Paper No. 9 Equity Investments Analysis

8,000.00 KShs

This paper is intended to equip the candidate with the knowledge, skills, and attitudes that will enable him/her to analyze and value equity investments.

A candidate who passes this paper should be able to:
• Undertake industry and company analysis
• Determine the value of equity securities
• Apply various models in valuing equity investments
• Calculate and interpret equity valuation multiples
• Undertake valuation of private companies
• Apply the concepts of equity market equilibrium
• Use case studies in equity investment



This paper is intended to equip the candidate with the knowledge, skills, and attitudes that will
enable him/her to analyze and value equity investments.

A candidate who passes this paper should be able to:
• Undertake industry and company analysis
• Determine the value of equity securities
• Apply various models in valuing equity investments
• Calculate and interpret equity valuation multiples
• Undertake valuation of private companies
• Apply the concepts of equity market equilibrium
• Use case studies in equity investment

1. Overview of equity markets and structure
1.1 Structure of the equity market: Financial system and intermediaries; components
of financial system, characteristics of well-functioning financial system and the
role of financial system in the economy, financial intermediaries’ classifications,
services offered, differences between financial intermediation and financial
disintermediation, roles of financial intermediaries.
1.2 Primary and secondary markets for equity securities
1.3 Trading equity securities; Types of market orders
1.4 Types of equity securities; ordinary shares (features, types, advantages and
limitations; preference shares (features, types, advantages, and limitations),
private versus public
1.5 Investing in foreign equity securities; factors to consider when making foreign
equity investment, reasons for investing in foreign equity, and challenges.
1.6 Risk and return characteristics of different types of equity securities
1.7 Market value and book value of equity securities importance
1.8 Comparison of a company’s cost of equity, accounting rate of return and
investors’ required rate of return
1.9 Equity security and company value

2. Fundamental analysis
2.1 Components of fundamental analysis; economic analysis, industry analysis and
company analysis

3. Overview of company analysis
3.1 Elements that should be covered in a thorough company analysis; forecasting of
the following costs: cost of goods sold, selling general and administrative costs,
financing costs, and income taxes
3.2 Comparing estimated values and market prices; information efficiency and
efficient market hypothesis
3.3 Approaches to balance sheet modeling
3.4 Growth companies and growth stocks; defensive company and stocks; cyclical
companies and stocks; speculative companies and stocks.
3.5 The elements of a competitive analysis for a company.
3.6 Contrast top-down and bottom-up approaches to economic forecasting.
3.7 The importance of quality of earnings analysis in financial forecasting and identify
the sources of information for such analysis.
3.8 Quality of earnings indicators and risk factors.

4. Overview of industry analysis
4.1 The uses of industry analysis and the relation between industry analysis and
company analysis
4.2 Methods by which companies can be grouped, current industry classification
systems, and classification of companies given description of activities and the
classification system
4.3 Factors that affect the sensitivity of a company to the business cycle and the
uses besides limitations of industry and company descriptors such as “growth,”
“defensive,” and “cyclical”
4.4 Company’s industry classification process to classify a potential “peer group” for
equity valuation
4.5 Elements that need to be covered in a thorough industry analysis
4.6 Principles of strategic analysis of an industry; competitive forces that shape
strategy; effect of competitive forces on prices and costs
4.7 Effects of barrier to entry, industry concentration, industry capacity, and market
share stability on pricing power and return on capital
4.8 Product and industry life cycle models; Classification of industry as to life cycle
phases (embryonic, growth, shakeout, maturity, and decline); limitations of lifecycle concept in forecasting industry performance
4.9 Comparison of representative industries from various economic sectors
4.10 Macroeconomic, Demographic, governmental, social, and technological
influences on industry growth, profitability, and risk

5. Market efficiency
5.1 The concept of market efficiency: definition and assumptions; importance of
market efficiency to investment participants
5.2 Market value and intrinsic value
5.3 Factors affecting a market’s efficiency
5.4 Forms of market efficiency: weak form, semi-strong form, and strong form;
implications of each form of market efficiency for fundamental analysis, technical
analysis and the choice between active and passive portfolio management
5.5 Random walk theory and efficient markets
5.6 Tests of market efficiency
5.7 Market pricing anomalies; Time series anomalies, Cross-sectional anomalies,
other anomalies and implications for investment strategies

6. Technical analysis
6.1 Overview of technical analysis: definition, assumptions, principles, differences
between technical and fundamental analysis, advantages and disadvantages
6.2 Technical analysis tools – charts, trends, chart patterns, technical indicators,
6.3 Dow theory: overview; assumptions; Using Dow Theory Concepts in Forex
Trading, interpretation
6.4 Elliott wave theory: overview; principle of the theory, assumptions; interpretation
6.5 Trend analysis
6.6 Relationships between market efficiency and technical analysis; application of
behavioural finance in technical analysis
6.7 Contrary opinion rules in relation to technical analysis
6.8 Forecasting methodology: conditional forecasting, economic forecasting
6.9 Market analysis

7. The equity valuation processes
7.1 Overview of equity valuation: Definition of value and the concept of alpha; the
relationship between alpha and perceived mispricing; intrinsic value; contrast the
going-concern concept of value to the concept of liquidation value
7.2 The steps in equity valuation process, and the objectives and tasks within each
7.3 Valuation models in equity valuation; the importance of expectations in the use of
valuation models, uses of valuation models; the use of valuation models within
the context of traditional and modern concepts of market efficiency; absolute and
relative valuation models
7.4 Alternative to traditional analysis techniques: cash flow returns on investment
7.5 The role of valuation in portfolio management
7.6 Contrast quantitative and qualitative factors in valuation
7.7 Covered under definition of value criteria for choosing an appropriate approach
for valuing a particular company.
7.8 The role of ownership perspective in valuation
7.9 The contents and format of an effective research report
7.10 The responsibilities of analysts in performing valuations and communicating
valuation results
7.11 Effects of inflation on the valuation process

8. Discounted dividend valuation
8.1 Streams of cash flow; compare of dividends, free cash flow, and residual income
as inputs to discounted cash flow models and identify investment situations for
which each measure is suitable.
8.2 The Dividend Discount Model: Calculate and interpret the value of shares using
the dividend discount model (DDM) for single and multiple holding periods.
8.3 Valuation of shares using the Gordon growth model and the model’s underlying
8.4 Gordon Growth Model: Computation and interpretation of implied growth rate of
dividends using the Gordon growth model and current share price.
8.5 Calculation of the value of noncallable fixed-rate perpetual preferred shares.
8.6 The Present Value of Growth Opportunity: Calculation and interpretation of the
present value of growth opportunities (PVGO) and the component of the leading
price-to-earnings ratio (P/E) related to PVGO.
8.7 Calculation and interpretation of the justified leading and trailing P/Es using the
Gordon growth model.
8.8 The strengths and limitations of the Gordon growth model and justify its selection
to value a company’s common shares.
8.9 The assumptions and justification of the two-stage DDM, the H-model, the three-stage DDM, or spreadsheet modeling to value a company’s common shares.
8.10 The growth phase, transitional phase, and maturity phase of a business.
8.11 The terminal value and alternative approaches to determining the terminal value
in a DDM.
8.12 Calculation and interpretation of the value of common shares using the two-stage
DDM, the H-model, and the three-stage DDM.
8.13 Estimation of a required return based on any DDM, including the Gordon growth
model and the H-model.
8.14 The use of spreadsheet modeling to forecast dividends and to value common
8.15 Estimation and interpretation the sustainable growth rate of a company and the
use of DuPont analysis to estimate a company’s sustainable growth rate;
8.16 Evaluation of whether a company’s share is overvalued, fairly valued, or
undervalued by the market based on a DDM estimate of value.
8.17 Free cash flow valuation
8.18 Free cash flow to firm (FCFF) and free cash flow to equity (FCFE) valuation
approaches: defining free cash flow, present value of free cash flow, single stage
FCFF and FCFE growth models compare the free cash flow to the firm (FCFF)
and free cash flow to equity (FCFE), The ownership perspective implicit in the
FCFE approach
8.19 The appropriate adjustments to net income, earnings before interest and taxes
(EBIT), earnings before interest, taxes, depreciation, and amortization (EBITDA),
and cash flow from operations (CFO) to calculate FCFF and FCFE to calculate
FCFF and FCFE; Approaches for forecasting FCFF and FCFE; computing FCFF
from net income (NI), computing FCFF from the statement of cash flows , Further
issues with free cash flow analysis; compare the FCFE model and dividend
discount models; how dividends, share repurchases, share issues, and changes
in leverage may affect future FCFF and FCFE
8.20 Free cash flow model valuations; the single-stage (stable-growth), two-stage, and
three-stage FCFF and FCFE models and select and justify the appropriate model
given a company’s characteristics.; company value and the free cash flow
model(s); the use of sensitivity analysis in FCFF and FCFE valuations; free cash
flow valuation models and determination of overvaluation vs. undervaluation
8.21 Terminal value; approaches for calculating the terminal value in a multistage
valuation model.

