CFA Equity Investments 2 — Questions and Answers
Question 1: An analyst uses a residual income model to value a stock. Residual income is defined as:
- Net income minus dividends paid to shareholders
- Net income minus the equity charge (required return × book value of equity) (Correct answer)
- Operating income minus the cost of debt
- Free cash flow minus capital expenditures
Correct answer: Net income minus the equity charge (required return × book value of equity)
Residual income = Net income – (required return on equity × beginning book value of equity); it measures value created above the cost of equity.
Question 2: Which industry structure, under Porter's Five Forces, would MOST support high profitability for existing firms?
- High rivalry, easy entry, many substitutes
- Few rivals, high barriers to entry, few substitutes (Correct answer)
- Many rivals, low switching costs, high supplier power
- Commodity products, price competition, low differentiation
Correct answer: Few rivals, high barriers to entry, few substitutes
High barriers to entry, few competitors, and limited substitutes reduce competitive pressure, allowing existing firms to maintain pricing power and high margins.
Question 3: A company repurchases shares in the open market. All else equal, this will MOST likely:
- Decrease earnings per share (EPS)
- Increase earnings per share (EPS) (Correct answer)
- Have no effect on EPS
- Decrease return on equity (ROE)
Correct answer: Increase earnings per share (EPS)
Share buybacks reduce the share count; if net income is unchanged, EPS rises because the same earnings are divided among fewer shares.
Question 4: The price-to-book (P/B) ratio is LEAST informative when analyzing a company in which sector?
- Banking
- Insurance
- Technology or software (Correct answer)
- Real estate
Correct answer: Technology or software
Technology and software firms have significant intangible assets (IP, brand, human capital) not fully captured on the balance sheet, making P/B less meaningful.
Question 5: In the two-stage dividend discount model, the second stage typically assumes:
- A high growth rate consistent with the initial stage
- A stable, sustainable long-run growth rate (Correct answer)
- Zero dividend growth indefinitely
- Dividends are reinvested rather than paid out
Correct answer: A stable, sustainable long-run growth rate
The two-stage DDM uses a high near-term growth rate followed by a terminal stage with a stable, long-run sustainable growth rate applied in perpetuity.
Question 6: Which of the following is an example of a top-down approach to equity analysis?
- Analyzing a company's financial statements to determine intrinsic value
- Starting with macroeconomic conditions, then narrowing to sector and finally individual stock selection (Correct answer)
- Screening stocks based on low P/E and high dividend yield
- Using discounted cash flow to value individual companies
Correct answer: Starting with macroeconomic conditions, then narrowing to sector and finally individual stock selection
A top-down approach begins with macroeconomic analysis (GDP, interest rates), then identifies attractive sectors, and finally selects individual stocks within those sectors.
CFA Equity Investments 2
An analyst uses a residual income model to value a stock.
Residual income is defined as: