Equities: CFA® Level II

It is 10–15% of the 2027 Level II exam. 75 learning outcomes across 6 learning modules.

100 practice questions and 0 formula cards on this topic in the app.

Equity Valuation: Applications and Processes

• Define intrinsic value and valuation, then explain where perceived mispricing comes from
• Explain what assuming a going concern means and set a going concern value against a liquidation value
• Set out the different definitions of value and argue which one fits the valuation of a listed company best
• Set out the uses of equity valuation
• Set out the questions an industry and competitive analysis should answer
• Contrast relative with absolute valuation models and give examples of each kind
• Explain valuing a firm as the sum of its parts and why conglomerates trade at a discount
• Explain the general criteria for picking a suitable way to value a particular company

Discounted Dividend Valuation

• Contrast dividends, residual income and free cash flow as DCF inputs and say in which investment settings each one fits
• Work out the value of a common share with the dividend discount model (DDM) over one holding period and over several, and explain the result
• Value a common share with the Gordon growth model, explaining what that model assumes
• Value perpetual preferred stock that pays a fixed rate and cannot be called
• Set out what the Gordon growth model does well and badly and argue for using it to value a firm's common shares
• Use the current share price and the Gordon growth model to back out the implied dividend growth rate, and explain it
• Work out PVGO (the present value of what future growth opportunities are worth) and the share of the leading P/E it accounts for, and explain both
• Derive justified leading and trailing P/Es from the Gordon growth model and explain what they mean
• Back out a required return from any DDM, including the H-model and the Gordon growth model
• Judge from a DDM value whether the market is pricing a stock too high, too low or fairly
• Explain the growth, transition and maturity phases a business passes through
• Explain what spreadsheet modelling, the H-model, the two-stage DDM and the three-stage DDM assume, and argue for choosing one to value a firm's shares
• Explain terminal value and the different ways of setting it in a DDM
• Value common shares with the H-model, the two-stage DDM and the three-stage DDM, and explain the results
• Explain how spreadsheet models are used to project dividends and value common shares
• Work out a firm's sustainable growth rate and explain it, showing how DuPont analysis can be used to estimate that rate

Free Cash Flow Valuation

• Contrast valuing a business by the free cash flow available to equity (FCFE) with valuing it by its free cash flow to the whole firm (FCFF)
• Explain whose point of view as owner the FCFE approach takes
• Explain which adjustments turn EBIT (pre-interest, pre-tax earnings), EBITDA, net income and operating cash flow (CFO) into FCFF and FCFE
• Work out FCFF and FCFE
• Set out ways of projecting FCFF and FCFE
• Explain how dividends, buybacks, new share issues and shifts in leverage can change future FCFF and FCFE
• Contrast the FCFE model with dividend discount models
• Assess using EBITDA and net income as stand-ins for cash flow when valuing a firm
• Explain how sensitivity analysis is used in FCFF and FCFE valuation
• Explain FCFF and FCFE models with one stable-growth stage, two stages and three stages, and argue which suits a given firm's characteristics
• Estimate what a firm is worth with the free cash flow model or models that fit it
• Set out ways of working out terminal value in a valuation model with several stages
• Judge from a free cash flow valuation whether a stock is priced too high, too low or fairly

Market-Based Valuation: Price and Enterprise Value Multiples

• Contrast comparables with forecasted fundamentals as ways of applying price multiples when valuing, and set out the economic logic behind each
• Work out a justified price multiple and explain what it means
• Set out why one might value a stock with dividend yield or alternative price multiples and what can go wrong
• Work out dividend yield and alternative price multiples and explain what they mean
• Work out underlying earnings and explain them, set out ways to normalise earnings per share (EPS), and compute normalised EPS
• Explain earnings yield (E/P) and argue for its use
• Set out the fundamentals that drive dividend yield and alternative price multiples
• Use a cross-sectional regression on fundamentals to predict a P/E, explain the result, and explain where such regressions fall short
• From forecasted fundamentals, work out a stock's justified price-to-earnings (P/E), price-to-book (P/B) and price-to-sales (P/S) ratios and explain them
• Work out the PEG (P/E-to-growth) ratio, explain what it means and how it is used in relative valuation
• Work out terminal value for a DCF (discounted cash flow) model with several stages from price multiples and explain this use
• Judge from comparisons of multiples whether a stock is priced too high, too low or fairly
• Assess a stock with comparables and explain why fundamentals matter when applying that method
• Explain the various cash flow definitions used in multiples of price and of enterprise value (EV) and where each falls short
• Work out EV multiples, explain what they mean and assess how useful EV/EBITDA is
• Explain why valuation comparisons across borders can differ
• Explain momentum indicators and how they are used in valuation
• Explain how the median, arithmetic mean, harmonic mean and weighted harmonic mean summarise the typical level of a set of multiples

Residual Income Valuation

• Work out economic value added, market value added and residual income and explain what they mean
• Explain what residual income models are used for
• Value a common share with the residual income model and contrast when value is recognised under it and under other present value models
• Explain the fundamentals that determine residual income
• Explain how residual income valuation links to the justified P/B ratio derived from forecasted fundamentals
• Work out a common share's intrinsic value with residual income models that have one constant-growth stage or several stages, and explain the result
• Back out the growth rate implied in residual income from the market P/B ratio and an estimated required return on equity
• Explain continuing residual income and defend an estimate of it at the forecast horizon in light of the firm's and industry's outlook
• Contrast residual income models with free cash flow and dividend discount models
• Explain where residual income models are strong and weak and argue for using one to value a firm's common stock
• Set out the accounting problems that arise when residual income models are applied

Private Company Valuation

• Contrast the key features of private and public companies that matter for valuation
• Set out why private businesses are valued and what financial analysts should concentrate on
• Explain the difficulties of estimating cash flow for private firms and the adjustments needed to arrive at normalised earnings
• Explain what has to be adjusted when setting the discount rate for a private firm
• Contrast the models for estimating the return required on private company equity, such as the build-up approach, the CAPM and the expanded CAPM
• Explain and assess how control and marketability discounts and premiums change the value of a private company
• Explain the asset-based, market and income ways of valuing a private firm and what bears on choosing each one
• Value a private firm using methods based on income
• Value a private firm using methods based on the market and set out the pros and cons of each method