CFA Level II Exam flashcards

A valuation model that assumes a company experiences two distinct stages of dividend growth: an initial period of high, non-constant growth, followed by a stable, constant growth rate.

• Suitable for companies with predictable high growth followed by stable growth.
• Calculates the present value of dividends in the high-growth phase and the terminal value of dividends in the stable-growth phase.
• Requires estimation of growth rates and duration of high-growth phase.

Memory trick: Growth Stages dictate the Dividend Discount Model's fit.

Valuation multiples that relate the total value of a company (market capitalization + net debt) to a measure of its operating performance, such as revenue, EBIT, or EBITDA.

• EV/EBITDA is a common EV multiple, useful for comparing companies with different capital structures.
• Less susceptible to differences in accounting choices for depreciation and amortization than P/E.
• Most effective when comparing companies within the same industry.

Memory trick: Industries apart, multiples fall apart.

A valuation multiple that measures a company's current share price relative to its per-share earnings. It indicates how much investors are willing to pay for each dollar of earnings.

• Calculated as Share Price / Earnings Per Share (EPS).
• Higher P/E often implies higher growth expectations or lower risk.
• Used for relative valuation within the same industry.

Memory trick: P/E's high, growth is nigh.

A valuation model that assumes a company's dividend growth occurs in three distinct phases: an initial period of high growth, followed by a transitional period of declining growth, and finally a stable, constant growth rate indefinitely.

• Suitable for companies with complex, evolving growth profiles.
• Requires estimation of growth rates and durations for all three stages.
• More complex to implement than two-stage models but provides greater flexibility.

Memory trick: Three phases mean three DDM stages.

A market-based valuation approach for private companies that uses valuation multiples (e.g., P/E, EV/EBITDA) derived from publicly traded companies similar to the target private company.

• Relies on the principle that similar businesses should have similar valuation multiples.
• Requires careful selection of comparable public companies and adjustments for differences.
• Common adjustments include size, growth, risk, marketability, and accounting.

Memory trick: Comparables need a 'CALM' adjustment.

Under the equity method, an investor recognizes its proportionate share of the investee's net income as 'Equity in Earnings of Affiliate' in its own income statement. This increases the investor's net income and retained earnings.

• Used for significant influence (20-50% ownership, or less with influence).
• Investor's net income includes its share of investee's net income.
• Investment account is adjusted for share of income and dividends.
• Higher reported net income compared to fair value methods for profitable investees.

Memory trick: INVESTMENT method IMPACTS Net Income and Balance Sheet.

Under U.S. GAAP, the balance sheet reports a net pension asset or liability equal to the funded status of the plan (Fair Value of Plan Assets - Projected Benefit Obligation).

• Funded status = FVPA - PBO.
• If FVPA > PBO, it's a net pension asset.
• If FVPA < PBO, it's a net pension liability.
• Unrecognized components (like prior service costs) are not directly on the balance sheet but affect OCI.

Memory trick: PBO and FVPA set the funded 'STATUS' on the balance sheet.

Under the temporal method, when the parent's currency is the functional currency, nonmonetary assets (e.g., inventory, property, plant, and equipment, intangible assets) are translated using the historical exchange rate that prevailed when the asset was acquired.

• Used when parent's currency is functional currency.
• Monetary assets/liabilities translated at current rate.
• Nonmonetary assets/liabilities translated at historical rates.
• Equity (capital) also translated at historical rates.

Memory trick: Temporal Method: 'Time' matters for nonmonetary items, 'Current' for cash-like.

When an investor accounts for a foreign associate using the equity method, its share of the associate's net income is translated into the investor's reporting currency using the average exchange rate for the reporting period.

• Applies to significant influence (20-50% ownership).
• Investor's share of net income translated at average rate.
• Investor's share of OCI translated at average rate.
• Investment account is adjusted for translated income and dividends.

Memory trick: Equity Income: 'Average' effort for average period earnings.

Bias in accounting estimates refers to management's use of subjective judgments and assumptions in financial reporting to achieve desired financial outcomes, often to inflate revenues, assets, or earnings, or to defer expenses and liabilities.

