2024

Equity

V1

Note: Juice notes are updated monthly; download the latest version at www.fintreeindia.com
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Equity
LM Name of Reading P.g.
1 Market Organization & Structure 1
2 Security Market Indexes 8
3 Market Efficiency 11
4 Overview of Equity Securities 13
5 Company Analysis: Past and Present 17
6 Industry and Competitive Analysis 22
7 Company Analysis: Forecasting 26
8 Equity Valuation: Concepts and Basic Tools 29
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Market Organization and Structure

FinTree Fruit 1 : The Functions of the Financial System

FinTree Fruit 2 : Classifications

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of Assets and Markets

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FinTree Fruit 3 : Major types of assets

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FinTree Fruit 4 : Financial Intermediaries

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FinTree Fruit 5 : Positions and Short Positions

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FinTree Fruit 6 : Leveraged Positions

FinTree Fruit 7 : Execution, Validity, Clearing Instructions

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FinTree Fruit 8 : Primary & Secondary Market

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FinTree Fruit 9 : Quote, Order & Brokered Markets

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FinTree Fruit 10 : Well-functioning Financial Systems

FinTree Fruit 11 : Market Regulation

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Security Market Indexes

FinTree Fruit 1 : Index Definition

FinTree Fruit 2 : Price FinTree

and Total Return

FinTree Fruit 3 : Choices and Issues

FinTree Fruit 4 : Index Construction

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FinTree Fruit 5 : Index Weighting - Price and Total Return

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FinTree Fruit 6 : Index Management: Rebalancing and Reconstitution

FinTree Fruit 7 : Uses of Market Indexes

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FinTree Fruit 8 : Equity indexes

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FinTree Fruit 9 : Fixed-income indexes

FinTree Fruit 10 : Indexes for Alternative Investments

FinTree Fruit 11 : Types of security market indices

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Market Efficiency
FinTree Fruit 1 : The Concept of Market Efficiency

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FinTree Fruit 2 : Market Value versus Intrinsic Value

FinTree Fruit 3 : Factors Affecting Market Efficiency Including Trading Costs

FinTree Fruit 4 : Forms of Market Efficiency

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FinTree Fruit 5 : Market & Other Pricing Anomalies

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FinTree Fruit 6 : Behavioral Finance

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Overview of Equity Securities

FinTree Fruit 1 : Characteristics of Equity Securities

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FinTree Fruit 2 : Ownership Characteristics among different equity classes

FinTree Fruit 3 : Private Versus

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Public Equity Securities

FinTree Fruit 4 : Non-Domestic Equity Securities

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FinTree Fruit 5 : Risk and Return Characteristics

FinTree Fruit 6 : Role

FinTree Fruit 7 : Equity and Company Value

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FinTree Fruit 8 : Accounting of ROE and Cost of Equity

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Company Analysis: Past and Present

FinTree Fruit 1 : Company and Industry Analysis Framework

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Forecasting

2.
Industry and
Competitive
Analysis

1.
Past and Present
Company Analysis

FinTree Fruit 2 : Key elements of the Initial Company Research Report

Section Content

Front Matter - Issuer name, symbols, analyst recommendation, target prices

Recommendation - Analysts’ recommendation, key supporting reasons
Company Description - Business model, strategy, charts (e.g., revenue breakdown)
Industry & Positioning - Industry size, growth, key drivers, market share trends
- Competitive analysis (Porter’s Five Forces), PESTLE analysis
- Evaluation of company’s industry position and strategy
Financial Analysis - Key drivers evaluation, forecasts, historical and future statements
Valuation - Company and security value estimates, target price
- Relative and present value approaches, sensitivity analyses
ESG Considerations - Evaluation of ESG indicators, ownership structure, compensation
Risks - Assessment of material risks, impact on financial analysis

FinTree Fruit 3 : Determining the Business Model

Determining Business

Components Models Information Sources

- Products/Services - Common Models - Issuer

- Customers - Analyst Focus - Public
- Sales Channels - Proprietary (Third-party)
- Pricing - Proprietary
- Resources (Primary Research)

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FinTree Fruit 4 : Revenue Analysis

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Pricing Power and Revenue Drivers:

ƒ Importance: Prices impact revenue; pricing power crucial for setting prices without sales impact.

