Equity Valuation: Concepts and Basic Tools

Q: How is the relationship between a stock's market price and its intrinsic value used to make investment decisions?

If Market Price Intrinsic Value, it is overvalued (Sell/Don't Buy); if they are equal, it is fairly valued.

Q: What is the common mistake made when identifying the numerator in the Gordon Growth Model?

Using the dividend just paid ($ D_0 $) instead of the next expected dividend ($ D_1 $).

CFA Level I · CFA · 6 min read

Welcome to Equity Valuation!

Hello there! Today, we are diving into one of the most exciting parts of the CFA Level I curriculum: Equity Valuation. If you’ve ever wondered how investors decide if a stock is a "bargain" or "too expensive," you’re in the right place. Valuation is the heart of investing. It’s the process of determining the "true" value of an asset.

Don't worry if the formulas look intimidating at first. Think of valuation like buying a used car: you look at what it can do for you (the cash it generates), what similar cars are selling for (multipliers), and what the parts are worth if you took it apart (asset-based). Let's break it down step-by-step!

1. Estimated Value vs. Market Price

Before we start calculating, we need to understand the goal. In a perfect world, the Market Price of a stock would exactly equal its Intrinsic Value (the "true" value based on a complete understanding of the company).

However, markets aren't always perfect. As a candidate, you need to know these three scenarios:
1. Market Price > Intrinsic Value: The stock is Overvalued (Don't buy/Sell).
2. Market Price < Intrinsic Value: The stock is Undervalued (Buy!).
3. Market Price = Intrinsic Value: The stock is Fairly Valued.

Did you know? Even if you calculate a "correct" intrinsic value, you can only make money if the market eventually agrees with you and moves the price toward that value. This is why timing and market sentiment matter!

Key Takeaway

The core of equity valuation is identifying the difference between what a stock is selling for and what it is actually worth.

2. Major Categories of Valuation Models

There isn't just one way to value a stock. The CFA curriculum groups them into three main buckets:

1. Present Value Models (Discounted Cash Flow): These look at the future cash the company will give you and "discount" it back to today's value. Examples include the Dividend Discount Model (DDM) and Free Cash Flow to Equity (FCFE).
2. Multiplier Models (Relative Valuation): These compare the stock's price to a specific metric, like earnings or sales. Think of this like looking at the price per square foot of houses in your neighborhood.
3. Asset-Based Models: This values the company by taking the total value of its assets and subtracting its liabilities. It’s like saying, "If we closed the business today and sold everything, what would be left for the owners?"

3. Present Value Models: The Dividend Discount Model (DDM)

If you buy a stock, you expect to receive dividends. The DDM says the value of a stock today is the present value of all its future dividends.

The One-Period DDM:
If you plan to hold a stock for one year, its value today ($ V_0 $) is:
$ V_0 = \frac{D_1 + P_1}{(1 + r)^1} $
Where:
$ D_1 $ = The dividend expected at the end of year 1.
$ P_1 $ = The expected price of the stock at the end of year 1.
$ r $ = The required rate of return.

The Gordon Growth Model (GGM):
This is a "forever" model. It assumes dividends will grow at a constant rate ($ g $) indefinitely. This is the most famous formula in this chapter:
$ V_0 = \frac{D_1}{r - g} $
*Important Note:* For this formula to work, $ r $ must be greater than $ g $. If the growth rate is higher than the discount rate, the math breaks!

Example: A company just paid a dividend ($ D_0 $) of \$2.00. It is expected to grow at 5% ($ g $) forever. Your required return ($ r $) is 10%.
\nStep 1: Find $ D_1 $. $ D_1 = 2.00 \times (1 + 0.05) = 2.10 $.
\nStep 2: Plug into GGM. $ V_0 = \frac{2.10}{0.10 - 0.05} = \frac{2.10}{0.05} = \$42.00 $.

Common Mistake: Using $ D_0 $ (the dividend just paid) instead of $ D_1 $ (the next dividend) in the numerator. Always read carefully to see if the question gives you the "recent" dividend or the "expected" dividend!

Quick Review: When to use GGM?

- For stable, mature companies.
- When the company has a history of paying dividends.
- When you expect constant growth.

4. Multiplier Models (Relative Valuation)

Multipliers are popular because they are easy to use. The most common is the P/E Ratio (Price-to-Earnings).