• Involves management discretion over uncertain items.
• Examples: Underestimating bad debt, overestimating useful lives, delaying impairments.
• Results in misrepresentation of true economic performance.
• Requires analyst vigilance and comparison to industry peers.

Memory trick: Low Quality: 'MAS'sive 'D'eception (Manipulation, Aggressive, Smoothing, Deferral).

Pension expense comprises several components. Interest cost, expected return on assets, and actuarial gains/losses (which include prior service cost amortization) are generally sensitive to changes in the assumed discount rate. Service cost, representing benefits earned in the current period, is primarily driven by compensation and benefit formulas, making it less sensitive to the discount rate.

• Service Cost: Benefits earned in current period.
• Interest Cost: PBO * Discount Rate.
• Expected Return on Assets: FVPA * Expected Return Rate.
• Amortization of PSC/Actuarial G/L: Affects PBO/FVPA, sensitive to discount rate.

Memory trick: PENSION is a SERVICE with INTEREST, ASSETS return, and ACTUARIAL adjustments.

Under IFRS, actuarial gains and losses on the defined benefit obligation and the difference between actual return on plan assets and interest income on plan assets (remeasurements) are recognized in Other Comprehensive Income (OCI) and are not subsequently reclassified to profit or loss.

• Remeasurements include actuarial gains/losses and asset return differences.
• Recognized directly in OCI under IFRS.
• Not subsequently reclassified to P&L.
• Differs from U.S. GAAP which allows for a 'corridor' approach or P&L recognition for some remeasurements.

Memory trick: IFRS Remeasurements: 'Always OCI' for actuarial and asset differences.

Under the current rate method, when a foreign subsidiary's functional currency is its local currency, all assets and liabilities on its balance sheet are translated into the parent's reporting currency using the current (year-end) exchange rate.

• Used when functional currency is local currency.
• Assets and liabilities translated at current (year-end) rate.
• Equity accounts (common stock, APIC) are translated at historical rates.
• Retained earnings is a plug figure, reflecting translated income and dividends.

Memory trick: Current Rate: 'All Current' for Balance Sheet, 'Average' for Income.

The functional currency is the currency of the primary economic environment in which an entity operates. If the functional currency is the local currency, the current rate method is used. If the functional currency is the parent's currency (or for highly inflationary economies under U.S. GAAP), the temporal method is used.

• Functional currency is key to selecting translation method.
• Self-contained operations imply local currency is functional currency.
• Integrated operations imply parent's currency is functional currency.
• Highly inflationary economies (U.S. GAAP) always use parent's currency as functional and temporal method.

Memory trick: Functional Currency: Local for Current, Parent for Temporal.

A method of translating foreign subsidiary financial statements when the foreign subsidiary's functional currency is the same as the parent's reporting currency, or when the foreign economy is highly inflationary.

• Monetary Assets/Liabilities: Current Rate
• Non-Monetary Assets/Liabilities: Historical Rate
• Income Statement: Average Rate (most items), Historical Rate (depreciation/COGS)
• Translation Adjustments: Income Statement (translation gain/loss)

Memory trick: Temporal for Times, Monetary Now, Non-Monetary Then.

Free Cash Flow to Equity (FCFE) is the cash flow available to equity holders after all expenses, reinvestment needs (CapEx and working capital), and net debt payments have been accounted for. It can be calculated from Net Income by adding back non-cash charges, subtracting CapEx, subtracting change in working capital, and adding back net borrowing.

• FCFE = NI + NCC - CapEx - ΔWC + Net Borrowing.
• Represents cash available to equity investors.
• Used in equity valuation models.
• Unlike FCFF, it is after interest payments and includes net debt changes.

Memory trick: FCFE: 'NI + NCC - C - W + B' (Net Income, Non-Cash, CapEx, Working Capital, Borrowing).

The current rate method is used when a foreign subsidiary's functional currency is its local currency. Translation adjustments arising from this method are reported in Other Comprehensive Income (OCI).

• Functional currency is the local currency.
• All assets and liabilities translated at current rate.
• Equity accounts (except retained earnings) translated at historical rates.
• Income statement items translated at average rate.

