CFA Level 1 - Equity Investments & Portfolio Management Flashcards

Question 1

What is the basic principle of the Dividend Discount Model (DDM)?

Accepted Answer

The DDM values a stock based on the present value of its expected future dividends. It assumes the intrinsic value of a stock is the sum of all future dividend payments, discounted back to the present.

Question 2

State the formula for the Gordon Growth Model (GGM) and its key assumptions.

Accepted Answer

The GGM is a specific DDM for valuing a stock with dividends growing at a constant rate. Formula: $V_0 = \frac{D_1}{r - g}$, where $V_0$ is the current intrinsic value, $D_1$ is the expected dividend in the next period, $r$ is the required rate of return, and $g$ is the constant growth rate of dividends. Key assumptions: $r > g$, and $g$ is constant forever.

Question 3

When is a Two-Stage Dividend Discount Model appropriate, and what does it involve?

Accepted Answer

A Two-Stage DDM is used when a company is expected to experience a period of high growth followed by a period of stable, lower growth. It involves calculating the present value of dividends during the high-growth phase and then the present value of a terminal value (using GGM) at the end of the high-growth phase.

Question 4

Define Free Cash Flow to Equity (FCFE) and explain its use in valuation.

Accepted Answer

FCFE is the cash flow available to common equity holders after all operating expenses and debt obligations have been paid and necessary investments in working capital and fixed capital have been made. It's used to value a company's equity by discounting expected future FCFE to the present.

Question 5

Define Free Cash Flow to Firm (FCFF) and how it differs from FCFE.

Accepted Answer

FCFF is the total cash flow generated by the company's operations that is available to all providers of capital (both debt and equity holders) after all operating expenses and necessary investments. It differs from FCFE as it's before any debt payments, and is discounted using the WACC.

Question 6

What is the Price-to-Earnings (P/E) ratio, and what does a high P/E typically imply?

Accepted Answer

The P/E ratio is a valuation multiple calculated as Market Price Per Share / Earnings Per Share (EPS). A high P/E ratio typically implies that investors expect higher future earnings growth, or that the company has lower risk, justifying a higher price for each dollar of earnings.

Question 7

Differentiate between trailing P/E and forward P/E.

Accepted Answer

Trailing P/E uses the past 12 months' EPS, while forward P/E uses estimated EPS for the next 12 months. Forward P/E is considered more relevant for future expectations but relies on forecasts.

Question 8

Explain the Price-to-Book (P/B) ratio and its common application.

Accepted Answer

The P/B ratio is calculated as Market Price Per Share / Book Value Per Share. It's often used to value financial institutions or companies with significant tangible assets, as book value can be a more stable measure than earnings.

Question 9

When is the Price-to-Sales (P/S) ratio particularly useful for valuation?

Accepted Answer

The P/S ratio is calculated as Market Price Per Share / Sales Per Share. It's particularly useful for valuing companies with volatile or negative earnings (e.g., startups or cyclical companies), as sales are generally less volatile than earnings.

Question 10

What is the EV/EBITDA multiple, and why is Enterprise Value (EV) used instead of market capitalization?

Accepted Answer

EV/EBITDA is a valuation multiple calculated as Enterprise Value / Earnings Before Interest, Taxes, Depreciation, and Amortization. EV is used because EBITDA is a pre-interest, pre-tax metric, making it comparable across companies with different capital structures. EV represents the total value of the firm, including both equity and debt.

Question 11

What is the core concept of Modern Portfolio Theory (MPT)?

Accepted Answer

MPT, developed by Harry Markowitz, suggests that investors can construct portfolios to maximize expected return for a given level of market risk, or minimize risk for a given level of expected return, by diversifying across different assets. It emphasizes the importance of asset correlation.

Question 12

Define the Efficient Frontier in the context of MPT.

Accepted Answer

The Efficient Frontier is a set of optimal portfolios that offer the highest expected return for a defined level of risk or the lowest risk for a given level of expected return. Portfolios below the frontier are suboptimal, and portfolios above are unattainable.

Question 13

What is systematic risk, and can it be diversified away?

Accepted Answer

Systematic risk (or market risk) is the risk inherent to the entire market or market segment. It is caused by factors such as interest rate changes, recessions, or wars. It cannot be eliminated through diversification.

