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Passing on investment strategy information to customers, informing them of risks and rewards as well as communicating research, market, and investment data

Studying a client’s investment portfolio and analyzing accounts is an essential part of the work a registered representative does.

That’s because, by doing so, the right products can be found and recommended to them that will suit their investment needs.

Modern portfolio theory and asset allocation

In this section, we look to understand how to diversify a portfolio by looking at the major asset classes that form part of asset allocation.

Asset classes

The spreading of assets around is possible through diversification.

And focusing on just one stock when investing is a mistake that many investors make.

But of course, if an investor is going to diversify, where you put them is of critical importance as well.

So what is asset class allocation?

Simply put, this is using funds in an investor’s portfolio to buy into various asset classes.

All of these will have their own characteristics, particularly when it comes to risk versus return.

In the world of securities, there are three primary asset classes.

  • Stock
  • Bonds
  • Cash

Each of these has subclasses within them of course.

Stock, for example, includes various subclasses that cover foreign equity, value versus growth, and market capitalization.

Bonds have medium and long-term maturity, for example, corporate, non-U.S and treasury issuers.

Lastly, cash includes short-term money market instruments and standard risk-free investments.

The following points are taken into account when it comes to proper asset allocation:

  • Investor’s attitude towards the preservation of their capital
  • Their income
  • How they see capital growth
  • Or some (sometimes all) of these combined

Note that asset allocation can also include tangible assets like:

  • REITs
  • Precious metals
  • Types of commodities
  • Collectables

Because they reduce inflation risks, these kinds of assets are popular and form part of asset allocation for that reason.

Note that institutional investors and others with high net worth also use other alternative investment asset classes.

These include:

  • Private equity
  • ETNs
  • Venture capital

These are only available to those who can afford their high cost of entry, however.

With asset allocation, a process is followed and it’s not just a free for all in purchasing various asset classes.

For example, a popular form of diversification uses a geographic underlying trend.

This means that to construct the portfolio, bonds are purchased from different areas of the country.

That’s just an example, however.

Strategic asset allocation

A passive strategy looks at drawing up a long-term investment portfolio and refers to the proportion of the various types of investments in it.

For example, with a standard asset allocation, the rule is to take the investor’s age from 100 which helps determine portfolio balance when it comes to stocks versus bonds.

For example, in a 40-year-old, the ratio would be 60% in stocks and 40% in bonds and cash while for a 60-year-old would be the opposite.

As time moves on, rebalancing takes place as target allocations are brought back by changing the asset mix.

Tactical asset allocation

An active strategy, this sees short-term portfolio adjustments.

Here, depending on market conditions, the portfolio mix between asset classes is adjusted.

Modern portfolio theory (MPT)

The allocation and diversification of portfolio holdings all play a crucial role when it comes to managing risk.

Choosing new investments should take into account what the investor already has in their portfolio to ensure that greater balance is achieved overall.

A simple example of this is having investments that are more volatile as well as those that are less volatile to balance things up overall.

On the whole, a scientific approach is used in MPT to choose investments by measuring risks.

This is done by looking at various portfolio combinations and then identifying which could provide the best returns on investment at varying risk levels.

The idea here is to minimize risk through the combination of investments that are price-stable along with those that are more volatile.

It’s the perfect way to structure a portfolio for those investors who are considered to be more risk-averse.

MPT also looks at the relationships between the various investments making up a portfolio.

In particular, by building portfolios of securities with uncorrelated returns, specific risks can be diversified.

Ultimately, it’s aimed at increasing expected returns while reducing risks.

Interestingly, securities that all move in the same direction ultimately don’t lower the risk in an investment portfolio.

Diversification can but only when prices move inversely between the held portfolio assets as well as at different times.

At the end of the day, it’s all about an MPT strategy wanting the securities in a specific portfolio to have a negative correlation.

The perfect score for this would be -1.0 which indicates that if a security goes up, another will go do proportionately.