ƒ Market Types:
• Competitive: Price-takers, returns align with cost of capital.
• Less Competitive: Power from differentiation, barriers, common in branded goods.

ƒ Evaluation: Analysts compare prices; rising profitability signals pricing power.

ƒ Substitutes: Lack of pricing power leads to substitutes, easy customer switching.

ƒ Profitability: Rising profitability signals sustained pricing power and investor value.

ƒ Signs of Power:
• Ability to increase prices despite cost rise.
• Long-term profitability growth.
• Competitors, substitutes don't drive prices down faster than costs.

FinTree Fruit 5 : Top-Down Revenue Analysis

Step 1: Market Identification

Step 2: Segmentation and Substitutes

Step 3: Calculate Market Share

Step 4: Trend Analysis

Step 5: Compare Competitors

Step 6: Insight Generation

Step 7: Strategic Considerations

Step 8: Anomaly Investigation

Step 9: Valuation Integration

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FinTree Fruit 6 : Operating Profitability and Working Capital Analysis

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• Nature of Costs: Costs related to goods/services, business management, compliance.
• Investing Costs: Linked to long-term assets (tangible/intangible).
• Financing Costs: Include returns to debt and equity investors.
• Cost Significance: Operating costs dominate, shaped by business model and size.
• Cost Categorization: Classified by behavior, nature, or function.

FinTree Fruit 7 : Behavior with Output: Fixed and Variable Costs

Pricing Power and Revenue Drivers:

ƒ Profitability Factors:
• Proportion of fixed to variable costs affects operating profit stability.
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ƒ Components Defined:
• Q: Units of outputs sold., P: Price per unit., VC: Variable operating costs per unit., FC: Fixed
operating costs.

ƒ Profit Equation:
• Contribution margin (P - VC) must be positive for profit.
• Q must exceed FC for profitability.

ƒ Operating Leverage:
• High fixed costs with positive contribution margin yield rapid profit growth.
• Operating profit falls with declining Q due to fixed costs.

ƒ Degree of Operating Leverage (DOL):

• Measures impact of sales change on operating profit change.
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ƒ Adjusting Leverage: Firms increase DOL by raising fixed costs and reducing variable costs

FinTree Fruit 8 : Natural and Functional Operating Cost Classifications and Measures of Operating Profitability
Cost Classification - Operating costs: natural or functional based on historical, industry, and entity-specific factors.
Profitability Measures - Gross Profit, EBITDA, and EBIT capture different functional costs.
Variable and Fixed Costs - Cost of sales mainly variable; other expenses (sales, admin, R&D) tend to be fixed.
- Depreciation may be fixed or variable.
- Financial notes offer insights; empirical analysis validates claims (e.g., assessing economies of
Empirical Analysis scale).
Long-Term Cost Drivers - Output growth impacts long-term costs: assets, human capital, and purchased goods.
Cost-to-Revenue Ratio - Expressing operating costs as a percentage aids in industry profitability analysis.
Industry Profitability - Competitive forces and market structure influence industry profitability.
- Lower unit costs with output growth (spreading fixed costs) or more products (leveraging shared
Economies of Scale and Scope costs).
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FinTree Fruit 9 : Working Capital

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Working Capital Management: Involves activity ratios - cash conversion cycle and net working capital to
sales ratio.
• Cash Conversion Cycle: Short cycle means less external financing, covering inventory, sales, and payables
time frames.
• Net Working Capital to Sales Ratio: Measures necessary capital relative to sales revenue.
• Minimum Investment: Net working capital is vital for operations, separate from capital investments.
• Negative Net Working Capital: Indicates suppliers fund operations, potentially advantageous.

