + \text{Capital Gains Yield} \]

\[ \text{Total Return} = \frac{D_1}{P_0} + \frac{P_1 - P_0}{P_0} \]

\[ \text{Book Value per Share} = \frac{\text{Total Equity} - \text{Preference Equity}}{\text{Common Shares Outstanding}} \]

\[ \text{Return on Equity (ROE)} = \frac{\text{Net Income}}{\text{Average Book Value of Equity}} \]

ROE is the engine of value. If a company earns a high ROE and retains earnings, book value grows faster. A company trading above book value (P/B > 1) implies the market expects ROE to exceed the required return on equity. A company with ROE below its cost of equity destroys value even if it's profitable in accounting terms.

Depository Receipts

Allow investors to buy shares of foreign companies in their domestic market. Types:

ADR (American Depositary Receipt) — foreign shares held by a US custodian bank; trades in USD on a US exchange
GDR (Global Depositary Receipt) — similar, but listed on multiple global exchanges
Sponsored ADR: company participates and must meet SEC disclosure; Unsponsored: bank creates it without company involvement

Reading 43

Company Analysis: Past and Present

How to read a company's history, assess its business model, and decompose profitability to identify the real drivers of value.

📌 Big Picture

This reading is about being a financial detective. The exam tests your ability to use financial ratios, DuPont decomposition, and qualitative business model assessment to evaluate a company. The 3-factor and 5-factor DuPont decompositions are high-priority formula targets. Understanding how leverage amplifies (or destroys) ROE is critical for both this reading and valuation in R46.

Business Model Analysis

Before diving into numbers, analysts assess the business model: how does this company create and capture value?

Revenue model: subscription, transactional, licensing, asset-based, service?
Pricing power: can the company raise prices without losing customers? (brand moat, switching costs)
Cost structure: fixed vs variable costs determines operating leverage
Capital intensity: how much investment is needed to generate $1 of revenue?
Competitive position: is growth profitable (high ROIC) or does competition erode margins?

Revenue Analysis

Revenue growth can be decomposed into three drivers:

\[ \text{Revenue Growth} = \underbrace{\text{Volume Growth}}_{\text{units sold}} + \underbrace{\text{Price Growth}}_{\text{pricing power}} + \underbrace{\text{Mix Effects}}_{\text{product mix shifts}} \]

A company growing revenue 10% via price increases is fundamentally different from one growing 10% via volume. Price-driven growth signals pricing power and often improves margins. Volume-driven growth may compress margins if unit economics are thin. The exam won't calculate this formula, but conceptual questions about revenue quality are common.

DuPont Decomposition Critical

DuPont breaks ROE into components to identify what is really driving returns. The 3-factor decomposition is most tested:

\[ \text{ROE} = \underbrace{\frac{\text{Net Income}}{\text{Sales}}}_{\text{Net Profit Margin}} \times \underbrace{\frac{\text{Sales}}{\text{Assets}}}_{\text{Asset Turnover}} \times \underbrace{\frac{\text{Assets}}{\text{Equity}}}_{\text{Financial Leverage}} \]

The extended 5-factor DuPont separates the tax burden and interest burden from profit margin:

\[ \text{ROE} = \underbrace{\frac{\text{Net Income}}{\text{EBT}}}_{\text{Tax Burden}} \times \underbrace{\frac{\text{EBT}}{\text{EBIT}}}_{\text{Interest Burden}} \times \underbrace{\frac{\text{EBIT}}{\text{Sales}}}_{\text{EBIT Margin}} \times \underbrace{\frac{\text{Sales}}{\text{Assets}}}_{\text{Asset Turnover}} \times \underbrace{\frac{\text{Assets}}{\text{Equity}}}_{\text{Leverage}} \]

🎯 Likely Exam Question

Company A has ROE = 18%. Its net profit margin is 9%, and asset turnover is 1.2×. What is its financial leverage multiplier?

ROE = Net Profit Margin × Asset Turnover × Leverage
18% = 9% × 1.2 × Leverage
Leverage = 18% / (9% × 1.2) = 18% / 10.8% = 1.67×

This means the company has $1.67 of assets for every $1 of equity — or debt/equity = 0.67×. If ROE were only 10.8% without leverage, the company is using financial leverage to boost equity returns from 10.8% to 18%.

