CFA Examination EQUITY ANLAYSIS Page 1 of 17
EQUITY ANALYSIS
A. EQUITY VALUATION MODELS
Intrinsic Value of Investments
P = (CF1/(1+r1)) + (CF2/(1+r2)2) + … + (CFn/(1+rn)n)
Problem with This Model for Equity:
Irregular & Unpredictible Cash Flows
No Definite Date of Maturity for Common Stock
Discount Rate is not directly observable
NOTE: In performing any analysis of Equity, there is Forecasting Risk that the Analyst is wrong
Ways to MINIMIZE Forecasting Risk
Use SCENARIO Analysis – with ranges & probabilities of valuation
Use SENSITIVITY Analysis – to see how important each variable is to the Valuation
Use SIMULATION Analysis – Monte Carlo Method
Dividend Discount Model
PCS = [D1/(1+rCE)1] + [D2/(1+rCE)2] + … + [D∞ / (1+rCE)∞ ]
Problems:
1. Must Forecast Dividends correctly out to ∞
2. Must choose the Appropriate Discount Rate (Cost of Equity)
Simplifications of the Dividend Discount Model
Constant Dividend Model (like a Preferred Stock)
Ppfd = (D1/rpfd)
Constant Growth Dividend Model (dividends grow at g, constant rate, forever)
PCS = [ D1 / (rCE – gD)]
Can Re-write the Constant Growth Dividend Model as follows (r – implied rate of return – Cost of
Equity)
Rimplied = [ (D1/PCS) + gD]
Earnings Model
P/E1 = [ K / (rCE – gE)]
CFA Examination EQUITY ANLAYSIS Page 2 of 17
Determining the Appropriate Discount Rate (2 Methods)
1. Traditional Build-Up Approach
rCE = (1+rrrf)(1+E(inflation))(1+req.risk premium) – 1
rCE = (1+rrf)(1+req.risk premium) –1
Note: rrf is usually thought to be the nominal secular growth rate of the economy over the long
term, modified over the short run by current monetary policies & social attitudes toward savings –
similar to a 0 coupon treasury with a Horizon = duration of the stock
Note: rerp is usually between 3 & 8 % and is related to the psycholigical factors