Of course, getting a negative correlation score of -1.0 isn’t that simple.

Capital Asset Pricing Model (CAPM)

CAPM helps calculate based on the risk taken, the return that investments should achieve.

And higher potential returns can be expected if more risks are taken.

The model says that because of the risks they take, investors should be rewarded.

It’s a model that uses calculations that determine something called the beta coefficient.

That’s the risk multiplier that’s needed to reach a required return.

If you look at a portfolio from a total risk point of view, it consists of:

  • Unsystematic (nonsystematic) risk
  • Systematic risk

We will cover them in greater detail later in this exam guide but here’s a quick breakdown.

Unsystematic (nonsystematic) risk is close to zero in portfolios in which an investor has made sure to diversify the stocks they hold.

Here, the only risk to the portfolio comes in the form of systematic risk.

This is when markets move together and the risk is the overall market that’s invested in.

If you look at individual investments, they have both systematic and unsystematic risks.

If added to a well-diversified portfolio, however, investors don’t have to worry about the unsystematic risk at all.

Beta coefficient 

We’ve briefly touched on the beta coefficient but let’s look at it a little more.

The first thing to note is that you’ll see it called beta from time to time but it’s all the same thing.

When we talk about the beta of a stock or portfolio, we are speaking about its volatility.

Specifically, however, we look at that volatility up against the overall market.

If a security moves in line with the market if it has a beta of one, for example.

Should security or portfolio have a beta of more than one, in terms of the overall market, it is more volatile.

Should a beta be less than one for a security or portfolio, in terms of the overall market, it is less volatile.

A beta of zero means that the security isn’t moving in relation to the market movement.

Examples of this are money market securities or money market mutual funds.

The overall market described above is based on the S&P 500.

Should it rise or fall by 10%, stocks with beta ratings of one will do the same.

If the beta is 0.75, and the market drops by 10%, the beta drops by 7.5%.

Alpha coefficient 

The job of an analyst is to tell investors when to hold, sell or buy securities.

They can do their analysis in many ways including using the CAPM as described above.

While the beta coefficient helps them look at a security’s expected returns, an alpha coefficient provides a different insight.

It shows us based on its expected return, the degree that either an asset or portfolio falls short or exceeds that return.

Buy recommendations would come as a result of positive alpha.

Let’s look at the following situation.

Should a market go up 10%, an investment with a beta of 1.5 goes up 15%.

If it only went up 12%, however, the investor gets less return on their money for taking a bigger risk.

This would be a negative alpha.

If it went up by 18% however, the return is greater than the risk taken by the investor.

This would be a positive alpha.

While you won’t have to make alpha calculations on the exam, you do need to understand how the concept works.

 Fundamenta financial analysis statement

What is fundamental analysis?

Well, it takes the overall economy and context of the industry into account when studying an individual company’s business prospects.

The way in which analysts do this is by looking at various aspects of the company in great detail.

This includes company management, for example, but other detailed information too, like an in-depth look at financial statements and other financial aspects.

Financial statements

Financial statements are packed with the information needed to carry out this analysis.

This includes information on:

  • Profitability
  • Cash flow
  • Debt
  • Overall financial strength
  • Operation efficiency

There’s an ongoing track record month on month so analysts can see just how financially viable a corporation might be when compared to its competitors.

Other financial reports can be used as well in this analysis, for example, income statements and balance sheets.

Balance sheet

A balance sheet is a perfect way to see the financial position of a company at a certain point in time.

Two particular points of interest can be seen on a balance sheet.

These are company assets, or what the company owns and the liabilities it has, or in other words, what it owes.

When you take the difference between these two, you can work out the overall equity of the company, or its net worth.

So basically, the financial health of a company is covered by this equation:

  • Assets = liabilities + owners’ equity

As mentioned earlier, the balance sheet is a snapshot of a moment that shows overall company health at that point.