A high ROE driven entirely by high leverage is a warning sign, not a strength. If the company earns returns below its cost of debt, leverage destroys value. Always decompose ROE — a 25% ROE driven by 5× leverage is very different from a 25% ROE driven by a 20% margin.

Quality of Earnings

The exam may ask you to identify characteristics of high vs low earnings quality:

Characteristic	High Quality	Low Quality / Red Flag
Accruals	Net income closely tracks operating cash flow	Large positive accruals (earnings >> cash flow)
Revenue recognition	Conservative, matches delivery of goods/services	Aggressive: recognised before delivery, channel stuffing
Expense recognition	Expensed promptly and conservatively	Capitalised to delay expense recognition
Non-recurring items	Rare, clearly disclosed, genuinely one-time	Repeated "one-time" restructuring charges every year
Cash conversion	High operating cash flow / net income ratio	Low OCF / NI — earnings not being converted to cash

Segment Analysis

For multi-segment companies, analyse each business unit separately: margins, growth rates, capital intensity, and competitive position may differ dramatically by segment. The exam may ask you to identify which segment drives most of the value or risk.

Reading 44

Industry and Competitive Analysis

Why the industry you're in matters as much as how well you run your company — Porter's Five Forces, the industry life cycle, and competitive positioning.

📌 Big Picture

This is one of the most conceptual equity readings. The exam tests whether you can apply Porter's Five Forces to a given scenario, identify where an industry is in its life cycle, and understand what external factors shape profitability. Life cycle stage identification and Five Forces application are the two most common exam question formats here.

Industry Classification Systems

The CFA curriculum notes several industry classification approaches:

GICS (Global Industry Classification Standard) — developed by MSCI and S&P; 11 sectors → 24 industry groups → 69 industries → 158 sub-industries. Most widely used.
ICB (Industry Classification Benchmark) — developed by FTSE Russell; 11 industries → 20 supersectors → 45 sectors → 173 subsectors.
Cyclical vs Defensive: Cyclical industries (autos, materials) are sensitive to economic cycles. Defensive/non-cyclical (utilities, consumer staples) are relatively insensitive.

The Industry Life Cycle Critical

Stage	Growth Rate	Profitability	Competition	Investment Needed	Examples
Embryonic	Slow (product not yet proven)	Low/negative	Few early movers	Very high	Early electric vehicles (2010s), lab-grown meat
Growth	Rapid	Rising	Increasing but dominated by a few	High	Cloud computing (2010s), EVs now
Shakeout	Slowing	Declining (price wars)	Intense; weak players exit	Moderate	Streaming services, smartphones
Mature	GDP-like or below	Stable but modest	Moderate (consolidated oligopoly)	Low (maintenance capex)	Commercial banking, soft drinks
Decline	Negative	Low/contracting	Reducing (players exit)	Minimal (harvesting)	Print newspapers, landlines, CD manufacturing

The shakeout stage is particularly important for investors. It's where the most value can be created (by picking the survivors) or destroyed (by picking the loser). The transition from growth to shakeout is often triggered by overcapacity — too many players entered during the growth phase, and price competition compresses margins until the weak exit.

Porter's Five Forces Critical

Michael Porter's framework identifies five forces that determine industry-level profitability. The exam frequently asks you to apply these to a given scenario and judge whether they make an industry more or less attractive:

Force	What It Captures	HIGH force = ?	Key Drivers
1. Rivalry Among Existing Competitors	Price/quality competition between current players	Lower profitability	# competitors, growth rate, product differentiation, exit barriers, capacity utilisation
2. Threat of New Entrants	How easily new competitors can enter	Lower margins (competitive pressure)	Capital requirements, economies of scale, brand loyalty, regulatory barriers, switching costs
3. Threat of Substitutes	Alternative products that meet the same need	Caps pricing power	Relative price-performance of substitutes, switching costs, buyer propensity to substitute
4. Bargaining Power of Buyers	Customers' ability to demand lower prices	Compresses margins	Concentration of buyers, purchase volume, switching costs, buyer's price sensitivity
5. Bargaining Power of Suppliers	Suppliers' ability to raise input costs	Compresses margins	Concentration of suppliers, uniqueness of input, switching costs, forward integration threat

🎯 Likely Exam Question

A pharmaceutical company sells a patented drug with no close substitutes. Its customers are large hospital chains that purchase in bulk. Which Porter force most significantly threatens the company's profitability?