FinTree Fruit 10 : Sources and Uses of Capital

Sources of Capital Uses of Capital

Cash and investments on hand

working capital (if negative)
Debt issuance Net working capital (if positive)
Equity issuance Capital expenditures and additions to
intangibles
Asset disposals Acquisitions
Debt paydown
Dividends and share repurchases

FinTree Fruit 11 : Degree of financial leverage

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Industry and Competitive Analysis

FinTree Fruit 1 : Uses of Industry Analysis

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FinTree Fruit 2 : Industry Classification

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FinTree Fruit 3 : GICS, ICB, and TRBC Structures

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GICS by S&P DJI and MSCI ICB by FTSE Russell TRBC by Refinitiv

11 Sectors 11 Industries 14 Economic Sectors

25 Industry Groups 20 Supersectors 33 Business Sectors

74 Industries 45 Sectors 62 Industry Groups

163 Sub-Industries 173 Subsectors 154 Industries

898 Activities

FinTree Fruit 4 : Limitations of Third-Party Industry Classification Schemes

1. Groupings of companies with business model variations or that sell substitute products
2. The classification of multi-product companies
3. Geographical considerations
4. Changes in groupings over time that affect prior-period comparability of industry statistics

FinTree Fruit 5 : Alternative Methods of Grouping Companies

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FinTree Fruit 6 : Industry Survey

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Industry Survey Steps:
• Estimate Size and Growth: Measure industry size using total annual sales from product/customer
perspective.
• Calculate Growth Rate: Calculate YoY growth or compounded annual growth rate.
• Consider Volume and Price/Mix: Break down growth contributions from volume and price/mix drivers.

Handling Private Companies:

• Industry size may include private companies; estimate using economic indicators, surveys, issuer data.
• Corroborate estimates for reasonableness.

Characterizing Industry Growth:

• Style Box Approach: Characterize growth using a style box (Exhibit 5).
• Compare to Broader Economic Growth: Compare historical industry growth with overall economic
growth during recessions and expansions.

Industry Concentration:
• Measure with Herfindahl-Hirschman Index (HHI).
• High HHI = less competition, potential regulatory challenges.

FinTree Fruit 7 : Porter’s Five Forces

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FinTree Fruit 8 : External Influences on Industry Growth

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Political Economic
Fiscal policies, regulatory GDP, inflation, interest
changes, geopolitical rates, exchange rates.
conditions.

Environmental Social
Transition to a lower-carbon PESTLE Cultural trends, demographics,
economy, waste and land use Framework social media impact,
regulations. Sustainability focus.

Legal Technological
Changes in laws and Sustaining and disruptive
regulations, business innovations, industry
practice influence. impact.

FinTree Fruit 9 : Competitive Positioning

Intentional vs. Unintentional Strategy:

• Intentional: Planned, measured, and aligned company-wide.
• Unintentional: Driven by individual incentives, historical practices, or industry norms.

Effectiveness and Value Added:

• Effective strategy seen in value added and economic profits.
• Evaluation is retrospective.

Forward-Looking Evaluation: Assess against industry forces, PESTLE influences, and resource capabilities.

Industry and Company Specificity: Evaluation is unique to each company and industry.

Three Competitive Strategies:

• Cost Leadership.
• Differentiation.
• Focus.

Avoiding "Stuck in the Middle": Undesirable situation for a company; clarity in strategy is crucial.

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Company Analysis Forecasting

FinTree Fruit 1 : Forecast Objects, Principles, and Approaches

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Objects
1. Drivers: Analyze key factors for accurate financial forecasts.
2. Lines: Directly forecast specific financial items.
3. Measures: Efficient but less transparent summary metrics.
4. Ad Hoc: Forecast unreported events affecting securities.

Principles
1. Regular Disclosure: Prefer regularly disclosed objects.
2. Simplicity: Avoid overly complex models; focus on vital drivers.

Approaches
1. Historical Results: Simple use of past values; limited for changes.
2. Base Rates: Use industry averages for stable conditions.
3. Guidance: Rely on reliable management-provided targets.
4. Discretionary: Use various approaches for unique situations.

Horizon
1. Align with strategy, industry cycles, and company changes.
2. Consider acquisitions and employer's preferences.

FinTree Fruit 2 : Forecasting Revenues

Aspect Summary
Top-Down: Compare growth to GDP or forecast product market growth and share.
Forecasting Approaches
Bottom-Up Drivers: Use volumes, prices, product/segment revenues, capacity, or return/yield.
Management-Disclosed: Exclude effects like exchange rates, acquisitions.
Handling Non-Recurring Items
Analyst-Judged: Assess unique events (e.g., COVID-19) and uncertain technological shifts.
Forecast Methods Historical, Base Rates, Guidance, Discretionary: Tailor to business model and risks.
Considerations: Address competition, business cycle changes, inflation/deflation, and tech shifts.
Risk Factors Integration Integration: Include risk views in profitability, working capital, and capital structure forecasts.
Scenario Analysis: Explore outcomes for various risk factor scenarios.

