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Equity Valuation Methods Flashcards

7 cards from real CFA practice questions. Tap to flip, then mark Knew It or Still Learning — missed cards come back until you master them.

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  1. In a two-stage dividend discount model, a company pays a $2.00 dividend growing at 15% for 5 years, then 4% forever. If the required return is 10%, what is the approximate intrinsic value?

    Answer: $52.60

    The two-stage DDM discounts each high-growth dividend plus the terminal value (Gordon Growth at year 5) back to the present at the required return of 10%.

  2. Which valuation approach is most appropriate when a company has negative earnings but positive operating cash flows?

    Answer: EV/EBITDA multiple

    EV/EBITDA is preferred when earnings are negative because EBITDA adds back depreciation and amortization, producing a positive metric for comparison.

  3. The justified P/E ratio based on fundamentals equals:

    Answer: (1 - b) / (r - g)

    The justified leading P/E = (1 - b) / (r - g), where b is the retention ratio, r is the required return, and g is the sustainable growth rate.

  4. In residual income valuation, the terminal value is often assumed to be zero because:

    Answer: Competitive forces erode economic profits to zero over time

    In competitive markets, excess returns above the cost of equity are competed away over time, driving residual income toward zero in the long run.

  5. An analyst uses the price-to-sales (P/S) ratio. Which company characteristic most limits the usefulness of P/S?

    Answer: Negative net profit margins

    P/S ignores profit margins, so a low P/S can appear attractive even if the company has persistently negative margins and is unlikely to become profitable.

  6. When applying the comparable company analysis (CCA), the most critical adjustment before comparing EV/EBITDA multiples across firms is to account for:

    Answer: Differences in capital structure and leverage

    EV/EBITDA is capital-structure neutral, but if EBITDA margins differ due to leverage costs being excluded, the analyst must still consider net debt differences in EV.

  7. A stock trades at a P/B ratio of 0.7 with an ROE of 8% and a cost of equity of 12%. This P/B is best described as:

    Answer: Fairly valued, because ROE is below the cost of equity

    When ROE < cost of equity, the justified P/B = ROE / cost of equity = 0.8/1.2 = 0.67, so a P/B of 0.7 is approximately fairly valued.