1. P/E Ratio: $ \frac{Price}{Earnings per Share} $. It tells you how much investors are willing to pay for every \$1 of profit.
\n2. P/S Ratio: $ \frac{Price}{Sales per Share} $. Useful for young companies that aren't profitable yet.
\n3. P/B Ratio: $ \frac{Price}{Book Value per Share} $. Often used for banks or companies with lots of liquid assets.
\n4. P/CF Ratio: $ \frac{Price}{Cash Flow per Share} $. Harder to manipulate than earnings.

Enterprise Value (EV) Multipliers:
\nSometimes we want to value the whole business (debt + equity), not just the shares. For that, we use EV/EBITDA.
\nEV = Market Cap + Preferred Stock + Debt - Cash.

Analogy: Buying a house. The "Price" is what you pay the owner. The "Enterprise Value" is like the price of the house plus any back taxes you have to pay, minus any cash you found hidden in the floorboards!

\n\n

Key Takeaway

Multipliers are relative. A P/E of 15 isn't "good" or "bad" until you compare it to the company's past P/E, its competitors, or the industry average.

\n\n

5. Asset-Based Valuation

This method assumes the value of a company is the Fair Value of its Assets minus the Fair Value of its Liabilities.

Why is this tricky?
\nThe values on a company's balance sheet are usually "Historical Costs" (what they paid years ago), which might be very different from what those assets are worth today (Market Value).
\n- Example: A piece of land bought in 1950 for \$10,000 might be worth \$2 million today. The asset-based model would use the \$2 million.

When to use it?
- For private companies.
- For natural resource companies (like oil or mining).
- For companies being liquidated (going out of business).

6. Summary and Final Tips

Equity valuation is a mix of art and science. No single model is perfect.

Remember these "Shortcuts" for the exam:
- If dividends are constant (no growth), $ V_0 = \frac{D}{r} $ (this is just a perpetuity!).
- If you see "just paid" or "recently paid," that is $ D_0 $. You must multiply it by $ (1+g) $ to get $ D_1 $.
- If the market price is lower than your calculated value, the stock is undervalued (a "buy" signal).
- Asset-based models are usually the "floor" or minimum value for a company.

Don't worry if the multistage models (where growth changes) feel hard. Just remember: it’s just a series of single-period calculations added together. You’ve got this!

Quick check

Can you answer these now?

Open each question to check the key ideas from this chapter.

How is the relationship between a stock's market price and its intrinsic value used to make investment decisions?

If Market Price < Intrinsic Value, the stock is undervalued (Buy); if Market Price > Intrinsic Value, it is overvalued (Sell/Don't Buy); if they are equal, it is fairly valued.

What are the three main categories of equity valuation models?

The three categories are: 1. Present Value Models (Discounted Cash Flow), 2. Multiplier Models (Relative Valuation), and 3. Asset-Based Models.

What is the formula for the one-period Dividend Discount Model (DDM)?

$ V_0 = \frac{D_1 + P_1}{(1 + r)^1} $, where $ D_1 $ is the expected dividend, $ P_1 $ is the expected future price, and $ r $ is the required rate of return.

What is the formula for the Gordon Growth Model (GGM) and its primary assumption?

$ V_0 = \frac{D_1}{r - g} $. It assumes that dividends will grow at a constant rate ($ g $) indefinitely.

What is the common mistake made when identifying the numerator in the Gordon Growth Model?

Using the dividend just paid ($ D_0 $) instead of the next expected dividend ($ D_1 $).

What are the four most common price-multipliers used in relative valuation?

1. Price-to-Earnings (P/E), 2. Price-to-Sales (P/S), 3. Price-to-Book Value (P/B), and 4. Price-to-Cash Flow (P/CF).

How is Enterprise Value (EV) calculated, and what does it represent?

$ EV = \text{Market Cap} + \text{Preferred Stock} + \text{Debt} - \text{Cash} $. It represents the cost to acquire the entire business.

Why does asset-based valuation often differ from the values found on a company's balance sheet?

Balance sheets use historical costs, while asset-based valuation requires the current fair market value of assets and liabilities.

What is the valuation formula for a company expected to pay a constant dividend with no growth?

$ V_0 = \frac{D}{r} $.

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