Equity Investments
Markets and Instruments
Equity analysis covers market structure, order types, and valuation. Understand the difference between primary and secondary markets, and among order types: market orders (execution certainty, price uncertainty) versus limit orders (price certainty, execution uncertainty). Know margin mechanics conceptually: initial margin, maintenance margin, and margin calls.
Valuation Approaches
Candidates must apply three families: discounted cash flow (dividend discount models, free cash flow models), multiplier-based relative valuation (P/E, P/B, P/S, EV/EBITDA), and asset-based valuation. The Gordon growth model, P0 = D1/(r − g), is foundational; it requires r > g and assumes constant growth. Leading versus trailing P/E differ in the earnings used; justify multiples against growth, payout, and risk.
Market Efficiency
Understand weak, semi-strong, and strong forms of the efficient market hypothesis and what each implies about active management and information advantages. Behavioral biases (overconfidence, anchoring, herding) explain anomalies that pure efficiency cannot.
Common Traps
- Using trailing earnings in a forward P/E or vice versa.
- Applying the Gordon model with g ≥ r, producing nonsense.
- Confusing enterprise value (net of debt and cash) with equity value in multiples.
- Ignoring that a high P/B may reflect high expected ROE, not overvaluation.
Worked Example
A stock just paid a dividend of 2.00, expected to grow at 4%, with required return 10%. D1 = 2.00 × 1.04 = 2.08. P0 = 2.08 / (0.10 − 0.04) = 34.67. Note the next dividend, not the last, belongs in the numerator.