Cfa level 2 curriculum free download

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You can also subscribe without commenting. Want to pass your exams? Start preparing the right way. Customize Your Study Plan Now. BA II Plus vs. HP12C guide. CFA Level 1 Tips. CFA Level 2 Tips. CFA Level 3 Tips. A discussion of key random factors and an examination of the sensitivity of outcomes to the outcomes of those factors are useful. Analysts who are CFA Institute members, however, have an additional and overriding responsibility to adhere to the Code of Ethics and the Standards of Professional Conduct in all activities pertaining to their research reports.

Going beyond this general statement of responsibility, some specific Standards of Professional Conduct particularly relevant to an analyst writing a research report are shown in Exhibit 3. I C Members and Candidates must not knowingly make any misrepresentations relating to investment analysis, recommendations, actions, or other professional activities. V A 1 Members and Candidates must exercise diligence, independence, and thoroughness in analyzing investments, making investment recommendations, and taking investment actions.

V A 2 Members and Candidates must have a reasonable and adequate basis, supported by appropriate research and investigation, for any investment analysis, recommendation, or action. V B 1 Members and Candidates must disclose to clients and prospective clients the basic format and general principles of the investment processes used to analyze investments, select securities, and construct portfolios and must promptly disclose any changes that might materially affect those processes.

V B 2 Members and Candidates must use reasonable judgment in identifying which factors are important to their investment analyses, recommendations, or actions and include those factors in communications with clients and prospective clients. V B 3 Members and Candidates must distinguish between fact and opinion in the presentation of investment analysis and recommendations. V C Members and Candidates must develop and maintain appropriate records to support their investment analysis, recommendations, actions, and other investment-related communications with clients and prospective clients.

The valuation process has five steps: 1 Understanding the business. A bottom-up forecasting approach aggregates individual company forecasts to industry forecasts, which in turn may be aggregated to macroeconomic forecasts. Two broad categories of valuation models are absolute valuation models and relative valuation models. Present value models of common stock also called discounted cash flow models are the most important type of absolute valuation model. The benchmark price multiple can be based on a similar stock or on the average price multiple of some group of stocks.

Analysts have an obligation to provide substantive and meaningful content. Cornell, Bradford. The Case of Intel. Graham, Benjamin, and David L.

Security Analysis. McGraw-Hill Professional Publishing. Grossman, Sanford, and Joseph Stiglitz. Jensen, Michael C. Lamont, Owen A. Evidence from the Industry Shocks. Lee, Charles M. Mulford, Charles W. Porter, Michael E. New York: Free Press. Republished with new introduction in Schilit, Howard, and Jeremy Perler. New York: McGraw-Hill.

Sloan, Richard G. The research note did not discuss how the target price was obtained or how it should be interpreted. Assume the target price represents the expected price of MFG. What further specific pieces of information would you need to form an opinion on whether MFG was fairly valued, overvalued, or undervalued? In investigating the financial disclosures of these acquired companies and talking to industry contacts, you conclude that XMI has been forcing the companies it acquires to accelerate the payment of expenses before the acquisition deals are closed.

As one example, XMI asks acquired companies to immediately pay all pending accounts payable, whether or not they are due. Subsequent to the acquisition, XMI reinstitutes normal expense payment patterns. The following information relates to Questions 9—16 Guardian Capital is a rapidly growing US investment firm.

Due to the rapid growth of assets under management, Guardian Capital recently hired a new analyst, Jack Richardson, to support the research process. But mispricing of assets is not directly observable.

It is therefore important that you understand the possible sources of perceived mispricing. He finds few barriers to new retail entrants, high intra-industry rivalry among retailers, low product substitution costs for customers and a large number of wholesale clothing suppliers. While conducting his analysis, Richardson discovers that Renaissance Clothing included three non-recurring items in their most recent earnings release: a positive litigation settlement, a one-time tax credit, and the gain on the sale of a non-operating asset.

Michelle Lee, a junior technology analyst at Guardian, asks the director of research for advice as to which valuation model to use for VEGA, a fast growing semiconductor company that is rapidly gaining market share.

According to management guidance, when the company turns profitable, it will invest in new product development; as a result, it does not expect to initiate a dividend for an extended period of time. Lee also notes that she expects that certain larger competitors will become interested in acquiring VEGA because of its excellent growth prospects.

