Equity Valuation – CFA Level2

A brief refresh from Level 1:

Equity valuation can be using DCF, Relative Value, Asset Based valuation.

Discounted Cash Flow (DCF) – PV of future cash flows. This DCF includes DDM, FCFF, FCFE.

DDM – Assumptions  – Return on Equity is constant, Dividend ratio is constant, Growth rate will remain constant, Cost of Equity > growth rate. Value of stock = D1/(k-g) when dividend is not the same every year. K = cost of equity.

Relative Value can be based on P/E, P/S, P/CF, P/EBITA etc. How should the price be relative to competitor as well as to sales , earning etc.

Asset Based Valuation would be (Assets – Liabilities) / # of shares.

Now lets get to Level 2 study as below


If Req Return (RR) > HPR , then stock overvalued.

If RR < HPR then stock undervalued.

Equity Risk Premium for a given stock can be calculated using

ERP = Historical Return – RFR

Forward looking ERP can be calculated using

  1. GGM ::: where ERP = D1/P0 + g – RFR where D1 = next period’s dividend, P0= current stock price, g = consensus growth rate , RFR = Risk free rate or benchmark rate.

2. Ibbotson and Chen Model ::: ERP = ((1+Expected Inflation) * (1+Expected real EPS growth rate ) *(1+