Equity Investments
What you must know
Market organisation and trading (order types, margin, short selling), equity indexes and their weighting schemes, market efficiency in weak, semi-strong and strong forms, and equity valuation: dividend discount models including Gordon growth and multistage, price multiples (P/E, P/B, P/S, EV/EBITDA), free cash flow models, and residual income. Also industry analysis (Porter's five forces, life-cycle stages) and company analysis.
Traps
(1) A price-weighted index is distorted by stock splits (divisor adjusts) and gives high-priced shares the most influence; a value-weighted index weights by market capitalisation; an equal-weighted index must be rebalanced. (2) Gordon growth requires g < r and assumes g = ROE x retention ratio stays constant forever. (3) A leading P/E uses next year's earnings; a trailing P/E uses last year's. (4) EV = market value of equity + debt + preferred - cash. (5) A perpetuity with no growth is valued as D/r. (6) In semi-strong efficiency, fundamental analysis cannot add value.
Worked example
A stock just paid a dividend of $1.92, dividends grow 4% forever, and the required return is 10%. D1 = 1.92 x 1.04 = $2.00, so value = 2.00/(0.10 - 0.04) = $33.33. Using D0 instead of D1 would give $32.00 - a common trap.