CFA Equity Valuation Methods 2 — Questions and Answers
Question 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?
- $41.20
- $52.60 (Correct answer)
- $47.80
- $38.90
Correct 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%.
Question 2: Which valuation approach is most appropriate when a company has negative earnings but positive operating cash flows?
- P/E multiple
- Price-to-book ratio
- EV/EBITDA multiple (Correct answer)
- Dividend discount model
Correct 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.
Question 3: The justified P/E ratio based on fundamentals equals:
- (1 - b) / (r - g) (Correct answer)
- D1 / (r - g)
- E1 × (1 + g)
- (r - g) / (1 - b)
Correct 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.
Question 4: In residual income valuation, the terminal value is often assumed to be zero because:
- Companies rarely survive beyond 10 years
- Competitive forces erode economic profits to zero over time (Correct answer)
- Residual income always equals zero in mature firms
- GAAP accounting eliminates residual income eventually
Correct 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.
Question 5: An analyst uses the price-to-sales (P/S) ratio. Which company characteristic most limits the usefulness of P/S?
- High revenue growth
- Negative net profit margins (Correct answer)
- Cyclical revenues
- High operating leverage
Correct 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.
Question 6: When applying the comparable company analysis (CCA), the most critical adjustment before comparing EV/EBITDA multiples across firms is to account for:
- Differences in dividend payout ratios
- Differences in capital structure and leverage (Correct answer)
- Differences in share counts outstanding
- Differences in accounting depreciation methods
Correct 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.
Question 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:
- Overvalued, since P/B should exceed 1.0
- Fairly valued, because ROE is below the cost of equity (Correct answer)
- Undervalued, because ROE exceeds book value
- Overvalued, because ROE is below the required return
Correct 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.
CFA Equity Valuation Methods 2
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?