The director of research advises Lee to consider that in her valuation. The difference between: A intrinsic value and market price. B estimated intrinsic value and market price. C intrinsic value and estimated intrinsic value. A Fair value B Liquidation value C Fair market value 11 With respect to Statement 4, which measure of value is most relevant for the analyst of the fund described?

A Liquidation value B Investment value C Going-concern value 12 According to Statement 5, analysts are expected to use valuation concepts and models to: A value private businesses.

B render fairness opinions. C extract market expectations. B substitution costs. C number of suppliers. Relative to sustainable earnings, reported earnings are likely: A unbiased. B upward biased. C downward biased. Santos reviews the growth prospects and quality of earnings for Phoenix Enterprises, one of the companies he follows.

He has developed a stock valuation model for this firm based on its forecasted fundamentals. His revenue growth rate estimate is less than that implied by the market price. He notes two reasons for his lower growth rate forecast: Reason 1 Successful companies tend to draw more competition, putting their high profits under pressure.

Santos meets with Walter Hartmann, a newly hired associate in his department. I can think of three examples: 1 A restaurant chain forecasts its sales to be its market share times forecast industry sales.

Practice Problems A undervalued. B fairly valued. C overvalued. A Restaurant chain B Electric utility company C Retail furniture company 20 Based on his trading strategy, which of the following should Hartmann recommend? Dormier is responsible for issuing either a buy, hold, or sell rating for the shares of Company A and Company B. The appropriate valuation model for each company was chosen based on the following characteristics of each company: Company A is an employment services firm with no debt and has fixed assets consisting primarily of computers, servers, and commercially available software.

Many of the assets are intangible, including human capital. The company has a history of occasionally paying a special cash dividend. The company pays a regular dividend that is solely derived from the earnings produced by the tobacco division.

Dormier assigns ratings to each of the companies and provides a rationale for each rating. Describe how you used a top-down approach, which is the policy at our company.

I have studied all of the public disclosure documents; I have participated in the company conference calls, being careful with my questions in such a public forum; and I have studied the dynamics of the underlying industries. The valuation models are robust and use an extensive set of company-specific quantitative and qualitative inputs. B evaluating the impact of general economic conditions on each company. C asking more probing questions during publicly available company conference calls.

Second, not all equities are publicly traded and have market prices, and the most recent market price can be stale for the many public equities that trade only infrequently.

The practical consequences are that an investor can only estimate intrinsic value and active security selection carries the risk of making mistakes in estimating value. Stated another way, the value added by being a going concern is a relevant investment characteristic that an intrinsic value estimate would recognize.

If one increased the discount rate, one would also need to increase the cash flow if a constant present value were to be maintained.

Given that the time frame for the return is established, you need to have an estimate of the required rate of return over the same time horizon. A is correct. The difference between the true real but unobservable intrinsic value and the observed market price contributes to the abnormal return or alpha which is the concern of active investment managers. The liquidation value of a company is its value if it were dissolved and its assets sold individually.

For its core equity fund, Guardian Capital screens its investable universe of securities for well-capitalized companies that are expected to generate significant future free cash flow from core business operations. The concern with future free cash flows implies that going-concern value is relevant.

This process assumes a valuation model, as discussed in the text. When many suppliers of the products needed by industry participants exist, competition among suppliers should limit their ability to raise input prices.

Thus the large number of suppliers is a factor that should positively affect industry profitability. The effects of favorable nonrecurring events in reported earnings would tend to bias reported earnings upward relative to sustainable earnings because non-recurring items are by definition not expected to repeat. Renaissance Clothing included three non-recurring items in their most recent earnings release that all led to higher earnings for the current period: a positive litigation settlement, a one-time tax credit, and the gain on the sale of a nonoperating asset.

The most important type of absolute equity valuation models are present value models also referred to as discounted cash flow models and the model described by Richardson is of that type.

The broad criteria for model selection are that a valuation model be consistent with the characteristics of the company being valued, appropriate given the availability and quality of the data and consistent with the purpose of the valuation. As VEGA does not pay a dividend and is not expected to for the foreseeable future; this would make the application of a dividend discount model problematic. However, the lack of a dividend would not be an obstacle to free cash flow valuation.

