CIFA Intermediate Level

Equity Investments Analysis flashcards

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How do a market order, a limit order and a stop order differ?

Market order: executes immediately at the best available price, putting certainty of execution ahead of price. Limit order: sets a maximum price to pay (buy) or a minimum to accept (sell), putting price ahead of certainty of execution. Stop order: becomes a market order once a trigger price is reached, commonly used to limit losses on an existing position.

What are Porter's five forces?

1. Threat of new entrants. 2. Bargaining power of suppliers. 3. Bargaining power of buyers. 4. Threat of substitute products. 5. Rivalry among existing competitors. Together they decide how much pricing power, and so how much sustainable profitability, an industry can support.

What do the weak, semi-strong and strong forms of market efficiency each say prices reflect?

Weak form: all past price and volume data. Technical analysis cannot consistently earn excess returns. Semi-strong form: all publicly available information. Neither technical nor fundamental analysis of public information can. Strong form: all information, public and private. Not even inside information can.

What three simultaneous trends does Dow theory describe?

Primary: the long-term trend. Secondary: medium-term corrections within the primary trend. Minor: short-term noise. A trend remains in force until a clear reversal signal appears.

What is the Gordon growth model, and what must hold for it to work?

V0 = D1 / (r - g), where D1 is next year's dividend, r the required return and g the constant growth rate. It assumes dividends grow at one constant rate forever, and r must be strictly greater than g; where g >= r the formula is meaningless. Example: D0 = KES 2.00, g = 5%, r = 13%. D1 = 2.10 and V0 = 2.10 / 0.08 = KES 26.25.

Why is FCFF discounted at the WACC and FCFE at the cost of equity?

FCFF is the cash flow available to all capital providers, debt and equity, so it is discounted at their blended cost, the WACC. The market value of debt is then subtracted to reach equity value. FCFE is the cash flow available to equity holders only, so it is discounted at the cost of equity and needs no adjustment for debt.

How is enterprise value calculated?

EV = market value of equity + market value of debt + preference shares + minority interest - cash and cash equivalents. It is the value of the whole operating business, independent of how it happens to be financed.

What is residual income, and why does it improve on net income?

Residual income = net income - equity charge, where the equity charge = equity capital employed x the required return on equity. Net income charges for debt through interest but makes no charge for the equity capital used to earn it. Residual income is the profit earned above what shareholders require.

How does the build-up approach estimate a private company's cost of equity?

Cost of equity = risk-free rate + equity risk premium + size premium + company-specific risk premium. No market beta is needed, which is why it suits a private company with no reliable beta comparable. Example: 12% + 6% + 3% + 4% = 25%.

What is Tobin's Q, and how is it read?

Tobin's Q = market value of assets / replacement cost of those assets. Above 1: the market values the assets above their replacement cost, which can encourage new investment or signal overvaluation. Below 1: the market values them below replacement cost, which discourages new investment or can signal undervaluation.

What is the difference between financial intermediation and disintermediation?