Equity Investments covers the valuation of stocks and the functioning of equity markets. At Level I the key models are the Dividend Discount Model and its variants (Gordon Growth, multi-stage), the Free Cash Flow to Equity model, and price multiples (P/E, P/B, P/S, P/CF). Market efficiency theory and equity market structures also appear. The topic accounts for 11–14% of the exam.
Market efficiency: Weak-form EMH → prices reflect all historical price/volume data (technical analysis adds no value). Semi-strong → prices reflect all public information (fundamental analysis adds no value). Strong → all public and private information (no one can consistently outperform).
Dividend discount models: know when to use each — GGM for stable, mature companies; two-stage DDM for growth companies expected to slow; FCFE when dividends don't reflect cash generation.
Price multiples interpretation: P/E is most widely used but distorted by leverage and accounting choices; P/B is better for financial firms; EV/EBITDA eliminates capital structure and D&A differences.
Equity market structure: auction markets (exchange-driven, transparent) vs. dealer markets (OTC, quote-driven). Know the distinction between limit orders and market orders and the role of market makers.
Applying the GGM when g ≥ r — the formula produces a negative or undefined price. Always check that the required return exceeds the growth rate before applying the model.
Confusing FCFF (free to all capital providers, before interest) with FCFE (free to equity holders, after interest and net borrowing). FCFF is discounted at WACC; FCFE is discounted at the cost of equity.
Treating a low P/E as automatically "cheap" — a low P/E may reflect genuinely low growth expectations, high risk, or unsustainably high near-term earnings rather than undervaluation.
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