The reading states that free cash flow valuation can be appropriate in such circumstances. Thus, the director of research would be most likely to recommend free cash flow valuation. If the revenue growth rate inferred by the market price exceeds the growth rate that the firm could reasonably expect, Santos should conclude that the market price is too high and thus that the firm is overvalued.

Expiring and weakening intellectual property and franchise agreements can also reduce potential growth. The retail furniture company forecasting sales based on sales per square meter is an example of bottom-up forecasting because it aggregates forecasts at a micro level to larger-scale forecasts. Pairs trading involves buying an undervalued stock and shorting an overvalued stock in the same industry.

The free cash flow to the firm model is the most appropriate of the choices because it can be used whether the company has significant marketable assets or consistently pays a cash dividend. This valuation model would be consistent with the characteristics of the company. Company B is a conglomerate operating in three unrelated industries with significantly different expected revenue growth rates.

Sumof-the-parts analysis is most useful when valuing a company with segments in different industries that have different valuation characteristics.

A control premium may be reflected in the value of a stock investment that would give an investor a controlling position. A top-down forecasting approach moves from macroeconomic forecasts to industry forecasts and then to individual company and asset forecasts. Analysts are expected to understand the general economic conditions before finalizing a research report and making a recommendation. This reading presents and illustrates key return measures relevant to valuation and is organized as follows.

Section 2 provides an overview of return concepts. Section 3 presents the chief approaches to estimating the equity risk premium, a key input in determining the required rate of return on equity in several important models. With a means to estimate the equity risk premium in hand, Section 4 discusses and illustrates the major models for estimating the required return on equity.

Section 5 presents the weighted average cost of capital, a discount rate used when finding the present value of cash flows to all providers of capital. Section 6 presents certain facts concerning discount rate selection. A summary and practice problems conclude the reading. The following sections explain the major return concepts most relevant to valuation.

The specified time period is the holding period under examination, whether it is one day, two weeks, four years, or any other length of time. To use a hypothetical return figure of 0. Such returns can be separated into investment income and price appreciation components. In particular, other areas of finance such as performance evaluation make use of return concepts not covered here e.

Return Concepts Equation 1 assumes, for simplicity, that any dividend is received at the end of the holding period. Holding period returns are sometimes annualized—e. For example, 1. As the example shows, however, annualizing holding period returns, when the holding period is a fraction of a year, is unrealistic when the reinvestment rate is not an actual, available reinvestment rate.

For a holding period in the past, the selling price and the dividend are known, and the return is called a realized holding period return, or more simply, a realized return. In forward-looking contexts, holding-period returns are random variables because future selling prices and dividends may both take on a range of values. Nevertheless, an investor can form an expectation concerning the dividend and selling price and thereby have an expected holding-period return, or simply expected return, for the stock that consists of the expected dividend yield and the expected price appreciation return.

Although professional investors often formulate expected returns based on explicit valuation models, a return expectation does not have to be based on a model or on specific valuation knowledge. Any investor can have a personal viewpoint on the future returns on an asset.

In fact, because investors formulate expectations in varying ways and on the basis of different information, different investors generally have different expected returns for an asset.

The comparison point for interpreting the investment implication of the expected return for an asset is its required return, the subject of the next section. It represents the opportunity cost for investing in the asset—the highest level of expected return available elsewhere from investments of similar risk.

As the opportunity cost for investing in the asset, the required return represents a threshold value for being fairly compensated for the risk of the asset.

By contrast, if the expected return on the asset falls short of the required rate of return, the asset will appear to be overvalued. The valuation examples presented in these readings will illustrate the use of required return estimates grounded in market data such as observed asset returns and explicit models for required return. We will refer to any such estimate of the required return used in an example as the required return on the asset for the sake of simplicity, although other estimates are usually defensible.

The concept of risk-free rate mentioned in the previous paragraphs is important in valuation. This risk-free rate then serves as a reference rate for practical purposes such as valuing other investments. In a given market, the yield on a sovereign debt instrument e. In this reading, we use the notation r for the required rate of return on the asset being discussed. The required rate of return on common stock and debt are also known as the cost of equity and cost of debt, respectively, taking the perspective of the issuer.

