CFA Equity Valuation Methods 3 — Questions and Answers
Question 1: In the H-model for dividend growth, 'H' represents:
- The high initial growth rate of dividends
- Half of the high-growth period length (Correct answer)
- The long-run sustainable growth rate
- The required return minus the terminal growth rate
Correct answer: Half of the high-growth period length
H is defined as half the length of the high-growth phase, reflecting the assumption that growth declines linearly from the high rate to the long-run rate.
Question 2: Which of the following is a key advantage of the free cash flow to equity (FCFE) model over the dividend discount model?
- FCFE is easier to forecast for cyclical firms
- FCFE can value firms that do not pay dividends (Correct answer)
- FCFE eliminates the need to estimate a terminal value
- FCFE uses market prices rather than accounting data
Correct answer: FCFE can value firms that do not pay dividends
FCFE represents cash available to equity holders regardless of dividend policy, making it applicable to non-dividend-paying companies where DDM cannot be used.
Question 3: The enterprise value (EV) of a company is best defined as:
- Market cap plus total book value of liabilities
- Market cap plus net debt plus minority interest plus preferred stock (Correct answer)
- Total assets minus current liabilities
- Market cap divided by EBITDA
Correct answer: Market cap plus net debt plus minority interest plus preferred stock
EV = market capitalization + total debt + minority interest + preferred stock − cash and equivalents, representing the total value to all capital providers.
Question 4: A company has FCFF of $10M, WACC of 9%, and a long-run growth rate of 3%. Its total debt is $50M and it has 5M shares outstanding. Intrinsic value per share is closest to:
- $13.33
- $16.67
- $23.33 (Correct answer)
- $33.33
Correct answer: $23.33
Firm value = FCFF/(WACC-g) = 10/(0.09-0.03) = $166.7M; equity value = 166.7 - 50 = $116.7M; per share = 116.7/5 = $23.33.
Question 5: Which situation most supports using an asset-based valuation approach over an income-based approach?
- A high-growth technology firm with negative EBITDA
- A profitable consumer staples company with stable cash flows
- A holding company whose value primarily lies in its investment portfolio (Correct answer)
- A cyclical industrial firm at the peak of the business cycle
Correct answer: A holding company whose value primarily lies in its investment portfolio
Asset-based valuation is most relevant for holding companies, investment firms, or asset-heavy businesses where market or liquidation values of assets drive intrinsic worth.
Question 6: Tobin's Q ratio is calculated as:
- Market value of equity divided by book value of equity
- Market value of the firm divided by replacement cost of assets (Correct answer)
- Enterprise value divided by EBITDA
- Net income divided by total assets
Correct answer: Market value of the firm divided by replacement cost of assets
Tobin's Q = market value of total assets / replacement cost of total assets; a ratio above 1 suggests the market values the firm above its replacement cost.
Question 7: When performing a sum-of-the-parts (SOTP) valuation, an analyst most likely assigns different valuation multiples to each segment because:
- Different segments have different risk profiles and growth prospects (Correct answer)
- GAAP requires different multiples for each business unit
- Different multiples eliminate the conglomerate discount automatically
- Each segment must be valued on a net asset value basis
Correct answer: Different segments have different risk profiles and growth prospects
SOTP recognizes that business segments in different industries carry different risks and growth rates, warranting sector-specific peer multiples for each division.
CFA Equity Valuation Methods 3
In the H-model for dividend growth, 'H' represents: