Equity Valuation

Determining the intrinsic value of a company's stock.

Equity valuation is the process of determining the intrinsic value of a company's stock based on its financial performance, growth prospects, and risk factors. Analysts use various valuation models, such as discounted cash flow, relative valuation, and asset-based valuation, to estimate a company's fair value and make investment recommendations.

5 minutes 5 Questions

Equity Valuation in CFA Level 2 explores sophisticated methods to determine a company's intrinsic value. The curriculum builds upon Level 1 fundamentals and delves into more complex approaches. The core valuation models covered include: 1. Discounted Cash Flow (DCF) models - Free Cash Flow to Firm (FCFF) and Free Cash Flow to Equity (FCFE) with multi-stage growth assumptions and terminal value calculations. 2. Residual Income models - Focus on economic profit created beyond required returns, incorporating accounting data adjustments. 3. Dividend Discount models - Multi-stage growth models for dividend-paying stocks. 4. Price Multiple methodologies - Advanced applications of P/E, P/B, EV/EBITDA ratios with justifications for premium/discount valuations. 5. Asset-based valuation - Techniques for valuing companies based on adjusted asset values. The curriculum emphasizes forecasting financial statements as inputs to these models, requiring candidates to project income statements, balance sheets, and cash flows. Industry-specific adjustments receive particular attention. Comparative analysis features prominently, teaching candidates to select appropriate peer companies and adjust for differences in size, growth, profitability, and risk. CFA Level 2 also covers special cases including valuation of private companies, financial institutions, distressed firms, and early-stage enterprises. Candidate skills tested include: - Selecting appropriate valuation models for different scenarios - Identifying key value drivers - Making technical adjustments to improve valuation accuracy - Recognizing limitations of each approach - Reconciling different valuation results The equity valuation section typically represents 10-15% of the CFA Level 2 exam, making it one of the most heavily weighted topics.

Concepts covered: Free Cash Flow Valuation, Discounted Dividend Valuation, Equity Valuation: Applications and Processes, Private Company Valuation, Residual Income Valuation, Market-Based Valuation: Price and Enterprise Value Multiples

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CFA Level 2 - Equity Valuation Example Questions

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Question 1

MNO Company, a publicly-traded firm, is considering the acquisition of XYZ Corp., a privately-held company in the same industry. The following information is available: MNO's current market capitalization: $500 million XYZ's EBITDA for the most recent year: $25 million Industry median EV/EBITDA multiple: 12x Based on the given information, which of the following is the most appropriate method to estimate the value of XYZ Corp. for the potential acquisition?

Use MNO's market capitalization as a proxy for XYZ Corp.'s value, as both companies operate in the same industry and the market capitalization reflects the fair value of the business. Determine the estimated equity value of XYZ Corp. by dividing MNO's market capitalization by the industry median EV/EBITDA multiple and adding XYZ's EBITDA. Calculate the estimated enterprise value of XYZ Corp. by multiplying its EBITDA by the industry median EV/EBITDA multiple.

Correct Answer: Calculate the estimated enterprise value of XYZ Corp. by multiplying its EBITDA by the industry median EV/EBITDA multiple.

The most appropriate method to estimate the value of XYZ Corp. for the potential acquisition is to calculate the estimated enterprise value of XYZ Corp. by multiplying its EBITDA by the industry median EV/EBITDA multiple. Here's why: - EBITDA is a commonly used metric to evaluate a company's operating performance and is often used in valuation multiples. - The industry median EV/EBITDA multiple provides a benchmark for valuing companies in the same industry, as it reflects the market's perception of the value of similar businesses. - By multiplying XYZ's EBITDA by the industry median EV/EBITDA multiple, we can estimate the enterprise value of XYZ Corp., which includes both equity and debt. The other options are not appropriate because: - Dividing MNO's market capitalization by the industry median EV/EBITDA multiple and adding XYZ's EBITDA does not provide a meaningful estimate of XYZ's equity value. - Using MNO's market capitalization as a proxy for XYZ Corp.'s value is not accurate, as the two companies may have different financial performances, growth prospects, and capital structures, despite operating in the same industry.

Question 2

OPQ Corporation has a current dividend per share of $4.00, which is expected to grow at a constant annual rate of 7% for the next 3 years, then grow at a constant rate of 4% indefinitely. The company's stock has a beta of 1.1, the risk-free rate is 2%, and the market risk premium is 5%. Using a two-stage discounted dividend model and the Capital Asset Pricing Model (CAPM), what is the closest estimate of the intrinsic value of OPQ Corporation's stock?

$97.52, calculated using a one-stage discounted dividend model with a constant growth rate of 5.5% derived from the given information $114.27, calculated using a two-stage model but with the growth rates reversed, applying 4% for the first 3 years and 7% thereafter $106.38

Correct Answer: $106.38

The correct answer is $106.38. To calculate the intrinsic value using a two-stage discounted dividend model and CAPM: First, calculate the expected dividends for the next 3 years using the 7% growth rate: Year 1: $4.00 * 1.07 = $4.28 Year 2: $4.28 * 1.07 = $4.58 Year 3: $4.58 * 1.07 = $4.90 Then, calculate the terminal value at the end of year 3 using the 4% perpetual growth rate and the required rate of return from CAPM: Required return = Risk-free rate + Beta * Market risk premium = 2% + 1.1 * 5% = 7.5% Terminal value = Dividend in year 4 / (Required return - Perpetual growth rate) = ($4.90 * 1.04) / (0.075 - 0.04) = $145.60 Finally, discount the dividends and terminal value back to the present using the required return: Intrinsic value = ($4.28 / 1.075) + ($4.58 / 1.075^2) + ($4.90 / 1.075^3) + ($145.60 / 1.075^3) = $3.98 + $3.96 + $3.94 + $94.50 = $106.38 The other answers are incorrect because they either use the wrong model, wrong growth rates, or wrong time periods.

Question 3

KLM Company, a publicly-traded firm, is considering acquiring NOP Inc., a privately-held company in the same industry. The following information is available: KLM's current stock price: $40 per share KLM's total shares outstanding: 5 million NOP's EBITDA for the most recent fiscal year: $15 million Industry average EV/EBITDA multiple: 6x Based on this information, what is the most appropriate way to estimate the value of NOP Inc. for the potential acquisition?

Calculate KLM's market capitalization by multiplying its stock price by the total shares outstanding and use that value to estimate NOP's worth, considering factors such as NOP's EBITDA and the industry average EV/EBITDA multiple. Multiply NOP's EBITDA by the industry average EV/EBITDA multiple to estimate its enterprise value. Determine the value of NOP by dividing KLM's current stock price by NOP's EBITDA and comparing the resulting ratio to the industry average EV/EBITDA multiple.

Correct Answer: Multiply NOP's EBITDA by the industry average EV/EBITDA multiple to estimate its enterprise value.

The most appropriate way to estimate the value of NOP Inc. for the potential acquisition is to multiply NOP's EBITDA by the industry average EV/EBITDA multiple. This method directly uses the given information about NOP's financial performance and the industry benchmark to arrive at a reasonable valuation. The other two options are incorrect because they either use irrelevant information or apply the valuation metrics incorrectly: - Calculating KLM's market capitalization is not directly relevant to estimating NOP's value, as the two companies are separate entities with different financial characteristics. - Dividing KLM's stock price by NOP's EBITDA does not provide a meaningful valuation metric and fails to utilize the industry average EV/EBITDA multiple, which is a more appropriate benchmark for valuing a company in the same industry.

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