Home > Accounting, CFA L2, equities, fundamental analysis > CFA Reading: Equity Concepts & Techniques

CFA Reading: Equity Concepts & Techniques

CFA Level 2 – Equity Investments; Study Session 11, Reading 38 in 2011 curriculum/Reading 36 in 2010.

This reading introduces some of the basic concepts of analyzing equity investments. I’m excluding the theoretical parts and will focus mostly on bits of interesting corollaries…

A global industry analysis should examine:

  • return potential evidenced by demand analysis
  • value creation
  • industry life cycle
  • competition structure
  • competitive advantage
  • competitive strategies
  • co-opetition and the value net (yes…co-opetition is a word)
  • sector rotation
  • risk elements evidenced by market competition
  • value chain competition
  • government participation
  • cash flow covariance

Dupont Analysis

Global financial analysis involves comparing company ratios with global industry averages. In this context, DuPont analysis uses various combinations of the tax retention, debt burden, operating margin, asset turnover, and leverage ratios.

Extended Dupont formula for Return on Equity (ROE):

Source: Schweser

 

Franchise Value or PVGO

Intrinsic P/E can be broken down into tangible P/E and Franchise P/E. Tangible P/E assumes constant earnings and Franchise P/E is the present value of growth opportunities divided by next year’s earnings i.e. PVGO/E. Think of tangible P/E as the average industry growth rate and franchise value as the additional growth that is unique to the company/industry.

Source: Schweser

 

r = required rate of return

b = Retention Ratio = (1 – Dividend Payout Ratio)

Analyze Effects of Inflation on Valuation

Inflation affects historical inventory and borrowing costs on reported earnings, as well as the inflation tax reflected in capital gains taxes (i.e. you purchase an asset today which increases in value equal to inflation rate, you decide to sell the asset and incur capital gains tax… you actual are losing capital because the rise in asset value is due to inflation).

To analyze the effect of inflation on a firm’s valuation, you must estimate the degree of inflation flow-through denoted by λ in textbook.

Source: Schweser

 

A company/industry with high inflation flow-through rate will be valued more because it can pass the higher input costs to the consumer and maintain profit margins.

Herfindahl Index (we have seen this before in Corporate Finance)

This index is used to measure competition in an industry. The US Department of Justice uses this index to measure industry concentration. The formula is straightforward…

Source: Schweser

 

I doubt that Canada’s Competition Bureau uses this index considering the prevalence oligopolistic industries in Canada (banking & communication are two big ones)

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