To raise new capital, the issuer would have to price the security to offer a level of expected return that is competitive with the expected returns being offered by similarly risky securities. In investment decisionmaking and valuation, the focus is on expected alpha. However, to evaluate the actual results of an investment discipline, the analyst would examine realized alpha. Present value models require the analyst to establish appropriate discount rates for determining the present values of expected future cash flows.

Expected return and required rate of return are sometimes used interchangeably in conversation and writing. When current price equals perceived value, expected return should be the same as the required rate of return.

However, when price is below above the perceived value, expected return will exceed be less than the required return as long as the investor expects price to converge to value over his or her time horizon.

In the next section, we show the conversion of a value estimate into an estimate of expected-holding period return. In the context of such a model with homogenous expectations, the required return is also the expected return for the asset.

In discussions of such models, therefore, expected return and required return are used interchangeably. Return Concepts 55 2. Take the case of an asset that an investor believes is 25 percent undervalued in the marketplace.

If price were expected to converge to value in exactly one year, an investor would earn The expected alpha of Toyota is about But if the investor expected the undervaluation to disappear by the end of nine months, then the investor might anticipate achieving a return of approximately We conduct the analysis on a periodic holding period basis because one cannot assume reinvestment at a rate incorporating a return from convergence is feasible. For example, a Another possibility is that price converges to value in two years.

The expected two-year expected holding period return would be This expected return based on two-year convergence could be compared to the expected return based on one-year convergence of Clearly, the convergence component of expected return can be quite risky. They are researching Microsoft Corporation,5 the largest US-headquartered technology sector company. Based only on the information given, answer the following questions concerning Microsoft. For both questions, ignore returns from reinvesting the quarterly dividends.

Solution to 2: If Microsoft is fairly valued, it should return its cost of equity required return , which is 7. Return Concepts 57 is subtracted to isolate the return from price appreciation.

Another solution approach involves subtracting the dividend yield from the required return to isolate the anticipated price appreciation return: 7. Thus, 1. A discount rate reflects the compensation required by investors for delaying consumption—generally assumed to equal the risk-free rate—and their required compensation for the risk of the cash flow. Generally, the discount rate used to determine intrinsic value depends on the characteristics of the investment rather than on the characteristics of the purchaser.

That is, for the purposes of estimating intrinsic value, a required return based on marketplace variables is used rather than a personal required return influenced by such factors as whether the investor is diversified in his or her personal portfolio. On the other hand, some investors will make judgmental adjustments to such required return estimates, knowing the limitations of the finance models used to estimate such returns.

In principle, because of varying expected future inflation rates and the possibly varying risk of expected future cash flows, a distinct discount rate could be applicable to each distinct expected future cash flow.

In practice, a single required return is generally used to discount all expected future cash flows. In a model that views the intrinsic value of a common equity share as the present value of expected future cash flows, if price is equal to current intrinsic value—the condition of market informational efficiency—then, generally, a discount rate can be found, usually by iteration, which equates that present value to the market price. An IRR computed under the assumption of market efficiency has been used to estimate the required return on equity.

An example is the historical practice of many US state regulators of estimating the cost of equity for regulated utilities using the model illustrated in Equation 3b below. Finally, obtaining an IRR from a present value model should not be confused with the somewhat similar-looking exercise that involves inferring what the market price implies about future growth rates of cash flows, given an independent estimate of required return: that exercise has the purpose of assessing the reasonableness of the market price.

Thus, it is the difference between the required return on equities and a specified expected risk-free rate of return. Possibly confusingly, equity risk premium is also commonly used to refer to the realized excess return of stocks over a risk-free asset over a given past time period. The realized excess return could be very different from the premium that, based on available information, was contemporaneously being expected by investors.

Equation 4 will be explained in Section 4. Equation 5 will be explained in Section 4. It is primarily used in the valuation of private businesses. Typically, analysts estimate the equity risk premium for the national equity market of the issues being analyzed but if a global CAPM is being used, a world equity premium is estimated that takes into account the totality of equity markets.

Even for the longest established developed markets, the magnitude of the equity risk premium is difficult to estimate and can be a reason for differing investment conclusions among analysts. Therefore, we will introduce the topic of estimation in some detail. Whatever estimates analysts decide to use, when an equity risk premium estimate enters into a valuation, analysts should be sensitive to how their value conclusions could be affected by estimation error. Two broad approaches are available for estimating the equity risk premium.