Bargaining power of buyers. Despite the strong patent protection (low threat of substitutes, high entry barriers), the concentration of buyers (large hospital chains buying in bulk) gives them significant negotiating leverage to demand discounts. High buyer concentration with large purchase volumes is the textbook driver of high buyer bargaining power.

Competitive Positioning: Cost vs Differentiation

Cost Leadership Strategy

Compete on being the lowest-cost producer. Works when: commodity-like products, price-sensitive customers, high economies of scale. Risk: technology disruption that erases cost advantage.

Differentiation Strategy

Compete on unique features, brand, or quality that justify a price premium. Works when: customers value uniqueness, switching costs are high. Risk: competitor imitation, price-sensitive downturn.

External Factors: PEST Analysis

Political/Regulatory: government regulation, trade policy, antitrust enforcement
Economic: GDP growth, interest rates, inflation, credit availability
Social/Demographic: aging population, urbanisation, consumer preferences
Technological: disruption risk, R&D intensity, automation, digitisation

Reading 45

Company Analysis: Forecasting

Building financial models — how to project revenue, margins, capital needs, and earnings from first principles.

📌 Big Picture

This reading is where qualitative analysis gets translated into numbers. The exam focuses on understanding the mechanics and limitations of different forecasting approaches, operating leverage, and the relationship between revenue growth, margins, and free cash flow generation. Operating leverage calculations (DOL) are the most quantitatively tested item here.

Top-Down vs Bottom-Up Forecasting Exam

Top-Down Approach

Start with macro forecasts (GDP, industry growth) → estimate market share → derive company revenue. Ensures macro consistency but may miss company-specific drivers.

Bottom-Up Approach

Start with individual product/segment revenue drivers → build up from first principles. Captures company-specific dynamics but may miss macro turning points.

Revenue Forecasting Methods

Method	How It Works	Best Used For
Growth Rate Extrapolation	Apply historical or consensus growth rate to current revenue	Stable, mature companies
Market Share Approach	Forecast total market × expected market share	Growth industries with reliable market data
Regression Analysis	Relate revenue to economic variables (GDP, commodity prices)	Cyclical companies with clear macro links
Capacity-Based	Capacity × utilisation rate × selling price per unit	Capital-intensive industries (airlines, utilities)

Operating Leverage Critical

Operating leverage measures how sensitive operating income is to changes in revenue. It arises from fixed costs — the more fixed costs, the higher the operating leverage.

\[ \text{Degree of Operating Leverage (DOL)} = \frac{\% \Delta \text{Operating Income}}{\% \Delta \text{Sales}} \]

\[ \text{DOL} = \frac{Q(P - V)}{Q(P - V) - F} = \frac{\text{Contribution Margin}}{\text{Operating Income}} \]

Where Q = quantity, P = price per unit, V = variable cost per unit, F = fixed costs.

🎯 Likely Exam Question (Numerical)

A company has revenue of $1,000, variable costs of $600, fixed costs of $250, and operating income of $150. What is its DOL? If sales increase 10%, what is the expected change in operating income?

Contribution Margin = Revenue − Variable Costs = $1,000 − $600 = $400
DOL = Contribution Margin / Operating Income = $400 / $150 = 2.67×

If sales increase 10%: % Δ Operating Income = DOL × % Δ Sales = 2.67 × 10% = 26.7%
New operating income = $150 × 1.267 = $190

Intuition: the company's fixed costs act as "leverage" — a 10% revenue gain amplifies to a 26.7% operating income gain. The downside is symmetric: a 10% revenue decline → 26.7% operating income decline.

High operating leverage is a double-edged sword. Companies with high fixed-cost bases (airlines, steel mills, utilities) see outsized earnings growth in up-cycles but outsized earnings collapses in downturns. This is why cyclical companies with high DOL are riskier and typically trade at lower P/E multiples even at the peak of the cycle.

Capital Expenditure and Working Capital Forecasting

\[ \text{FCFF} = \text{EBIT}(1 - t) + \text{D\&A} - \Delta\text{Working Capital} - \text{Capex} \]

\[ \text{FCFE} = \text{Net Income} + \text{D\&A} - \Delta\text{Working Capital} - \text{Capex} + \text{Net Borrowing} \]

Forecasting capex typically uses one of three approaches:

Historical capex / revenue ratio — simple but ignores investment cycles
Management guidance — useful when credible
Asset replacement schedule — maintenance capex + growth capex based on asset life

Scenario and Sensitivity Analysis

A single-point estimate is misleading — analysts should build at minimum a base, bull, and bear case. The exam may ask which variable is most important for sensitivity analysis (typically the variable with the highest elasticity relative to the key value driver — usually gross margin % or revenue growth rate).

Reading 46

Equity Valuation: Concepts and Basic Tools

The three families of valuation — dividends, cash flows, and multiples — with numerical examples for every formula the exam will test.

📌 Big Picture

This is the most numerically intense equity reading. Expect 3–5 direct calculation questions in the exam. The Gordon Growth Model (GGM), multi-stage DDM, P/E justified multiple, and EV/EBITDA are all heavily tested. Master the logic: every valuation method is ultimately asking "what is the present value of the cash flows I will receive from owning this asset?" The different methods are just different ways of estimating that same number.

Intrinsic Value and Sources of Value Exam

Intrinsic value is the analyst's estimate of the "true" present value of a security. It differs from market price because:

Markets are not always efficient (see R41)
Different investors have different information
Short-term market prices reflect sentiment; intrinsic value is a long-run fundamental estimate

If your estimate of intrinsic value exceeds the market price → the stock is undervalued → consider buying. If market price exceeds intrinsic value → overvalued → consider selling or avoiding. The entire field of fundamental equity analysis is built on this simple inequality.

Dividend Discount Models (DDM) Critical

The DDM values a stock as the present value of all future dividends. The logic: the only cash you ever receive from a stock is dividends (including the liquidating dividend or terminal sale proceeds).

Gordon Growth Model (GGM) — One-Stage DDM

\[ V_0 = \frac{D_1}{r - g} = \frac{D_0(1+g)}{r - g} \]

Where D₁ = expected dividend next period, r = required return on equity, g = constant dividend growth rate.

🎯 Likely Exam Question (Numerical)

A stock just paid a dividend of $2.00 (D₀ = $2.00). Dividends are expected to grow at 5% per year forever. The required return is 10%. What is the intrinsic value?

D₁ = D₀ × (1 + g) = $2.00 × 1.05 = $2.10
V₀ = D₁ / (r − g) = $2.10 / (0.10 − 0.05) = $2.10 / 0.05 = $42.00

If the stock is currently trading at $38, it appears undervalued by $4. If trading at $46, it appears overvalued.

The GGM only works when g < r. If the growth rate exceeds the required return (g ≥ r), the formula produces a negative or infinite value — which is meaningless. For high-growth companies, use a multi-stage model. Also: a small change in g or r dramatically changes the output — the GGM is highly sensitive to its inputs.

Multi-Stage DDM (Two-Stage)

\[ V_0 = \sum_{t=1}^{n} \frac{D_t}{(1+r)^t} + \frac{V_n}{(1+r)^n} \]

Where Vn = terminal value at end of high-growth phase = D_{n+1} / (r − g_L), and g_L = long-run sustainable growth rate.

🎯 Likely Exam Question (Numerical)

A company will pay dividends of $1.50, $1.80, and $2.16 over the next 3 years. After Year 3, dividends grow at 4% forever. The required return is 9%. Calculate the intrinsic value.

Step 1 — PV of dividends in Years 1–3:
PV₁ = $1.50 / 1.09¹ = $1.376
PV₂ = $1.80 / 1.09² = $1.515
PV₃ = $2.16 / 1.09³ = $1.668

Step 2 — Terminal value at Year 3:
D₄ = $2.16 × 1.04 = $2.246
V₃ = $2.246 / (0.09 − 0.04) = $2.246 / 0.05 = $44.93

Step 3 — PV of terminal value:
PV(V₃) = $44.93 / 1.09³ = $34.69

V₀ = $1.376 + $1.515 + $1.668 + $34.69 = $39.25

Free Cash Flow to Equity (FCFE) Model Formula

\[ \text{FCFE} = \text{Net Income} - (1 - \text{DR}) \times (\text{Capex} - \text{Depreciation}) - (1 - \text{DR}) \times \Delta\text{Working Capital} \]

Where DR = debt ratio (proportion of investment financed by debt). FCFE is then discounted at the required return on equity:

\[ V_0 = \frac{\text{FCFE}_1}{r - g} \]

FCFE valuation is theoretically superior to DDM because it values the cash a company could pay to shareholders (whether or not it actually does). DDM only works for companies with stable, predictable dividends. For non-dividend-paying or irregular-dividend-paying companies, FCFE is the preferred approach.