Memory trick: FUNctional currency determines the METHOD, OCI is a CURRENT event.

Capitalization records an expenditure as an asset on the balance sheet, depreciating it over its useful life. Expensing records an expenditure as an expense on the income statement in the period incurred.

• Capitalization defers expense recognition.
• Expensing impacts current period net income significantly.
• Choice affects assets, expenses, and net income.

Memory trick: CAPitalize Assets, EXPense Income Now.

Key differences exist in the treatment of actuarial gains/losses, amortization of past service costs, and the components of net periodic pension cost, leading to variations in reported pension liabilities and expenses.

• IFRS: Actuarial G/L immediate OCI.
• U.S. GAAP: Actuarial G/L OCI, then corridor amortization to P&L.
• IFRS: Net interest expense on net DB liability/asset.
• U.S. GAAP: Expected return on plan assets.

Memory trick: IFRS Clear OCI, US GAAP Corridor Delay.

Under U.S. GAAP, if a foreign subsidiary operates in a highly inflationary economy (cumulative inflation >= 100% over 3 years), the parent's reporting currency is designated as the functional currency, and the temporal method is used for translation.

• Applies when cumulative 3-year inflation is >= 100%.
• Parent's reporting currency becomes the functional currency.
• Temporal method is used, not current rate method.
• Translation adjustments are recognized in net income, not OCI.

Memory trick: Hyperinflation (U.S. GAAP): 'USD' is the functional, 'Temporal' is the method.

Changes in PBO or plan assets due to changes in actuarial assumptions or actual experience differing from expected. Under U.S. GAAP, they are recognized in OCI and amortized to profit or loss.

• Initial recognition in OCI.
• Amortized to profit or loss over time.
• Corridor approach may apply for amortization.

Memory trick: OCI is the holding pen, then slowly to Income.

Under the current rate method, when a foreign subsidiary's functional currency is its local currency, all income statement accounts (revenues, expenses, gains, losses), including net income, are translated into the parent's reporting currency using the average exchange rate for the reporting period.

• Used when functional currency is local currency.
• Income statement items translated at average rate.
• Reflects economic activity occurring evenly throughout the period.
• Translation adjustment (OCI) arises from balance sheet translation.

Memory trick: Current Rate: 'All Current' for Balance Sheet, 'Average' for Income.

When an investor obtains control (typically >50% ownership) over another entity, both IFRS and U.S. GAAP require the use of full consolidation, where 100% of the acquiree's financial statement items are combined with the acquirer's, and a non-controlling interest is reported.

• Control usually means >50% voting rights.
• Full consolidation combines 100% of assets, liabilities, revenues, expenses.
• Non-controlling interest (minority interest) is reported.
• Applies universally under both IFRS and U.S. GAAP for control.

Memory trick: Investments: Control means 'Full' combination, Influence means 'Equity' line.

The present value of all free cash flows to the firm beyond the explicit forecast period, typically calculated using a perpetual growth model.

• Calculated at the end of the explicit forecast period (e.g., Year 3).
• Uses the first cash flow *after* the forecast period (e.g., FCFF4).
• Discounted back to the valuation date to find its present value.

Memory trick: Future Cash Flows Forever, Discount Them Back!

A valuation model that estimates the value of a firm based on the assumption that free cash flow to firm (FCFF) grows at a constant rate indefinitely.

• Suitable for mature companies with stable growth.
• Formula: Value = FCFF1 / (WACC - g).
• FCFF1 is the FCFF expected in the next period.

Memory trick: FCFF: Firm's Cash Flow, Constant Growth, Capital Cost.

To ensure comparability when using P/E ratios, analysts must adjust for differences in accounting methods, capital structure changes (like share repurchases), and non-recurring items.

• Share repurchases impact EPS and thus P/E.
• Use forward P/E with adjusted EPS for future capital structure.
• Adjust for non-recurring items affecting earnings.

Memory trick: Compare P/E, Adjust for Capital, Growth, and Accounting.

A valuation approach for early-stage companies that estimates a future exit value (e.g., using a revenue multiple) and discounts it back to the present at a high required rate of return to account for high risk.

