Equity Valuation at CFA Level II
Equity valuation is the largest single topic at CFA Level II, and for good reason: determining what a stock is worth is the central question of investment analysis. The curriculum presents multiple valuation approaches, and the exam tests your ability to choose the right model for a given situation, execute the calculations, and interpret the results.
This guide covers the four major frameworks: dividend discount models, free cash flow models, residual income, and relative valuation. For each, you will learn when to use it, how to apply it, and where candidates typically make errors.
Dividend Discount Models
The Gordon Growth Model
The Gordon Growth Model (GGM) values a stock as the present value of all future dividends, assuming they grow at a constant rate forever. The formula is: Value equals D1 divided by (r minus g), where D1 is the expected dividend next year, r is the required return on equity, and g is the constant dividend growth rate.
Suppose a company pays a current dividend of $2.40 per share, dividends are expected to grow at 4% indefinitely, and the required return is 10%. The intrinsic value equals ($2.40 times 1.04) divided by (0.10 minus 0.04), which equals $2.496 divided by 0.06, or $41.60.
The GGM is appropriate for mature, stable companies with predictable dividend policies — think large utilities or consumer staples firms. It breaks down when g approaches or exceeds r (the denominator collapses), when the company does not pay dividends, or when growth is expected to change over time.
The H-Model
The H-model handles the transition from high growth to stable growth without requiring a full multi-stage calculation. It assumes that the growth rate declines linearly from an initial high rate (gS) to a long-term stable rate (gL) over a half-life period of H years.
The formula is: Value equals D0 times (1 + gL) divided by (r minus gL), plus D0 times H times (gS minus gL) divided by (r minus gL). The first term is the stable-growth value; the second term captures the additional value from the high-growth transition period.
The H-model is useful when an analyst believes growth will fade gradually rather than dropping abruptly, which is more realistic for many companies. It avoids the computational complexity of a full two-stage or three-stage DDM while capturing the essential economics.
Multi-Stage DDM
For companies with distinct growth phases, the multi-stage DDM values each phase separately. A typical two-stage model projects dividends at a high growth rate for years 1 through n, then applies the Gordon Growth Model to the terminal value starting in year n+1.
Consider a firm with current dividends of $1.50, 15% growth for years 1 through 5, then 5% growth thereafter, with a required return of 12%. You project each dividend through year 5, calculate the terminal value at year 5 using the GGM on the year 6 dividend, and discount everything back to the present.
Free Cash Flow Models
FCFF vs. FCFE
Free Cash Flow to the Firm (FCFF) represents cash available to all capital providers (debt and equity holders). Free Cash Flow to Equity (FCFE) represents cash available only to equity holders after debt payments.
FCFF equals net income plus non-cash charges (depreciation, amortization) plus interest expense times (1 minus tax rate) minus capital expenditures minus the increase in working capital. FCFE equals FCFF minus interest times (1 minus tax rate) plus net borrowing.
A simpler route to FCFE: net income plus depreciation minus capex minus change in working capital plus net borrowing.
FCFF is discounted at the WACC to get firm value, from which you subtract debt to get equity value. FCFE is discounted at the cost of equity to get equity value directly. When the capital structure is expected to change significantly, FCFF with WACC is generally more stable because the cost of equity is more sensitive to leverage changes.
When to Use FCF Models
FCF models are preferred over DDM when the company does not pay dividends or pays dividends that diverge significantly from its ability to pay. Many growth companies retain all earnings and pay no dividends, making DDM inapplicable. FCF models capture the intrinsic cash-generating power regardless of dividend policy.
FCF models are also preferred when the analyst wants to value the company from an acquirer's perspective, since an acquirer controls dividend policy.
Residual Income Valuation
The residual income model values equity as the book value per share plus the present value of future residual income, where residual income equals net income minus the equity charge (book value times the cost of equity).
The formula is: Value equals B0 plus the sum of (ROE minus r) times Bt-1 divided by (1 + r) to the power t, for all future periods. The term (ROE minus r) represents the spread between the return earned and the return required. A company that earns exactly its cost of equity has zero residual income and is worth its book value.
Residual income is particularly useful when free cash flows are negative (as with capital-intensive growth companies) or when the company has a meaningful and reliable book value. It also works well for financial institutions where book value is a primary metric.
The key advantage is that most of the value is captured in the observable book value, reducing the sensitivity of the model to long-term forecasts compared to DDM or FCF approaches.
Relative Valuation
Price Multiples
Relative valuation compares a stock's pricing multiples to those of comparable companies or the stock's own historical range. The major multiples include P/E (price to earnings), P/B (price to book), P/S (price to sales), and EV/EBITDA (enterprise value to earnings before interest, taxes, depreciation, and amortization).
Trailing P/E uses the most recent 12 months of earnings; forward P/E uses the next 12 months of estimated earnings. Forward P/E is generally preferred because stock prices reflect expectations about the future, not the past.
The justified P/E can be derived from the Gordon Growth Model: the justified forward P/E equals (1 minus b) divided by (r minus g), where b is the retention ratio. This connects the multiple to fundamentals and provides a benchmark against which the market multiple can be compared.
EV/EBITDA
EV/EBITDA is the most widely used enterprise-level multiple because EBITDA is capital-structure neutral (unaffected by leverage) and removes the impact of different depreciation policies. It is particularly useful for comparing companies with different capital structures or across jurisdictions with different tax rates.
However, EV/EBITDA has limitations: it ignores capital expenditure requirements (a capital-intensive company may deserve a lower multiple), it can be manipulated through working capital management, and it is meaningless for financial institutions where interest is an operating cost.
Choosing the Right Multiple
Use P/E for profitable companies with stable earnings and similar capital structures. Use P/B for financial institutions, asset-heavy companies, or when earnings are volatile. Use P/S for companies with negative earnings but positive revenue. Use EV/EBITDA when comparing companies with different leverage, or across borders with different tax regimes.
Choosing the Right Valuation Model
The exam frequently asks which model is most appropriate for a given company. The decision tree is: Does the company pay dividends that reflect earnings capacity? Use DDM. Are dividends absent or disconnected from fundamentals? Use FCF. Is book value meaningful and free cash flow negative? Use residual income. Do you need a quick relative comparison? Use multiples.
In practice, analysts use multiple models and triangulate. If three different approaches produce similar values, conviction is high. If they diverge significantly, investigate why — the divergence often reveals key assumptions that deserve closer scrutiny.
Common Exam Pitfalls
Forgetting to grow the current dividend by one period for GGM: use D1, not D0. Confusing FCFF and FCFE discount rates: FCFF uses WACC, FCFE uses cost of equity. Ignoring terminal value: in a two-stage model, the terminal value typically accounts for 60 to 80 percent of total value — getting it wrong is costly. Applying a P/E multiple to an industry where earnings are distorted by cyclicality: use normalized or mid-cycle earnings instead.
Practice these models with our CFA Level II equity valuation questions, or explore the community Q&A for worked examples and peer discussion.