It doesn’t, however, tell us if the financial health of that company is declining or on the rise.

Let’s talk about the various factors that make up the balance sheet.

To begin, we will focus on assets.

There are two major kinds: current and fixed assets.

Current assets are cash the company has as well as items that might be converted into cash over the next 12-month period.

These can include the following:

  • Cash and the equivalents of
  • Cash equivalents like short-term investments (these include money market instruments and other securities that can easily be sold)
  • Accounts receivable (money due from customers but reduced to include bad debt allowances)
  • Inventory that includes finished goods ready for sale, work in process, and the cost of stored raw materials
  • Prepaid expenses (these have already been paid but haven’t been used as of yet and can include operating supplies, insurance, rent, and advertising)

Fixed assets usually relate to larger items such as equipment and property owned by the company.

These are different from current assets because it’s not that easy to convert them into cash that quickly.

Also, because of wear and tear on a working property, for example, a factory, their value will reduce over time.

That leads to their cost being taken off taxable income in yearly installments.

This can make up for their loss in value over time.

Companies have intangible assets too.

For example, this can include brand names, trademarks, contractual rights, and perhaps even formulas (think KFC’s 11 herbs and spices).

Now let’s look at liabilities.

This is claimed against a company’s assets as we’ve already seen and it’s the creditors of the company that will do the claiming.

On the balance sheet, you will usually find two different kinds of liabilities.

These are current and long-term liabilities.

The liabilities that must be paid by a corporation in the next six months are known as current liabilities.

These will include:

  • Accounts payable which include various business costs and money owed to suppliers
  • Accrued wages payable which included unpaid commissions, salaries, and wages
  • Current long-term debt which includes debt due within the next 12 month period
  • Notes payable which pertains to cash or credit borrowed or equipment purchased and the balance still due on it
  • Accrued taxes which include local, state, and federal taxes

Long-term liabilities are going to be due for payments in a period longer than 12 months.

These financial obligations include the likes of mortgages and bonds, for example.

Income statement

Now let’s look at another important financial statement that’s produced by companies.

That’s the income statement.

It can also be called a P&L or profit and loss statement from time to time.

This usually looks at a period of time for a company, anything from quarter or year-to-year for example with the company revenue and expenses as the point of focus.

In other words, it compares the revenue generated against the overall cost and expenses incurred.

The income statement is the perfect way to judge not only the profitability of the company but the overall efficiency as well.

Various components make up an income statement.

These are both operating and nonoperating expenses for the most part.

To start, revenues cover the money that came in during a specific period as a result of the total sales made by the company.

There’s the cost of goods sold (COGS) too that we must pay attention to.

These are all the costs that accumulate to create finished goods.

It can include the cost of labor, materials needed, production costs, and more.

The production costs will include assets used in the production in terms of the way they depreciate.

To find the gross operating profit, simply look at the revenues minus COGS.

To account for material costs, you can use two methods: first in, first out (FIFO or last in, first out (LIFO)

With LIFO, higher costs of recently purchased inventory, which are the last items in, means that COGS will reflect higher.

Reported income will be reduced too as there are higher reported production costs under LIFO as well.

Should the FIFO method be used, the opposite will be true.

Subtracting COGS, rent, utilities and other operating costs from sales will arrive at the net operating profit and will determine pretax margins.

Note that the figure that results from this is called EBIT or earnings before interest and taxes.

If a company pays interest on any debt they have, this will not fall under operating costs and is not considered one.

Taxable income, however, is reduced by paying interest.

Determining taxable income means interest payment expenses must be taken from operating income.

This is also called pretax income.

When dividends are paid, it’s done so from net income, but only after taxes have been paid first.

If there is remaining income after this, it can be invested back into the business, usually after it is added to retained earnings.

Last in this section, let’s look at accounting for depreciation.

Fixed assets are always shown on balance sheets with depreciation factored in.

Tax laws require that the inevitable loss of value on large assets must be deducted over the asset’s life.

