Equity Investments
Equity Investments covers how markets are organised, how indexes are constructed, what market efficiency implies, and how to value a share using discounted dividends or multiples. Items range from conceptual (weak vs semi-strong efficiency) to computational (Gordon growth, index levels).
Market organisation and indexes
- A price-weighted index sums share prices and divides by a divisor; a split requires the divisor to be adjusted so the index level is unchanged, and high-priced shares dominate the weighting.
- A market-capitalisation-weighted index needs no rebalancing when prices move, but does when constituents change.
- Weak-form efficiency: prices reflect past prices. Semi-strong: prices reflect all public information. Strong: prices reflect everything, including private information.
Valuation
- Gordon growth model: P0 = D1 / (r - g), where D1 is next year's dividend. Leading P/E = payout ratio / (r - g).
- Free cash flow to equity = net income + non-cash charges - fixed capital investment - working capital investment + net borrowing.
- Multiples must be compared across peers with similar growth, risk and capital structure; EV/EBITDA is capital-structure neutral.
Worked example
A company just paid a dividend of 2.00. Dividends are expected to grow at 4% indefinitely and the required return is 10%. D1 = 2.00 x 1.04 = 2.08. P0 = 2.08 / (0.10 - 0.04) = 2.08 / 0.06 = 34.67. Using the trailing dividend by mistake gives 2.00 / 0.06 = 33.33, understating value by roughly 4%. The payout ratio here is not given, but if the dividend of 2.08 were 40% of earnings, leading P/E would be 0.40 / 0.06 = 6.7x.
Traps that cost marks
- Putting D0 in the numerator of the Gordon model instead of D1.
- Applying the model when g is greater than or equal to r, which makes it meaningless.
- Forgetting to adjust a price-weighted index divisor after a stock split.
- Treating a low P/E as cheap without checking whether the peer group differs in growth or leverage.