CFA Refresher Readings
Equity: Study Session 12
Learning Outcome Statements
“Discounted Dividend Valuation”
The practitioner should be able to:
- Discuss the advantages and disadvantages of dividends, free cash flow, and residual income as measures of cash flow in discounted cash flow valuation, and identify the investment situation for which each measure is suitable
- Determine the circumstances in which a dividend discount model (DDM) is appropriate for valuing a stock
- Explain the capital asset pricing model (CAPM), arbitrage pricing theory (APT), and bond yield plus risk premium approaches for estimating the required rate of return for an equity investment, and calculate the required rate of return using each approach
- Estimate the Gordon growth model equity risk premium
- Discuss the limitations of using the CAPM and APT to estimate the required return on equity
- Calculate the expected holding-period return on a stock, given its current price, expected next-period price, and expected next-period dividend and contrast the expected holding-period return to the required rate of return
- Discuss the effect on expected return of the convergence of price to value, given that price does not equal value
- Calculate the value of a common stock using the DDM for one-, two-, and multiple-period holding periods
- Calculate the value of a common stock using the Gordon growth model, and explain the underlying assumptions
- Calculate justified leading and trailing price-to-earnings (P/E) ratios based on fundamentals, using the Gordon growth model
- Calculate the value of fixed-rate perpetual preferred stock, given the stock’s annual dividend and the discount rate
- Calculate the present value of growth opportunities (PVGO), given current earnings per share, the required rate of return, and the value of the stock
- Explain the strengths and limitations of the Gordon growth model, and justify the selection of the Gordon growth model to value a company, given the characteristics of the company being valued
- Explain the assumptions and justify the selection of the two-stage DDM, the H-model, the three-stage DDM, or spreadsheet modeling
- Explain the growth phase, transitional phase, and maturity phase of a business
- Explain terminal value and discuss alternative approaches to determining the terminal value in a discounted dividend model
- Calculate the value of a common stock using the two-stage DDM, the H-model, and the three-stage DDM
- Explain how to estimate the implied expected rate of return for any DDM, including the two-stage DDM, the H-model, the three-stage DDM, and the spreadsheet model, and calculate the implied expected rate of return for the H-model and a general two-stage model
- Explain the strengths and limitations of the two-stage DDM, the H-model, the three-stage DDM, and the spreadsheet model
- Define sustainable growth rate and explain the underlying assumptions and calculate and interpret the sustainable growth rate for a company
- Estimate, using the DuPont model, a forecast for return on equity that can be used to estimate a company’s sustainable growth rate
The practitioner should be able to:
- Define and interpret free cash flow to the firm (FCFF) and free cash flow to equity (FCFE)
- Describe the FCFF and FCFE approaches to valuation, and contrast the appropriate discount rates for each model and explain the strengths and limitations of the FCFE model
- Contrast the ownership perspective implicit in the FCFE approach to the ownership perspective implicit in the dividend discount approach
- Discuss the appropriate adjustments to net income, earnings before interest and taxes (EBIT), earnings before interest, taxes, depreciation, and amortization (EBITDA), or cash flow from operations (CFO) to calculate FCFF and FCFE
- Calculate FCFF and FCFE given a company’s financial statements prepared according to U.S. GAAP or International Accounting Standards
- Discuss approaches for forecasting FCFF and FCFE
- Contrast the recognition of value in the FCFE model to the recognition of value in dividend discount models
- Explain how dividends, share repurchases, share issues, and changes in leverage may affect FCFF and FCFE
- Critique the use of net income and EBITDA as proxies for cash flow in valuation
- Discuss the single-stage (stable-growth), two-stage, and three-stage FCFF and FCFE models (including assumptions), and explain the company characteristics that would justify the use of each model
- Calculate the value of a company using the single-stage, two-stage, and three-stage FCFF and FCFE models
- Explain how sensitivity analysis can be used in FCFF and FCFE valuations
- Discuss the approaches for calculating the terminal value in a multi-stage valuation model
- Describe the characteristics of companies for which the FCFF model is preferred to the FCFE model
“Market-Based Valuation: Price Multiples”
The practitioner should be able to:
- Distinguish between the method of comparables and the method based on forecasted fundamentals as approaches to using price multiples in valuation, and discuss the economic rationales for each approach
- Define a justified price multiple
- Discuss rationales for using each price multiple and dividend yield in valuation, discuss possible drawbacks to the use of each price multiple and dividend yield, and calculate each price multiple and dividend yield
- Calculate underlying earnings given earnings per share (EPS) and nonrecurring items in the income statement and discuss the methods of normalizing EPS, and calculate normalized EPS by each method
- Explain and justify the use of earnings yield (E/P)
- Discuss the fundamental factors that influence each price multiple and dividend yield
- Calculate the justified price-to-earnings ratio (P/E), price-to-book ratio (P/B), and price-to-sales ratio (P/S) for a stock, based on forecasted fundamentals
- Calculate a predicted P/E, given a cross-sectional regression on fundamentals, and explain limitations to the cross-sectional regression methodology
- Define the benchmark value of a multiple
- Evaluate a stock by the method of comparables using each of the price multiples and explain the importance of fundamentals in using the method of comparables
- Calculate the P/E-to-growth ratio (PEG), and explain its use in relative valuation
- Calculate and explain the use of price multiples in determining terminal value in a multi-stage discounted cash flow (DCF) model
- Discuss alternative definitions of cash flow used in price multiples, and explain the limitations of each definition
- Discuss the sources of differences in cross-border valuation comparisons
- Describe the main types of momentum indicators and their use in valuation