• Focuses on future exit value at a specific horizon.
• Uses industry multiples of future revenues/earnings.
• Applies a very high discount rate (VC hurdle rate).

Memory trick: Early Valuations: VC Future, First Chicago Scenarios.

When using an asset-based valuation, various balance sheet items must be adjusted from book value to fair market value to reflect the true economic worth of the company's assets and liabilities.

• Tangible assets (PPE) often need revaluation.
• Intangible assets (patents, brands) are frequently understated.
• Liabilities also need to be adjusted to market values.

Memory trick: Assets to Market, Liabilities to Fair Value.

The Price-to-Earnings (P/E) ratio is influenced by a company's expected earnings growth rate, required rate of return, and dividend payout ratio (or retention rate).

• Higher expected growth rate typically leads to higher P/E.
• Higher required rate of return typically leads to lower P/E.
• Higher payout ratio (lower retention) can lead to lower P/E if growth opportunities are present.

Memory trick: P/E is Driven by Growth, Risk, and Payout.

Factors that influence a company's Price-to-Book (P/B) ratio, primarily return on equity, growth rate, and cost of equity.

• P/B = (ROE - g) / (r - g) (simplified relation).
• Higher ROE generally leads to higher P/B.
• Higher cost of equity (r) generally leads to lower P/B.

Memory trick: P/B is driven by Returns, Growth, and Cost.

A private company valuation method that estimates value based on multiples derived from prices paid in recent acquisition transactions for similar companies.

• Uses data from actual M&A transactions.
• Multiples are applied to the target company's metrics.
• Adjustments for differences between target and guideline companies are crucial.

Memory trick: Private Valuations: Cash, Public, Transactions, Income.

Challenges in sum-of-the-parts valuation include accurately identifying and valuing distinct business segments, allocating shared costs and liabilities, and dealing with intercompany transactions.

• Difficult to allocate corporate overhead and debt.
• Requires robust segment-specific comparable data.
• Intercompany transactions need careful adjustment.

Memory trick: Parts Valuation: Allocate, Compare, Transactions, and Synergy.

A valuation model that allows for varying dividend growth rates over different periods, typically a high-growth phase, a transition phase, and a stable-growth phase.

• Used for companies with non-constant dividend growth.
• Requires calculating dividends for each stage and a terminal value.
• All future cash flows (dividends and terminal value) are discounted to present.

Memory trick: Many Stages: Dividends Dance, Then Settle Down.

A Free Cash Flow to Equity (FCFE) valuation model that incorporates three distinct phases of growth: an initial high-growth period, followed by a transition/moderate-growth period, and then a stable, perpetual growth period.

• Used for companies with complex growth profiles.
• Allows for more realistic modeling of growth deceleration.
• Requires careful estimation of growth rates for each stage.

Memory trick: FCFE Stages: One, Two, Three for Growth.

The maximum rate at which a company can grow its sales and earnings without external equity financing, calculated as (1 - payout ratio) * Return on Equity (ROE).

• Also known as 'g' in the Gordon Growth Model.
• Assumes constant financial leverage and payout ratio.
• Reflects internal growth capacity.

Memory trick: Dividend Growth equals Sustainable Growth: Retention Times ROE.

Capital expenditures can be categorized into maintenance CapEx (necessary to sustain current operations) and expansion CapEx (for growth initiatives). Their distinction is crucial for certain cash flow analyses.

• Maintenance CapEx is non-discretionary.
• Expansion CapEx is discretionary and growth-oriented.
• FCFF typically includes both, but adjustments can be made.

Memory trick: FCFF for Firm, CapEx is Key: Maintain, Grow, or Exclude.

A real estate valuation method that estimates a property's value by dividing its first-year Net Operating Income (NOI) by a market-derived capitalization rate (cap rate).

• Value = NOI1 / Cap Rate.
• Assumes stable, perpetual income stream.
• Cap rate reflects market expectations for return and growth.

Memory trick: Direct Cap: NOI Over Cap Rate.

