Equity Investments

Stock Valuation Methods

Equity valuation is the process of estimating the intrinsic value of a company's stock. Investment adviser representatives must understand valuation methods to determine whether a stock is reasonably priced, to make appropriate recommendations, and to construct portfolios aligned with client objectives. The primary valuation approaches taught on the Series 65 include the dividend discount model, price-to-earnings analysis, and growth rate analysis.

Dividend Discount Model (DDM)

The Dividend Discount Model values a stock based on the present value of all expected future dividend payments. The most commonly tested version is the Gordon Growth Model (also called the constant growth DDM), which assumes dividends grow at a constant rate indefinitely:

V = D₁ ÷ (r − g)

Where:

V = Intrinsic value of the stock
D₁ = Expected dividend in the next period (D₀ × (1 + g))
r = Required rate of return (discount rate)
g = Expected constant growth rate of dividends

The model requires that the required rate of return (r) exceeds the growth rate (g); otherwise the formula produces a negative or infinite value. The DDM is most appropriate for mature, stable companies that pay consistent dividends, such as utilities and consumer staples companies. It is less suitable for growth companies that pay little or no dividends.

XYZ Corporation just paid a dividend of $2.00 per share. Dividends are expected to grow at 5% per year. An investor's required rate of return is 12%.

D₁ = $2.00 × (1 + 0.05) = $2.10

V = $2.10 ÷ (0.12 − 0.05) = $2.10 ÷ 0.07 = $30.00

If the stock is currently trading at $25, it appears undervalued (intrinsic value $30 > market price $25). If trading at $35, it appears overvalued.

Price-to-Earnings (P/E) Analysis

The P/E ratio is the most widely used relative valuation metric. Rather than calculating absolute intrinsic value, it compares a stock's price to its earnings to assess whether the stock is cheap or expensive relative to its earnings power and relative to comparable companies.

There are two variations: Trailing P/E uses earnings from the past twelve months (actual, reported earnings), while Forward P/E uses estimated earnings for the next twelve months (analyst consensus estimates). Forward P/E is generally more useful for investment decisions because stock prices reflect future expectations.

P/E ratios vary significantly across industries, growth rates, and market conditions. High-growth technology companies might trade at P/E ratios of 30-50x or higher, while mature utility companies might trade at 12-18x. The P/E ratio should be compared to the company's own historical range, its industry peers, and the overall market to provide meaningful context.

Growth Rate Analysis

A company's sustainable growth rate represents the maximum rate at which it can grow earnings and dividends without raising external capital. It is calculated as:

Sustainable Growth Rate = ROE × Retention Ratio

The retention ratio (also called the plowback ratio) equals 1 minus the dividend payout ratio. It represents the proportion of earnings reinvested in the business rather than distributed as dividends. For example, if a company has an ROE of 15% and retains 60% of its earnings (pays out 40% as dividends), its sustainable growth rate is 15% × 0.60 = 9%.

The Series 65 frequently tests the sustainable growth rate formula. Remember: g = ROE × (1 − Payout Ratio). If a company pays out 100% of earnings as dividends, its sustainable growth rate is zero because nothing is reinvested. If a company retains all earnings (0% payout), the growth rate equals ROE. Also remember that D₁ in the DDM is NEXT year's expected dividend, not the most recent dividend paid.

Types of Stock

Stocks can be classified by their investment characteristics, which helps advisers select appropriate investments for client portfolios. Understanding these classifications is essential for portfolio construction and client suitability analysis.

Growth Stocks

Growth stocks are shares in companies expected to grow earnings at an above-average rate relative to the overall market. These companies typically reinvest most or all of their earnings back into the business rather than paying dividends. Growth stocks tend to have high P/E ratios because investors are willing to pay a premium for expected future earnings growth. They perform best during economic expansions and when interest rates are low. Examples include technology companies, innovative healthcare firms, and emerging market leaders. Growth stocks carry higher risk because their valuations depend heavily on future expectations that may not materialize.

Value Stocks

Value stocks are shares that appear to trade at a discount relative to their intrinsic value. They typically have low P/E ratios, low price-to-book ratios, and above-average dividend yields. Value investors believe the market has temporarily underpriced these stocks due to short-term problems, investor overreaction, or neglect. Value investing, popularized by Benjamin Graham and practiced by Warren Buffett, involves identifying stocks where the market price is significantly below estimated intrinsic value, providing a "margin of safety."

Income Stocks

Income stocks are shares in companies that pay above-average dividends relative to the market. These are typically mature, stable companies with predictable cash flows, such as utilities, telecommunications companies, and real estate investment trusts (REITs). Income stocks are appropriate for investors seeking regular cash income, such as retirees. They tend to be less volatile than growth stocks but may underperform during periods of rapidly rising interest rates because their dividend yields become less attractive relative to bond yields.

Cyclical vs. Defensive Stocks

Cyclical stocks are shares in companies whose earnings are closely tied to the business cycle. They perform well during economic expansions and poorly during contractions. Examples include automobile manufacturers, airlines, hotels, luxury goods, construction companies, and steel producers. Cyclical stocks have high beta values (above 1.0), meaning they tend to amplify market movements.