Question 14

What is unsystematic risk, and how can investors manage it?

Accepted Answer

Unsystematic risk (or specific/idiosyncratic risk) is the risk unique to a specific company or industry. Examples include a product recall or a labor strike. It can be significantly reduced or eliminated through diversification.

Question 15

State the formula for the Capital Asset Pricing Model (CAPM) and explain its purpose.

Accepted Answer

CAPM is a model that describes the relationship between systematic risk and expected return for assets. Formula: $E(R_i) = R_f + \beta_i (E(R_m) - R_f)$, where $E(R_i)$ is the expected return of the asset, $R_f$ is the risk-free rate, $\beta_i$ is the asset's beta, and $E(R_m)$ is the expected market return. Its purpose is to calculate the required rate of return for an asset.

Question 16

In the context of CAPM, what does Beta ($\beta$) represent?

Accepted Answer

Beta ($\beta$) is a measure of an asset's systematic risk, indicating its sensitivity to overall market movements. A $\beta$ of 1 means the asset moves with the market, $\beta > 1$ means it's more volatile, and $\beta < 1$ means it's less volatile.

Question 17

What is the Security Market Line (SML), and what does it illustrate?

Accepted Answer

The SML is a graphical representation of the CAPM, plotting expected return against beta. It illustrates the required rate of return for any asset given its systematic risk. Assets plotted above the SML are considered undervalued, and those below are overvalued.

Question 18

Explain the primary goal of diversification in portfolio management.

Accepted Answer

The primary goal of diversification is to reduce portfolio risk without necessarily sacrificing expected return. By combining assets with low or negative correlations, the overall volatility of the portfolio can be reduced, primarily by mitigating unsystematic risk.

Question 19

How does the correlation coefficient ($\rho$) between assets impact portfolio risk?

Accepted Answer

The correlation coefficient ($\rho$) measures the degree to which two assets move in relation to each other. A $\rho = +1$ means perfect positive correlation (no diversification benefit), $\rho = -1$ means perfect negative correlation (maximum diversification benefit), and $\rho = 0$ means no linear relationship. Lower or negative correlations significantly reduce portfolio risk.

Question 20

Describe the fundamental concept of the risk-return trade-off in investing.

Accepted Answer

The risk-return trade-off is the principle that higher potential returns are typically associated with higher levels of risk. Investors must accept greater risk to achieve higher expected returns, and conversely, lower risk investments generally offer lower expected returns.

Question 21

What is the Capital Allocation Line (CAL), and how does it relate to the risk-free asset?

Accepted Answer

The CAL represents all possible combinations of a risk-free asset and a risky portfolio. It illustrates the risk-return trade-off for portfolios that combine a risk-free asset with a specific risky portfolio. Its slope is the Sharpe ratio of the risky portfolio.

Question 22

What is the Sharpe Ratio, and what does it measure?

Accepted Answer

The Sharpe Ratio measures the risk-adjusted return of an investment. Formula: $Sharpe Ratio = \frac{E(R_p) - R_f}{\sigma_p}$, where $E(R_p)$ is the expected portfolio return, $R_f$ is the risk-free rate, and $\sigma_p$ is the portfolio's standard deviation. A higher Sharpe Ratio indicates better risk-adjusted performance.

Question 23

Briefly describe the three forms of market efficiency according to the Efficient Market Hypothesis (EMH).

Accepted Answer

1. **Weak-form:** Prices reflect all past market data (e.g., historical prices, trading volumes). Technical analysis is ineffective.
2. **Semi-strong form:** Prices reflect all publicly available information (including financial statements, news). Fundamental analysis is ineffective.
3. **Strong-form:** Prices reflect all public and private information. Even insider information cannot generate abnormal returns.

Question 24

Differentiate between active and passive investment management strategies.

Accepted Answer

1. **Active management:** Aims to outperform a specific market benchmark by actively selecting securities, timing the market, or employing other strategies. It involves higher costs and research.
2. **Passive management:** Aims to replicate the performance of a market index (e.g., S&P 500) by investing in all or a representative sample of the index's securities. It typically involves lower costs and less research.

CFA Level 1 - Equity Investments & Portfolio Management

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