When a firm first becomes GIPS compliant, it must present a minimum of five years of GIPS-compliant performance. If the firm or composite has been in existence for less than five years, it must present performance since the composite's or firm's inception.

• Minimum initial presentation: 5 years of GIPS-compliant data.
• If less than 5 years old, present since inception.
• Add 1 year annually until 10 years are presented.

Memory trick: GIPS History: Start with Five, Grow to Ten.

GIPS requires firms to present a minimum of five years of GIPS-compliant performance, building up to a minimum of 10 years over time.

• Initial minimum: 5 years.
• Add 1 year annually until 10 years are presented.
• If composite/firm less than 5 years old, present since inception.

Memory trick: GIPS: Five to Ten, Fairly Shown.

Members and Candidates must make full and fair disclosure of all matters that could reasonably be expected to impair their independence and objectivity or interfere with their duties to clients, prospective clients, or their employer.

• Disclose all actual and potential conflicts of interest.
• Disclosure must be prominent and timely.
• Applies to personal, firm, and client conflicts.

Memory trick: Firm's Conflicted? Disclose, Don't Disguise.

Members and Candidates must deal fairly and objectively with all clients when taking investment action.

• Treat all clients impartially.
• Do not discriminate against any clients.
• Allocate investment opportunities (e.g., IPOs, block trades) fairly.

Memory trick: Treat Clients Fairly: No favoritism, equal opportunity.

The Global Investment Performance Standards (GIPS) are a set of ethical standards for investment performance presentation, ensuring fair representation and full disclosure of investment performance.

• All fee-paying discretionary portfolios must be included in a composite.
• Firms must define 'firm' and adhere to specific calculation and presentation standards.
• Verification is optional but must be performed by an independent third party for the entire firm.

Memory trick: GIPS: Ethical, Transparent, Comparable Performance.

Members and Candidates must exercise diligence, independence, and thoroughness in analyzing investments, making investment recommendations, and taking investment actions.

• Have a reasonable and adequate basis for all recommendations.
• Conduct thorough analysis and research.
• Use sound judgment in forming conclusions.

Memory trick: Research: Diligent, Independent, Factual.

Members and Candidates must make reasonable efforts to ensure that investments are suitable for the client's financial situation and consistent with the client's written objectives and constraints.

• Understand client's risk tolerance, objectives, and constraints.
• Ensure investment recommendations align with the IPS.
• Avoid recommending investments that contradict client's stated needs.

Memory trick: Suitability: Match investments to client's needs, not just returns.

Permissible if brokerage benefits clients, the value is reasonable, and the arrangement is disclosed to clients.

• Must benefit the client (e.g., research, execution services).
• Brokerage commissions should be reasonable relative to benefits.
• Requires disclosure to clients.
• Prioritizes best execution for clients.

Memory trick: Soft Dollars: Disclose, Benefit, Best Execute.

Members and Candidates must act for the benefit of their employer and not deprive their employer of the advantage of their skills and abilities, divulge confidential information, or otherwise cause harm, especially when transitioning between jobs.

• Do not take employer property (client lists, models) upon leaving.
• Do not solicit clients or prospective clients before leaving, unless specific agreements allow.
• Protect employer's confidential and proprietary information.

Memory trick: Leaving: Loyalty, No Stealing, Clean Break.

Members and Candidates who possess material nonpublic information that could affect the value of an investment must not act or cause others to act on the information.

• Information is 'material' if its disclosure would likely affect the price of a security or if investors would want to know it.
• Information is 'nonpublic' until it has been disseminated to the market generally.
• Do not act or cause others to act on such information.

Memory trick: Integrity: No Insider Info, No Market Manipulation.

When a material error is discovered in client communications, Members and Candidates must promptly take steps to correct it, typically by informing compliance and then the client.

• Material errors must be corrected.
• Prioritize informing compliance department.
• Client must be informed in a timely manner.

Memory trick: Error Found? Compliance First, Client Soon.

Members and Candidates must not engage in practices that distort prices or artificially inflate trading volume with the intent to mislead market participants.

• Do not spread false or misleading information.
• Do not engage in transactions designed to deceive.
• Avoid actions that create artificial price movements or trading volume.