Depending on the type of asset, that could be a very long time and shorter for others.

That’s determined by a depreciation schedule.

The allowable portion for the year will be shown on the income statement.

This will appear as an expense and for the most part, will form part of COGS.

When a company makes use of accelerated depreciation, in the early years, the expenses will be far higher.

That means lower-income taxes and lower pretax income.

Later on, however, it results in higher income.

Other important terms linked to financial statements

When dealing with balance sheets, income statements, and other similar documents, there are plenty of terms that are important to understand.

Shareholder equity

This is also called owner’s equity or sometimes, net worth.

Once all creditors have been paid, this is the claim a stockholder has on company assets.

To work out what it is, simply take total assets minus total liabilities.

There are three kinds of shareholders equity that you will find on balance sheets:

  • Capital stock at par
  • Capital in excess of par
  • Retained earnings

Capital stock at par is the par value of preferred and common stock (or capital stock).

Par value describes when the stockholders first contribute capital and is the total dollar value assigned to stock certificates.

Note that this is an arbitrary value with no relationship to market prices.

Capital in excess of par is also called paid-in surpluses and additional paid-in capital. When a company issues stock in a primary offering, this describes the money over par value received for that stock.

Almost always, when stock is initially issued, it will be above the par value.

Retained earnings describe company profits that have not been used for dividend payouts.

Since the formation of the company, this is all the earnings held minus any dividends that have been paid out to stockholders.

Note that when a company suffers from operating losses, this will reduce the retained earnings.

Retained earnings are sometimes called earner surplus or accumulated earnings.

Capital structure The sum of a corporation’s equity securities and its long-term debt is known as capitalization.

Capital structure, however, is the relative amounts of equity and debt that form that capitalization.

Companies can fund their business in different ways

For example, some may use their retained earnings while others make use of borrowed funds.

On a balance sheet, a company will build capital structure with equity and debt.

This includes four specific elements:

  • Long-term debt (bonds and debentures)
  • Capital stock (common and preferred)
  • Capital in excess of par (paid-in or capital surplus)
  • Retained earnings (earned surplus)

Balance sheets will be affected should a company change its capitalization.

It does this through the issuing of bonds or stocks.

Liquidity calculations

Below, we look at ways that financial analysts work out if the current obligations of a company can be met.

The most critical thing to look at is how much cash or capital a company has on hand in the form of working capital.

This shows if it can meet short-term obligations by turning assets into cash quickly.

The working capital formula is: Working capital = current liabilities – current assets.

Working capital can be affected by:

  • Sales of securities, profits, or the sale of noncurrent assets can all increase working capital
  • Declaring cash dividends, net losses as well as paying off debt can all decrease working capital

Along with working capital, when it’s paired with current ratio, the information is even more useful.

Like working capital, this looks at current assets and liabilities, but rather than provide an overall figure like working capital, shows them as a ratio of each other.

The higher that is, the more liquidity a company has.

The current ratio is achieved by dividing current assets by current liability.

There’s the quick asset ratio too.

Also known as the acid-test ratio, this doesn’t use current assets, but rather quick assets.

These are all the assets available to a company that can quickly provide cash on hand, so it doesn’t include inventory.

Simply divide the quick assets by the current liabilities to work out the quick asset ratio of a company.


When a company uses long-term debt to improve its return on equity, that’s known as leverage.

High leverage means a company’s long-term debt to equity rating is high.

While stockholders can benefit from this, especially if the debt services costs are exceeded by the return on the borrowed money, it can be risky.

That’s because having debt always brings up the chances of defaulting on payments, especially during an economic or business downturn.

Calculating the debt-to-equity ratio helps to show the financial leverage currently employed by a company.

The equation for this is: Debt-to-equity ratio = long-term debt divided by total capital employed.

This will provide a percentage and the higher that is, the higher the company is leveraged.