Defensive (non-cyclical) stocks are shares in companies that provide essential goods and services regardless of economic conditions. They tend to maintain stable earnings throughout the business cycle. Examples include utilities, healthcare, consumer staples (food, beverages, household products), and discount retailers. Defensive stocks have low beta values (below 1.0) and outperform during recessions on a relative basis.

Other Classifications

Blue chip stocks: Large, well-established companies with long histories of stable earnings, consistent dividends, and strong balance sheets. Examples include companies in the Dow Jones Industrial Average. Blue chips are considered lower risk within the equity universe.
Penny stocks: Low-priced securities (generally below $5 per share) that trade on OTC markets or smaller exchanges. They are highly speculative, thinly traded, and subject to price manipulation. Penny stocks are unsuitable for most clients due to their extreme risk and lack of transparency.
Small-cap, mid-cap, and large-cap: Market capitalization (share price times shares outstanding) classifies companies by size. Small-cap (under $2 billion) stocks offer higher growth potential but greater risk and volatility. Mid-cap ($2-10 billion) offers a balance. Large-cap (over $10 billion) provides stability but typically slower growth.

Stock Type	P/E	Dividends	Beta	Best Environment
Growth	High	Low/None	High (>1.0)	Economic expansion, low rates
Value	Low	Moderate	Varies	Market recoveries
Income	Moderate	High	Low (<1.0)	Stable/falling rates
Cyclical	Varies	Varies	High (>1.0)	Economic expansion
Defensive	Moderate	Steady	Low (<1.0)	Economic contraction

Market Indexes

Market indexes measure the performance of a group of securities and serve as benchmarks for evaluating portfolio performance. Investment adviser representatives must understand major indexes to set appropriate benchmarks for client portfolios and to discuss market performance intelligently.

Major U.S. Stock Indexes

Dow Jones Industrial Average (DJIA): The oldest and most recognized market index, consisting of 30 large-cap U.S. companies. The DJIA is price-weighted, meaning stocks with higher share prices have greater influence on the index. A $200 stock has twice the impact of a $100 stock, regardless of total market capitalization. The DJIA's narrow composition (only 30 stocks) makes it less representative of the broad market.
S&P 500: Widely considered the best gauge of U.S. large-cap equity performance. It tracks 500 leading companies and covers approximately 80% of available U.S. market capitalization. The S&P 500 is market-capitalization weighted, meaning larger companies have greater influence. It is the most commonly used benchmark for equity portfolios and serves as the basis for numerous index funds and ETFs.
Nasdaq Composite: Includes all stocks listed on the Nasdaq exchange (over 3,000 companies). It is market-cap weighted and heavily concentrated in technology stocks, making it a useful barometer for the technology sector. The Nasdaq-100 tracks the 100 largest non-financial Nasdaq-listed companies.
Russell 2000: The most widely used benchmark for U.S. small-cap stocks. It consists of the 2,000 smallest companies in the Russell 3000 Index. The Russell 2000 is market-cap weighted and is the standard benchmark for small-cap portfolio managers.
Wilshire 5000 Total Market Index: Designed to measure the total U.S. stock market, including all actively traded U.S. equities. Despite its name, it currently includes approximately 3,500 stocks. It is market-cap weighted and represents the broadest measure of the U.S. equity market.

Price-weighted: Each stock's weight is proportional to its share price. Higher-priced stocks have more influence (e.g., DJIA).

Market-cap weighted: Each stock's weight is proportional to its total market capitalization (price × shares outstanding). Larger companies have more influence (e.g., S&P 500, Nasdaq, Russell).

Equal-weighted: Every stock has the same weight regardless of price or market cap. This gives smaller stocks more influence than in a cap-weighted index.

Technical Analysis

Technical analysis studies historical price and volume data to identify patterns and trends that may predict future price movements. Unlike fundamental analysis, which focuses on a company's financial health and intrinsic value, technical analysis assumes that all relevant information is already reflected in the stock price and that prices move in identifiable trends and patterns. While investment advisers typically rely more on fundamental analysis, the Series 65 tests key technical concepts.

Figure 3.1 — Support and Resistance Levels. Support is a price level where buying pressure tends to prevent further decline. Resistance is where selling pressure tends to prevent further advance. The 50-day moving average (gold dashed line) smooths price fluctuations.

Support and Resistance

Support is a price level at which a stock tends to find buying interest, preventing the price from falling further. When a stock approaches its support level, buyers see it as an attractive price and step in, creating demand that props up the price. If the stock breaks below support on high volume, it is a bearish signal suggesting further decline.

Resistance is a price level at which selling pressure tends to prevent the price from rising further. At resistance, traders who previously purchased the stock at that level may sell to break even, and short sellers may initiate positions. A breakout above resistance on high volume is a bullish signal. When support is broken, it often becomes new resistance, and when resistance is broken, it often becomes new support.