Memory trick: Market must be Fair: No Manipulation, No Deception.

For GIPS compliance, a 'firm' must be defined as a distinct business unit managed with a separate and distinct investment decision-making process.

• Focuses on investment decision-making unit.
• Not necessarily the entire legal entity or parent company.
• Ensures consistent performance reporting.

Memory trick: Distinct Decision-making Defines the Firm.

Members and Candidates must make reasonable efforts to ensure that performance information is fair, accurate, and complete.

• Do not misrepresent performance.
• Include all relevant disclosures, including calculation methodology and investment objectives.
• Present performance fairly, accurately, and completely.

Memory trick: Communicate Clearly: Integrity, Objectivity, Performance.

Members and Candidates must adhere to the firm's investment policy statement and client mandates, even if personal research suggests otherwise.

• IPS is a binding document for managing client assets.
• Compliance with IPS is central to Standard III(A) and I(A).
• Recommendations must align with client/fund objectives and constraints.

Memory trick: IPS Rules: Follow Them, Don't Flee Them.

If a client insists on an unsuitable investment that conflicts with their IPS, the advisor must explain the unsuitability and, if necessary, decline the transaction or terminate the relationship.

• Advisor must always prioritize client's best interests.
• IPS is the governing document for suitability.
• Must decline if investment is clearly unsuitable and client insists.

Memory trick: Unsuitable Request? Refuse, Explain, Protect.

Members and Candidates must make a reasonable inquiry into a client's financial situation, investment experience, and investment objectives and must determine that an investment is suitable for the client's financial situation and consistent with the client's written objectives and constraints.

• Understand client's financial situation, experience, and objectives.
• Ensure investments are suitable for the client.
• Consider client's written objectives and constraints.

Memory trick: Clients Prefer Loyal Suitability, Fairly Disclosed.

Members and Candidates must act for the benefit of their employer and not deprive their employer of the advantage of their skills and abilities, divulge confidential information, or otherwise cause harm to their employer.

• Act in employer's best interest.
• Do not engage in independent practice that conflicts with employer.
• Protect employer's confidential information and property.

Memory trick: Loyalty to Employer, No Additional Comp, No Misconduct.

Members and Candidates must make reasonable efforts to ensure investments are suitable for a client's financial situation and consistent with their written objectives and constraints, including the IPS.

• Understand client's IPS thoroughly.
• Ensure current holdings and future recommendations align with IPS.
• Address any discrepancies with the client before taking action.

Memory trick: Manage portfolios with Suitability and Client Communication.

Credit risk in an interest rate swap arises when one counterparty's position becomes 'in-the-money' (has positive value) and the other counterparty defaults.

• The 'in-the-money' party faces a loss equal to the positive value of the swap if the 'out-of-the-money' party defaults.
• Interest rate movements determine which party is 'in-the-money'.
• For a fixed-rate payer, rising rates generally create positive value; for a floating-rate payer, falling rates generally create positive value.

Memory trick: Credit Risk: Who's 'Winning' if the Other Guy 'Quits'?

The process of determining the fair market value of an interest rate swap at a point in time after initiation, typically by valuing its fixed and floating legs.

• At initiation, a plain vanilla swap has zero value.
• Value changes as market interest rates change.
• Floating leg value resets to par at each payment date (just after payment).

Memory trick: Fixed-Float Value: Present Value of Floating Payments MINUS Present Value of Fixed Payments.

The upside breakeven point for a long strangle strategy is the strike price of the call option plus the total premiums paid for both the call and put options.

• A long strangle involves buying an out-of-the-money call and an out-of-the-money put.
• It profits from a large price movement in either direction.
• Total premiums paid reduce potential profit and define breakeven points.

Memory trick: Strangle's Break: Call Strike + Total Premium for UP, Put Strike - Total Premium for DOWN!

An option strategy involving buying both a call and a put option with the same strike price and expiration date on the same underlying asset.

• Profits from large price movements (high volatility) in either direction.
• Maximum loss is limited to the premiums paid.
• Requires significant price movement to be profitable.

Memory trick: Straddles and Strangles: Volatility's Bets.