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FinTree Fruit 3 : Forecasting Operating Expenses and Working Capital

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Forecasting Operating Expenses
Challenges in Forecasting - Limited issuer disclosures force analysts to use aggregated forecast objects.
- Revenues and costs must align coherently; e.g., if a low-margin segment grows
Coherent Revenue and Cost Forecasts
faster, overall profit margin deterioration should be forecast.
- Forecast COGS as a percentage of sales or gross margin, considering market share
Cost of Sales and Gross Margins
changes and introducing differentiated products.
- Explore detailed cost analysis (by segment, input, or product line) for better
Detailed Analysis of Costs
justification. Fluctuating input costs can impact operating profit significantly.
- Incorporate a company's hedging strategy into forecasts, especially for
Hedging Strategy Consideration
commodity-driven firms. Gradual sales price increases can offset rising costs.
- Use competitors' gross margins as a cross-check, but be mindful of differing
Cross-Checking with Competitors
business models impacting gross margins and operating costs.

Forecasting SG&A Expenses

- SG&A expenses have a less direct relationship with revenues; consider flexibility, as
Direct Relationship with Revenues
seen in the case of Siam Cement Group.
- Model selling and distribution expenses as a percentage of sales; consider a fixed
Variable and Fixed Components in SG&A
growth rate for more fixed general corporate costs.
- For segment models, use summary measures as detailed cost items are often not
Segment-Based Modeling
disclosed by segment.

Forecasting Working Capital

- Utilize efficiency ratios combined with sales and cost forecasts for working capital
Using Efficiency Ratios
projections.
- While historical results are common, choose forecast approaches based on specific
Historical Results Approach
company characteristics and needs.

FinTree Fruit 4 : Forecasting Capital Investments and Capital Structure

Capital Expenditure Capital Structure

Forecasting Forecasting

Types:Maintenance CapEx sustains the Leverage Ratios: Debt to Capital, Debt to

business, Growth CapEx expands it. Equity, Debt to EBITDA are common.

Maintenance CapEx: Based on historical Considerations: Historical practices, man-

depreciation, adjusted for inflation. agement's strategy, guidance on target struc-
ture, and covenants
Growth CapEx: Discretionary, tied to
management's plans and revenue growth. Note: Examples excluded for brevity.

Depreciation Forecast: Based on net PP&E

and intangibles, considering useful life
assumptions

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FinTree Fruit 5 : Scenario Analysis

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Scenario Analysis in Forecasting
1. Identify Risks: Recognize critical risk factors.
2. Assess Likelihood: Judge probability of outcomes.
3. Generate Scenarios: Develop varied forecasts.
4. Compare Forecasts: Evaluate against market views.
5. Assess Valuations: Align with market valuations.
6. Decision-Making: Inform investment decisions.

Purpose
1. Risk Mitigation: Anticipate and mitigate impact.
2. Decision Support: Structured decision-making.
3. Investor Perspective: Assess potential outcomes.

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Equity Valuation: Concepts and Basic Tools

FinTree Fruit 1 : Overvalued, undervalued or fairly valued

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FinTree Fruit 2 : Categories of Equity Valuation Models

FinTree Fruit 3 : Background for the Dividend Discount Model

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FinTree Fruit 4 : Dividend

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payment chronology

FinTree Fruit 5 : Dividend Discount Model (DDM) and Free-Cash-Flow-to-Equity Model (FCFE)

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FinTree Fruit 6 : Preferred Stock Valuation

FinTree Fruit 7 : The Gordon Growth Model

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FinTree Fruit 8 : Multistage Dividend Discount Models

FinTree Fruit 9 : Multipler

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Models

FinTree Fruit 10 : Enterprise Value

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FinTree Fruit 11 : Asset-Based Valuation

FinTree Fruit 12 : Advantages

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and disadvantages

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CFA® Level I JuiceNotes 2024
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