Now let’s look at book value per share as it shows a corporation’s liquidation value.

That assumes that all assets are sold, all debtors are paid and then the amount that is left gets split among stockholders.

Remember, preferred stockholders would get paid first and then common stockholders.

The equation to work out the book per value share takes this all into account.

It is: Book value per share = tangible assets – liabilities – par value of preferred shares/shares of common stock outstanding.

Balance sheet balancing

In finance, a balance sheet must balance.

That’s why every financial change that affects a business will be recorded on the company books as two offsetting changes.

This is commonly known as double-entry bookkeeping.

As an example, a company pays out a declared cash dividend.

This will see their cash reduced, which is a current asset, and dividends payable (a current liability) removed.

In other words, each side of the balance sheet would have been changed by the same amount, so effectively, there is no change to the working capital available to the company.

Fixed assets, however, will depreciate over time.

These are known as depreciating assets and this covers machinery, equipment, and buildings, for example.

There are two ways in which depreciation will affect a company:

  • The overall value of the fixed assets reduces over time
  • The deduction of the annual depreciation from company books will affect the income statement by reducing taxable income

A company has the chance to choose from two types of depreciation.

The straight-line method takes place during the useful life of the assets and a company depreciates it each year by an equal amount.

The accelerated method sees fixed asset depreciation being more during the beginning years of an asset’s useful life and becoming less during its later years.

Various computations for income statements

With income statements, several important ratios can be worked out from the information found within them.

In this section, we are going to look at a few of them.

Earnings per share (EPS)The Princeton Review CFA Study Material

This looks at each company share and measures the value of the company earnings on them.

EPS = earnings available to common / number of shares outstanding

The remaining earnings after the preferred stockholders have been paid their dividend describe what earnings are available to common stockholders.

Remember, once they’ve been paid the preferred stock dividend, preferred stockholders have no further claims on earnings.

While we are on the subject of EPS, let’s talk about EPS after dilution.

What this assumes is that warrants, convertible bonds, preferred stock, and all other convertible securities have been converted into the common.

Don’t worry, however, other than knowing what EPS after dilution is, the calculations for it, which are complex, are not covered on the exam.

Current yield (dividend yield)

This shows the annual income payment (dividends, not interest) as a percentage of the current price of common stock.

The equation for current yield is:

Current yield = annual dividends per common share/market value per common share

Dividend payout ratio

This covers dividends and the proportion of earnings that are paid to stockholders.

The equation for this is:

Dividend payout ratio = annual dividends per common share / earning per share (EPS)

Companies that are growing tend to reinvest money in the business, so the dividend payout ratio is usually low.

Established companies, however, tend to pay out dividends often, so this will be higher for them.

Earnings before interest and taxes (EBIT)

To help analysts assess the company’s performance without including income tax rates or interest expenses, earnings before interest and taxes (EBIT) is used.

In this way, the single measure of success is just operating profitability.

It’s the perfect way to compare various companies overall as it cuts out the need to look at debt and tax obligations which would be different for all of them.

Earnings before taxes (EBT)

Another way to compare companies easily is by using earnings before taxes (EBT).

This removes the tax structure while evaluating a company.

Lower EBTs mean the company has fewer obligations to debt.

The more it increases, the higher leveraged a company is going to be.

Price-to-earnings ratio

This looks at the prices of different common stocks and compares them with earnings accused to one share of stocks.

The equation to work this out is:

P/E ratio = current market price of the common share/earnings per share.

Cyclical companies will have a lower P/E ratio than those considered growth companies.

With growth companies, investors are attracted to possible future earnings that are expected to be higher than those that rise and fall in a cycle.

So they are prepared to pay more per dollar for current earnings.

It’s not only companies that are subject to cyclical fluctuations where P/E ratios are lower but those in declining industries as well.

EPS can be calculated too if you know the P/E ratio and the current market price of the stock:

EPS = current market price of common stock / P/E ratio.

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