Chapter 8: Equity Valuation - CFA Equity Investments

1 The Goal of Equity Valuation

The core of equity valuation is to determine a security's intrinsic value—its true, underlying worth based on investment fundamentals like earnings, cash flows, and growth prospects. This estimated value is then compared to the security's current market price.

Undervalued

Intrinsic Value > Market Price

Potential Buy

Overvalued

Intrinsic Value < Market Price

Potential Sell

Fairly Valued

Intrinsic Value = Market Price

Hold Position

2 The Three Main Categories of Valuation Models

Analysts use three primary categories of models to estimate intrinsic value, often using multiple models to build a more confident conclusion.

1. Present Value Models (DCF)

These models estimate intrinsic value as the present value of all expected future cash flows to the shareholder. The two main types are the Dividend Discount Model (DDM) and the Free-Cash-Flow-to-Equity (FCFE) Model.

2. Multiplier Models (Comps)

These models value a stock by comparing its price multiple (e.g., P/E, P/S, P/B) to a benchmark, such as the average multiple of its peer group or its own historical average.

3. Asset-Based Models

These models determine value based on the estimated market value of the company's assets minus its liabilities and preferred shares. It focuses on the net asset value of the company.

3 Present Value Models in Detail

The Dividend Discount Model (DDM)

The DDM values a stock as the present value of its expected future dividends. For a finite holding period, the value is the sum of the present values of the dividends plus the present value of the expected sales price (the terminal value).

V₀ = Σ [Dₜ / (1 + r)ᵗ] + [Pₙ / (1 + r)ⁿ]

The Gordon Growth Model (GGM)

The GGM is a special case of the DDM that assumes dividends grow at a constant rate (g) forever. It is best suited for mature, stable, dividend-paying companies.

V₀ = D₁ / (r - g)

Where V₀ = current stock value, D₁ = expected dividend next year, r = required rate of return, and g = constant dividend growth rate.

Illustrative Example: Gordon Growth Model

A company is expected to pay a dividend of $2.00 next year (D₁). The dividend is expected to grow at a constant rate of 5% per year (g), and the required rate of return is 10% (r).

Step 1: Apply the GGM formula.
V₀ = $2.00 / (0.10 - 0.05)
V₀ = $2.00 / 0.05 = $40.00

Conclusion: The intrinsic value of the stock is $40.00.

Multistage DDM

For companies with non-constant growth (e.g., a high-growth company that will eventually mature), a multistage DDM is more appropriate. These models use different growth rates for different periods before assuming a constant long-term growth rate to calculate a terminal value.

4 Multiplier Models (Method of Comparables)

This approach is based on the law of one price: similar assets should trade at similar prices. It involves comparing a company's price multiple to a benchmark to determine its relative valuation.

Common Price Multiples

Price-to-Earnings (P/E): Best for profitable, stable companies.

Price-to-Sales (P/S): Useful for companies with negative earnings.

Price-to-Book (P/B): Useful when book value is a good indicator of intrinsic value.

Enterprise Value to EBITDA (EV/EBITDA): Good for comparing companies with different capital structures and tax rates.

If a company's multiple is below the benchmark (e.g., peer average), it may be undervalued. If it is above, it may be overvalued.

5 Asset-Based Valuation

This method values a company based on the market value of its net assets.

Value = Market Value of Assets - Market Value of Liabilities - Value of Preferred Shares

This approach is most useful for:

Private Firms & Liquidations

Valuing private firms or firms in liquidation.

Tangible Asset Companies

Companies with significant tangible assets (e.g., resource companies).

Valuation Floor

Serving as a "valuation floor" when significant intangibles exist.

Its main limitation is that the market values of assets can be difficult to estimate, and it often excludes the value of intangible assets like brands and synergies.

Congratulations!

You have completed all 8 chapters of the CFA Equity Investments study guide. You now have a comprehensive understanding of:

Market Organization and Structure

Security Market Indices

Market Efficiency

Overview of Equity Securities

Company Analysis

Industry and Competitive Analysis

Competitive Strategy Analysis

Equity Valuation Concepts

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