One is based on historical average differences between equity market return and government debt returns, and the other is based on current expectational data. These are presented in the following sections. When reliable long-term records of equity returns are available, historical estimates have been a familiar and popular choice of estimation.

If investors do not make systematic errors in forming expectations, then, over the long term, average returns should be an unbiased estimate of what investors expected. The fact that historical estimates are based on data also gives them an objective quality. In using a historical estimate to represent the equity risk premium going forward, the analyst is assuming that returns are stationary—that is, the parameters that describe the return-generating process are constant over the past and into the future.

Broad-based, market-value weighted indexes are typically selected. Specifying the length of the sample period typically involves trade-offs. Dividing a data period of a given length into smaller subperiods does not increase precision in estimating the mean—only extending the length of the data set can increase precision. However, the assumption of stationarity is usually more difficult to maintain as the series starting point is extended to the distant past.

The specifics of the type of nonstationarity are also important. For a number of equity markets, research has brought forth abundant evidence of nonconstant underlying return volatility. Nonstationarity—in which the equity risk premium has fluctuated in the short term, but around a central value—is a less serious impediment to using a long data series than the case in which the risk premium has shifted to a permanently different level.

Practitioners taking a historical approach to equity premium estimation often focus on the type of mean calculated and the proxy for the risk-free return. There are two choices for computing the mean and two broad choices for the proxy for the risk-free return. In the table, standard error and standard deviation are those of the annual excess return series.

This result contrasts with the estimation of variance and covariance in which higher frequency of estimation for a given time span does increase the precision in estimating variance and covariance. Statistics for Austria exclude —22, and statistics for Germany exclude — Source: Damodaran , Table 6.

The excerpt from Exhibit 1 presented below presents a comparison of historical equity risk premium estimates for the United States and Japan. This comparison highlights some of the issues that can arise in using historical estimates.

As background to the discussion, note that as a mathematical fact, the geometric mean is always less than or equal to the arithmetic mean; furthermore, the yield curve is typically upward sloping long-term bond yields are typically higher than short-term yields.

The United States illustrates the typical case in which realized values relative to bills, for any definition of mean, are higher than those relative to bonds. The premium estimates for Japan are notably higher than for the United States. Because the promised yield on long-term bonds is usually higher than that on shortterm bills, the equal arithmetic mean premium relative to bonds compared to bills in the case of Japan is atypical.

The analyst would need to investigate the reasons for it and believe they applied to the future before using the estimate as a forecast for the future. In all markets, the geometric mean premium relative to long-term bonds gives the smallest risk premium estimate. As a result, the sample mean estimates the true mean with potentially substantial error.

The Equity Risk Premium bonds. This problem of sampling error becomes more acute, the shorter the series on which the mean estimate is based.

Referring to Panel A of Exhibit 1, the histogram in Exhibit 2, focusing on the geometric mean, shows that 75 percent of values fall in onepercentage-point intervals from 2 percent to 5 percent.

The modal interval is 2—3 percent with the 3—4 percent interval as a close second. However, approximately 25 percent of values fall in the two extreme intervals. In some applications, an analyst might not want or be able to incorporate the market value weight information needed to calculate the weighted harmonic mean. In such cases, the simple harmonic mean can still be calculated.

In general, unless all the observations in a data set have the same value, the harmonic mean is less than the arithmetic mean. As explained and illustrated earlier in this reading, using the median rather than the arithmetic mean to derive an average multiple mitigates the effect of outliers. The harmonic mean is sometimes also used to reduce the impact of large outliers—which are typically the major concern in using the arithmetic mean multiple—but not the impact of small outliers i.

The harmonic mean tends to mitigate the impact of large outliers. The harmonic mean may aggravate the impact of small outliers, but such outliers are bounded by zero on the downside. We can use the group of telecommunications companies examined earlier in the reading see Exhibit 5 to illustrate differences between the arithmetic mean and harmonic mean. Exhibit 29 shows mean values including and excluding the outliers. The harmonic mean Once the outliers are eliminated, the values for the arithmetic mean This example illustrates the importance for the analyst of understanding how an average has been calculated, particularly when the analyst is reviewing information prepared by another analyst, and the usefulness of examining several summary statistics.

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