Price Multiples Critical

Relative valuation methods compare a company's price to a fundamental metric and compare that ratio to peers or historical averages.

Multiple	Formula	Best Used For	Limitation
P/E	Price / EPS	Profitable mature companies; widely comparable	Meaningless if earnings are negative; affected by capital structure and accounting policies
P/B	Price / Book Value per Share	Financial companies (banks, insurers); asset-heavy businesses	Ignores intangibles; book value distorted by accounting differences
P/S (Price/Sales)	Price / Revenue per Share	Companies with negative earnings; startups; revenue-based models	Ignores profitability; high-margin and low-margin businesses are not comparable
P/CF	Price / Operating Cash Flow per Share	Companies with high non-cash charges (D&A)	Operating CF can be manipulated via working capital
EV/EBITDA	(Market Cap + Debt − Cash) / EBITDA	Capital structure-neutral; M&A (enterprise value basis); leveraged companies	Ignores capex; EBITDA ≠ free cash flow (especially for capex-intensive firms)

Justified (Fundamental) P/E from the GGM

\[ \frac{P}{E} = \frac{D_1/E_1}{r - g} = \frac{\text{Payout Ratio}}{r - g} \]

🎯 Likely Exam Question (Numerical)

A company has a dividend payout ratio of 40%, ROE = 12%, and required return = 9%. What is the justified P/E multiple?

Step 1: g = ROE × Retention Ratio = 12% × (1 − 0.40) = 12% × 0.60 = 7.2%
Step 2: Justified P/E = Payout Ratio / (r − g) = 0.40 / (0.09 − 0.072) = 0.40 / 0.018 = 22.2×

If the stock trades at 18× earnings, it appears undervalued relative to the fundamental P/E of 22.2×.

The sustainable growth rate formula g = ROE × (1 − Payout Ratio) is critical and frequently combined with the GGM or justified P/E. Examiners love two-step questions: first calculate g from ROE, then plug into a valuation formula. Don't forget that higher ROE increases both g AND the justified P/E — double impact.

Asset-Based Valuation

\[ \text{Asset-Based Value} = \text{Fair Value of Assets} - \text{Fair Value of Liabilities} \]

Asset-based valuation estimates value from the balance sheet, restated to fair (market) values. Best suited for:

Companies with significant tangible assets (real estate, natural resources, investment companies)
Liquidation analysis
Financial companies (banks, insurers) where assets can be valued relatively precisely

Asset-based valuation usually represents a floor — the liquidation value. For a going concern, enterprise value typically exceeds asset-based value because of intangibles (brand, customer relationships, human capital) that don't appear on the balance sheet. If an asset-based value exceeds the market price, it may signal a liquidation opportunity.

Reconciling Valuation Methods

Company Type	Preferred Method	Reason
Stable dividend-paying company	DDM (GGM)	Dividends are predictable and sustainable
High-growth, non-dividend-paying	Multi-stage DDM or FCFE	GGM breaks down when g > r or no dividends
Capital-intensive, leveraged	EV/EBITDA	Capital structure-neutral; useful for M&A analysis
Loss-making / startup	P/S or asset-based	No earnings to capitalise; P/E meaningless
Financial company (bank, insurer)	P/B	Balance sheet is the main value driver; earnings are volatile

Reference

Master Formula Sheet — All 8 Readings

Every formula you need, in one place.

