Equity Analysis Part 3 - Introduction
The equity part three topics will build the previous two sessions and discuss commonly used models for valuing stocks. There are a number of formulas covered, but none of them are terribly complex and many candidates will have likely seen at least a few of them before either in an academic or professional capacity. Flashcards are a great tool for learning the formulas. Keep in mind, candidates are also expected to understand the strengths and weaknesses of the different models, as well as the situations where one model may be more appropriate than others.
One thing that keen candidates should pick up on is the strong influence that the Gordon Growth Model and its variants have across the valuation spectrum. Several of the multiples presented can be derived from a “GGM like” model.
This tutorial aligns with Study Session 11 material in the Level II CFA Program Curriculum ©.
Notes
rce = common notation for required return on common equity (or required return on equity for short).
rrf = common notation for return on a risk free asset; the standard risk free asset is government debt, such as U.S. Treasuries
b = common notation for a company’s earnings retention ratio
k = common notation for a company’s dividend payout ratio (= 1 – b).
β = beta; used in applications involving the Capital Asset Pricing Model
Subscript 0 vs. Subscript 1: a “0” in the subscript represents the current period/time, while a “1” in the subscript indicates the value reflects the next future period.
BVE = Book Value of Equity; candidates much pay attention to the context in which this is applied (i.e. on a total basis or a per share basis); if the company has preferred stock, then the valuation may only want to include the Book Value of Common Equity (BVCE).
Multi-time period discounting vs. Multi-stage modeling: multi-time period discounting applies discounting future values over multiple time periods (year 1, year 2, …, year n); multi-stage modeling (which incorporates multi-time period discounting) is the valuation of a company that is anticipated to go through more than one growth stage (ex. high growth, then mature growth).
Material
I. Free Cash Flow Valuation
II. Market Based Valuation