Moving Averages

A moving average smooths price data by calculating the average closing price over a specified number of periods. The two most commonly used are the 50-day moving average (short-term trend) and the 200-day moving average (long-term trend). When the stock price crosses above its moving average, it is considered a bullish signal. When it crosses below, it is bearish.

A golden cross occurs when the 50-day moving average crosses above the 200-day moving average, signaling a potential long-term uptrend. A death cross occurs when the 50-day crosses below the 200-day, signaling a potential long-term downtrend. These signals are widely followed by technical traders.

Volume Analysis

Volume measures the number of shares traded during a given period and serves as a confirmation tool for price movements. Price advances accompanied by increasing volume are considered more reliable because they indicate broad participation. Price advances on declining volume may indicate weakening momentum and a potential reversal. The principle is: volume confirms the trend.

Chart Patterns

Technical analysts study recurring price patterns that have historically preceded specific price movements:

Head and Shoulders: A reversal pattern consisting of a peak (left shoulder), a higher peak (head), and a lower peak (right shoulder), connected by a "neckline." Completion of this pattern (breaking below the neckline) signals a bearish reversal. An inverse head and shoulders signals a bullish reversal.
Double Top/Bottom: Two successive peaks (double top) at approximately the same price level signal resistance and potential downside reversal. Two successive troughs (double bottom) signal support and potential upside reversal.
Triangles: Formed by converging trendlines. Ascending triangles (flat top, rising bottom) are generally bullish. Descending triangles (flat bottom, falling top) are generally bearish. Symmetric triangles can break either way.

Remember the difference between crosses: "Golden is Good, Death is Doom." A golden cross (short-term MA crosses ABOVE long-term MA) is a bullish signal. A death cross (short-term MA crosses BELOW long-term MA) is a bearish signal. Also remember: Volume Validates — price movements on high volume are more significant than those on low volume.

Market Theories

Several theories attempt to explain how markets work and whether it is possible to consistently outperform them. Understanding these theories helps advisers select appropriate investment strategies for clients.

Random Walk Theory

The random walk theory, popularized by Burton Malkiel in his book "A Random Walk Down Wall Street," asserts that stock price changes are random and unpredictable. According to this theory, because all available information is already reflected in current prices, future price movements are driven by new information, which by definition is unpredictable. The random walk theory supports the weak form of the Efficient Market Hypothesis and suggests that technical analysis cannot produce consistent excess returns.

Modern Portfolio Theory (MPT)

Developed by Harry Markowitz in the 1950s, Modern Portfolio Theory demonstrates that investors can construct an "efficient frontier" of optimal portfolios that offer the maximum expected return for a given level of risk. The key insight is that diversification reduces portfolio risk without necessarily reducing expected return, because assets with low or negative correlations offset each other's price movements. MPT is covered in detail in Chapter 6 on Portfolio Management.

Active vs. Passive Management

The debate between active and passive management is one of the most important practical implications of market efficiency theory:

Active management attempts to outperform a benchmark index through stock selection, sector rotation, and market timing. Active managers believe they can identify mispriced securities or predict market movements through research and analysis. Active management involves higher costs (management fees, trading costs, research expenses) and generates more taxable events. Academic research shows that the majority of actively managed funds underperform their benchmark indexes over long periods after fees.
Passive management seeks to replicate the performance of a market index by holding the same securities in the same proportions. Passive strategies accept market returns and focus on minimizing costs and tracking error. Index funds and most ETFs follow passive strategies. They offer lower fees, greater tax efficiency, and broad diversification. Passive management has grown dramatically as evidence of the difficulty of consistent active outperformance has accumulated.

The choice between active and passive management depends on the adviser's belief in market efficiency, the specific market segment, cost considerations, and client preferences. Many advisers use a core-satellite approach: index funds for efficient large-cap markets (core) combined with active management in potentially less efficient areas like small-cap, international, or alternative investments (satellites).

Deep Dive Behavioral Finance and Market Anomalies

Behavioral finance challenges the assumption of rational investors that underpins the EMH. Key cognitive biases that affect investment decisions include:

Overconfidence: Investors overestimate their ability to pick stocks or time markets, leading to excessive trading and underperformance.
Anchoring: Investors fixate on irrelevant reference points, such as a stock's 52-week high or their purchase price, rather than making decisions based on current information and intrinsic value.
Loss aversion: Investors feel the pain of losses approximately twice as intensely as the pleasure of equivalent gains. This leads to holding losers too long (hoping to break even) and selling winners too quickly (locking in gains).
Herding: The tendency to follow the crowd, buying when others are buying and selling when others are selling. Herding can amplify market bubbles and crashes.
Recency bias: Giving excessive weight to recent events and projecting recent trends into the future. This contributes to performance chasing (investing in recent winners).
Mental accounting: Treating money differently based on its source or intended use, rather than viewing all wealth fungibly. For example, treating a tax refund as "found money" and spending it more freely.

Advisers who understand behavioral biases can help clients avoid costly mistakes by maintaining discipline, diversification, and long-term focus despite emotional impulses.