Formula	Description	Reading
$\text{Leverage Ratio} = 1/\text{Initial Margin}$	Trading leverage for margin account	39
$\text{Margin Call} = P_0 \times \frac{1-\text{IM}}{1-\text{MM}}$	Long margin call trigger price	39
$\text{Margin Call (Short)} = P_0 \times \frac{1+\text{IM}}{1+\text{MM}}$	Short margin call trigger price	39
$\text{Short Profit} = P_{\text{short}} - P_{\text{cover}} - \text{Divs}$	Net profit on short position	39
$\text{Price-Wtd Index} = \sum P_i / \text{Divisor}$	Price-weighted index calculation	40
$\text{Cap-Wtd Return} = \sum w_i R_i$	Market-cap weighted index return	40
$\text{BVPS} = \frac{\text{Equity} - \text{Pref Equity}}{\text{Shares}}$	Book value per common share	42
$\text{ROE} = \frac{\text{Net Income}}{\text{Avg Equity}}$	Return on equity	42 / 43
$\text{ROE} = \text{Margin} \times \text{Turnover} \times \text{Leverage}$	3-factor DuPont decomposition	43
$\text{ROE} = \text{Tax} \times \text{Interest} \times \text{EBIT Margin} \times \text{Turnover} \times \text{Leverage}$	5-factor DuPont decomposition	43
$g = \text{ROE} \times b = \text{ROE} \times (1 - \text{Payout})$	Sustainable dividend growth rate	43 / 46
$\text{DOL} = \frac{Q(P-V)}{Q(P-V)-F}$	Degree of operating leverage	45
$\% \Delta \text{OI} = \text{DOL} \times \% \Delta \text{Sales}$	Operating leverage impact formula	45
$V_0 = \frac{D_1}{r-g}$	Gordon Growth Model (GGM)	46
$V_0 = \sum_{t=1}^{n} \frac{D_t}{(1+r)^t} + \frac{V_n}{(1+r)^n}$	Multi-stage DDM	46
$\frac{P}{E} = \frac{\text{Payout}}{r-g}$	Justified P/E (fundamental)	46
$\text{EV} = \text{Mkt Cap} + \text{Debt} - \text{Cash}$	Enterprise value	46
$\text{EV/EBITDA}: \text{EV} = \text{EBITDA} \times \text{Multiple}$	EV-based valuation	46

Formula	Description	Reading
\(\text{Leverage Ratio} = 1/\text{Initial Margin}\)	Trading leverage for margin account	39
\(\text{Margin Call} = P_0 \times \frac{1-\text{IM}}{1-\text{MM}}\)	Long margin call trigger price	39
\(\text{Margin Call (Short)} = P_0 \times \frac{1+\text{IM}}{1+\text{MM}}\)	Short margin call trigger price	39
\(\text{Short Profit} = P_{\text{short}} - P_{\text{cover}} - \text{Divs}\)	Net profit on short position	39
\(\text{Price-Wtd Index} = \sum P_i / \text{Divisor}\)	Price-weighted index calculation	40
\(\text{Cap-Wtd Return} = \sum w_i R_i\)	Market-cap weighted index return	40
\(\text{BVPS} = \frac{\text{Equity} - \text{Pref Equity}}{\text{Shares}}\)	Book value per common share	42
\(\text{ROE} = \frac{\text{Net Income}}{\text{Avg Equity}}\)	Return on equity	42 / 43
\(\text{ROE} = \text{Margin} \times \text{Turnover} \times \text{Leverage}\)	3-factor DuPont decomposition	43
\(\text{ROE} = \text{Tax} \times \text{Interest} \times \text{EBIT Margin} \times \text{Turnover} \times \text{Leverage}\)	5-factor DuPont decomposition	43
\(g = \text{ROE} \times b = \text{ROE} \times (1 - \text{Payout})\)	Sustainable dividend growth rate	43 / 46
\(\text{DOL} = \frac{Q(P-V)}{Q(P-V)-F}\)	Degree of operating leverage	45
\(\% \Delta \text{OI} = \text{DOL} \times \% \Delta \text{Sales}\)	Operating leverage impact formula	45
\(V_0 = \frac{D_1}{r-g}\)	Gordon Growth Model (GGM)	46
\(V_0 = \sum_{t=1}^{n} \frac{D_t}{(1+r)^t} + \frac{V_n}{(1+r)^n}\)	Multi-stage DDM	46
\(\frac{P}{E} = \frac{\text{Payout}}{r-g}\)	Justified P/E (fundamental)	46
\(\text{EV} = \text{Mkt Cap} + \text{Debt} - \text{Cash}\)	Enterprise value	46
\(\text{EV/EBITDA}: \text{EV} = \text{EBITDA} \times \text{Multiple}\)	EV-based valuation	46