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CFA® Level II · Equities · free lesson
Equity Valuation: Applications and Processes
Before choosing a formula, an analyst has to know what value means, why it is being estimated and which model fits the company. This module defines intrinsic value and the sources of perceived mispricing, sets out the uses and steps of a valuation, contrasts absolute and relative models including sum-of-the-parts analysis, and shows how to match a model to a company and a purpose. Level II vignettes test these ideas through break-up valuations, model choices and statements to evaluate.
What you will learn
1. Define intrinsic value, explain where perceived mispricing comes from, and contrast going-concern value with liquidation value and other definitions of value.
- Intrinsic value assumes complete understanding of the asset; an analyst can only estimate it.
- Perceived mispricing = true mispricing (V - P) + valuation error (V_E - V); only true mispricing earns a profit.
- Prices tend to converge to intrinsic value over time, often after a catalyst.
- Going-concern value assumes continued operation; liquidation value is what the assets fetch if the business is wound up.
- If liquidation value exceeds going-concern value, the value-maximising choice is to sell or close the business.
- Investment value is value to a specific buyer (for example with synergies) and can exceed fair market value.
2. Describe the main uses of equity valuation and the steps of the valuation process, including industry and competitive analysis and a review of earnings quality.
- Uses: stock selection, inferring market expectations, corporate events, fairness opinions, planning, communication, private businesses, share-based payment.
- Process: understand the business, forecast, select a model, convert forecasts to value, apply the conclusions.
- Porter's five forces judge industry profitability; competitive strategy shows how the company aims to beat its cost of capital.
- Reverse-engineering a model shows what the price implies; compare implied growth with a realistic forecast.
- Review earnings quality before forecasting: receivables outpacing sales and earnings above operating cash flow are red flags.
3. Contrast absolute and relative valuation models, and explain sum-of-the-parts valuation and the conglomerate discount.
- Absolute models (present value or asset-based) estimate intrinsic value from the company's own fundamentals.
- Relative models value a share against peers; a whole peer group can be mispriced.
- SOTP values each segment separately, deducts capitalised head-office costs and then subtracts net debt and other claims.
- Conglomerate discount = 1 - market value / SOTP value.
- Explanations: inefficient internal capital markets, weak management behind diversification, and measurement problems.
4. Choose a valuation approach that fits a company's characteristics, the available data and the purpose of the analysis.
- Test the model against company characteristics, data quality and the purpose of the valuation.
- DDM: stable dividends linked to earnings. FCF: low or unrelated dividends, positive FCF, control perspective.
- Residual income: negative or volatile FCF but reliable accounting; standard for banks and insurers.
- Asset-based: holding, resource and liquidating companies; weak where intangibles drive value.
- Use several models and reconcile them; prefer simple models with defensible inputs.
Module at a glance
- Intrinsic value is an ideal; an analyst's estimate adds valuation error to any true mispricing.
- Going-concern value is the default, but liquidation value governs when it is higher.
- Investment value is value to a specific buyer and can exceed fair market value.
- Valuation process: understand the business, forecast, choose a model, value, apply the conclusions.
- Absolute models use the company's own fundamentals; relative models compare it with peers that may themselves be mispriced.
- SOTP adds segment values, deducts capitalised central costs, net debt and other claims; the shortfall of price below it is the conglomerate discount.
- Choose models that fit the company, the data and the perspective: control favours free cash flow, minority dividend payers favour the DDM, banks favour residual income.
This free module has 4 lessons, 16 practice questions with full explanations.