Equity Valuation

CFA® Level II, published weight 10–15%. DDM, free cash flow, multiples, residual income, private companies.

What the outline covers

Equity Valuation: Applications and Processes
Discounted Dividend Valuation
Free Cash Flow Valuation
Market-Based Valuation: Price and Enterprise Value Multiples
Residual Income Valuation
Private Company Valuation

Sample questions

These 5 questions are free in the app too. Try each one before opening the answer.

Question 1

A firm has negative free cash flow to equity, pays no dividend, and applies clean surplus accounting. The most appropriate valuation model is:

A. Gordon growth dividend discount model
B. FCFE discount model
C. Residual income model
D. Two-stage dividend discount model

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C. Residual income recognises much of the value in current book value, making it workable where dividends and near-term free cash flow are absent.

Reading: Equity Valuation — Residual Income Valuation, LOS 5.a

Question 2

An analyst forecasts FCFF and discounts it at the cost of equity. This produces:

A. A correct estimate of equity value
B. A correct estimate of firm value
C. An overstated value, because the discount rate is too high for the cash flow
D. An understated value, because the discount rate is too high for the cash flow

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D. FCFF belongs to all capital providers and must be discounted at WACC. The cost of equity exceeds WACC, so discounting FCFF at it understates value.

Reading: Equity Valuation — Free Cash Flow Valuation, LOS 3.b

Question 3

A firm has book value per share of $20, expected EPS of $3.00 and a required return on equity of 11%. The residual income for the coming year is:

B₀ = $20 · EPS $3.00 · r = 11%

A. $0.80
B. $2.20
C. $3.00
D. $5.20

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A. RI = EPS − r × B₀ = 3.00 − 0.11 × 20 = 3.00 − 2.20 = $0.80. The equity charge is what distinguishes RI from accounting earnings.

Reading: Equity Valuation — Residual Income Valuation, LOS 5.c

Question 4

A controlling-interest value is $100 per share. A discount for lack of control of 20% and a discount for lack of marketability of 15% apply. The minority, non-marketable value is closest to:

Control value $100 · DLOC 20% · DLOM 15%

A. $65.00
B. $68.00
C. $70.00
D. $80.00

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B. 100 × (1 − 0.20) × (1 − 0.15) = 100 × 0.80 × 0.85 = $68.00. The discounts compound; adding them to 35% is the planted shortcut.

Reading: Equity Valuation — Private Company Valuation, LOS 6.e

Question 5

Compared with a trailing P/E, a justified leading P/E is preferable when:

A. Earnings are volatile and the most recent year was unrepresentative
B. The firm has no analyst coverage
C. Book value is negative
D. The firm pays no dividend

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A. Leading P/E uses forecast normalised earnings, which avoids anchoring on an unrepresentative trailing figure.

Reading: Equity Valuation — Market-Based Valuation, LOS 4.c

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