Overview
Equity Investments covers how equity markets are organized, how securities are valued, and how industry and company analysis supports investment decisions. Valuation is the most heavily tested area — candidates must be comfortable with dividend discount models, price multiples, and free cash flow approaches.
Market Organization and Structure
Equity markets serve two functions: primary markets allow issuers to raise new capital (IPOs, rights offerings); secondary markets enable trading among investors. Order-driven markets (exchanges) match buy and sell orders directly; quote-driven markets (dealers) use market makers who post bid and ask prices.
Margin trading amplifies returns (and losses) by borrowing to buy securities. The maintenance margin is the minimum equity level; if equity falls below it, a margin call requires the investor to deposit more funds or liquidate positions.
Short selling involves borrowing shares, selling them, and hoping to buy them back at a lower price. The short seller must pay dividends to the lender and faces theoretically unlimited loss potential.
Market Efficiency
The Efficient Market Hypothesis (EMH) holds that security prices fully and instantly reflect all available information:
- Weak form: Prices reflect all past trading data — technical analysis cannot generate alpha
- Semi-strong form: Prices reflect all public information — fundamental analysis cannot generate persistent alpha
- Strong form: Prices reflect all information including insider knowledge
Market anomalies (momentum, value premium, size effect) challenge the semi-strong form, but many anomalies diminish after transaction costs or reflect risk factors rather than mispricing.
Equity Valuation
Dividend Discount Model (DDM): P₀ = D₁ / (r − g), where D₁ is next year’s dividend, r is the required return, and g is the constant growth rate. Only valid when g < r and the firm pays dividends.
Free Cash Flow to Equity (FCFE): Value equity by discounting cash flows available to shareholders after debt service. Preferred when dividends do not reflect the firm’s capacity to pay.
Price Multiples:
- P/E ratio = Price per share / EPS — most widely used; compare to peers or historical average
- P/B ratio = Price per share / Book value per share — useful for financial companies
- P/S ratio = Price per share / Revenue per share — used when earnings are negative
- EV/EBITDA — enterprise value multiple, capital-structure neutral
The justified P/E using DDM = payout ratio / (r − g), linking valuation to fundamentals.