9. Valuation Multiples
9.1 Overview of valuation multiples: Definition and importance; rationale and
drawbacks for using valuation multiples

10. Price multiples
10.1 Method of comparable and the method based on forecasted fundamentals as
approaches to using price multiples in valuation
10.2 Alternative price multiples and dividend yield in valuation; fundamental factors
that influence alternative price multiples and dividend yield
10.3 Normalised earnings per share (EPS) and its calculation
10.4 Measures of relative value: Price-to-earnings (P/E) ratio, Price-to-book (P/B)
ratio, Price-to-cash flow ratio, and Price-to-sales (P/S) ratio
10.5 Predicted P/E regression

11. Enterprise value multiples
11.1 Alternative definition of cash flow
11.2 Enterprise value multiples and its use in estimating equity value
11.3 Momentum indicators and their use in valuation
11.4 Sources of differences in cross boarder valuation comparisons

12. Residual income valuation
12.1 Residual income concept – economic value added (EVA), and market value
added (MVA) concepts and their applications
12.2 Residual income valuation model- the uses of residual income models;
calculation of intrinsic value of a common share using the residual income model
and comparison of residual income to other present value models;
12.3 Fundamental determinants of residual income-; relationship between residual
income valuation and the justified price-to-book ratio based on forecasted
fundamentals; calculation and interpretation of the intrinsic value of a common
share using single-stage (constant-growth) and multistage residual income
12.4 Calculation of implied growth rate in residual income- given the market price-to-book ratio and required rate of return on equity;
12.5 Multistage residual income valuation-single stage and multi-stage residual
income valuation Residual income valuation in relation to other approaches comparison between residual income models and dividend discount and free
cash flow models; strengths and weaknesses of residual income models and
justification of selection of a residual income model to value a company’s shares
12.6 Accounting and international considerations- accounting issues in applying
residual income models;
12.7 Evaluate whether a stock is overvalued, fairly valued, or undervalued based on a
residual income model.

13. Private company valuation
13.1 Private and public company valuation: similarities and contrasts – Reasons for
performing private company valuations; uses of private business valuation and
applications of greatest concern to financial analysts;
13.2 Definitions (standards) of value; definitions of value and how different definitions
can lead to different estimates of value;
13.3 Valuation approaches, earnings normalization, and cash flow estimation issues;
the income, market, and asset-based approaches to private company valuation
and factors relevant to the selection of each approach; cash flow estimation
issues related to private companies and adjustments required to estimate
normalized earnings;
13.4 Income approach methods of private company valuation; determination of the
value of a private company using free cash flow, capitalized cash flow, and/or
excess earnings methods;
13.5 Factors that require adjustment when estimating the discount rate for private
companies; comparing various models used to estimate the required rate of
return to private company equity (for example, the CAPM, the expanded CAPM,
and the build-up approach);
13.6 Market approach methods of private company valuation; use of market value
method to the value of a private
13.7 Advantages and disadvantages of each method;
13.8 Asset-based approach to private company valuation; use of the asset-based
approach to value a private
13.9 Valuation discounts and premiums; the effects on private company valuations of
discounts and premiums based on control and marketability.
13.10 The role of valuation standards in the valuation of private companies; the role of
valuation standards in valuing private companies.

14. Equity market equilibrium
14.1 Justification for the short-term and long-term equilibrium
14.2 Grinold-Kroner model
14.3 Yardeni model
14.4 Tobins Q
14.5 Short-term valuation methods
14.6 Stock market diversity and its measure (entropy)