CFA Level I · CFA Level I Exam

Introduction to Equity Valuation: formula sheet

Full chapter guide

Key formulas

Mispricing (valuation gap): Mispricing = Intrinsic value (estimated) − Market price; Positive means undervalued. Negative means overvalued. Zero means fairly valued.
Undervalued: Intrinsic value > Market price; The analyst's estimate is above price. Suggests a buy, if you trust the estimate.
Overvalued: Intrinsic value < Market price; The analyst's estimate is below price. Suggests a sell or avoid.
Efficient market: Market price ≈ Intrinsic value; Holds when price reflects all available information. Mispricing cannot be exploited consistently.
Five steps of the valuation process: Understand business → Forecast performance → Select model → Convert forecasts to valuation → Apply valuation (recommend/communicate); Learn the order. Many questions ask which step an activity belongs to.
Porter's five forces: New entrants, supplier power, buyer power, substitutes, rivalry among existing competitors; Stronger forces mean lower industry profit potential and weaker pricing power.
Value versus price decision: Intrinsic value > market price → undervalued; intrinsic value < market price → overvalued; Holds for your estimate of value. The conclusion is only as reliable as your inputs.
Top-down revenue: Company revenue = Industry sales × Company market share; Forecast industry sales first, often from GDP growth and an industry-to-GDP relationship, then apply an expected market share.
Bottom-up revenue: Revenue = Σ (Units sold × Price per unit) across products or segments; You can also use number of outlets × sales per outlet. Sum all segments for the total.
Revenue growth: Growth = (Revenue this year ÷ Revenue last year) − 1; Use it to compare your forecast with history and with industry growth.
Market share: Market share = Company sales ÷ Industry sales; A rising share needs a reason, such as a better product, lower prices or new markets.
Earnings from forecast: Net income = Revenue × Net profit margin; A quick link from a revenue forecast to earnings when margin is the assumption.
DDM (general form): V₀ = Σ Dₜ ÷ (1 + r)ᵗ, for t = 1 to ∞; r is the required return on equity. Use it when dividends are the cash flows to shareholders.
Gordon growth model: V₀ = D₁ ÷ (r − g); Needs constant growth forever and r > g. D₁ = D₀ × (1 + g).
FCFE valuation: Equity value = Σ FCFEₜ ÷ (1 + r)ᵗ; Discount at the cost of equity. Per-share value = equity value ÷ shares outstanding.
FCFF valuation: Firm value = Σ FCFFₜ ÷ (1 + WACC)ᵗ; Equity value = Firm value − Debt (+ cash if not already in firm value); Discount at WACC, not at cost of equity.
Justified P/E from the Gordon growth model: Justified P/E₁ = (D₁ ÷ E₁) ÷ (r − g), the leading P/E; Links the multiple to payout ratio, growth and required return.
Value from a multiple: Value per share = benchmark multiple × company's metric per share; Example: benchmark P/E × EPS. Metric and multiple must be on the same basis (trailing or forward).
Asset-based value: Equity value = Fair value of assets − Fair value of liabilities; Use fair values, not book values, where they differ.
Standard V(A) Diligence and Reasonable Basis: Thorough analysis + adequate support = reasonable basis; Applies before you make or act on a recommendation. Reliance on third-party research still needs checking.
Standard V(B) Communication with Clients: Disclose process and limits; separate fact from opinion; Include the important factors behind the recommendation, including risks and limitations.
Standard V(C) Record Retention: Keep records that support analysis, conclusions and communications; Records belong to the firm. The Handbook suggests at least seven years where no regulation says otherwise.
Standard I(B) Independence and Objectivity: Use reasonable care and judgment; no gifts or pressure that compromise independence; Applies to research, recommendations and any professional activity.
Standard VI(A) Disclosure of Conflicts: Avoid conflicts or make full, fair, prominent disclosure; Covers stock ownership, banking ties, compensation and other relationships.

Quick revision

Intrinsic value is the value justified by the company's fundamentals, which may differ from market price.
If intrinsic value is above market price, the analyst views the share as undervalued; if below, overvalued.
Market prices can differ from intrinsic value because the analyst's view of fundamentals differs from the market's.
The valuation process runs from understanding the business to forecasting, selecting a model, valuing, and applying the result.
Absolute valuation estimates value from the company's own expected cash flows or earnings.
Relative valuation estimates value by comparing with similar companies, often using multiples.
Forecasts are model inputs, so weak or inconsistent assumptions weaken the value however good the model is.
Model choice should fit the company's characteristics and the quality of the available data.
A valuation is an estimate, so report the assumptions and the uncertainty behind it.
Recommendations need a reasonable and adequate basis and must be objective and independent.
Financial reporting questions use IFRS unless the question says US GAAP.
Answer every question; there is no penalty for a wrong answer.

Common mistakes

Treating market price as the same as intrinsic value Fix: Remember price is where the stock trades. Intrinsic value is your estimate of what it is worth. They differ whenever mispricing exists.
Reversing undervalued and overvalued Fix: Always ask whether value is above price. Value above price means the stock is cheap, so undervalued.
Putting model selection before understanding the business. Fix: Remember the model must fit the business, so business understanding and forecasting come first.
Treating forecasting as part of understanding the business. Fix: Understanding is qualitative and descriptive. Forecasting turns that understanding into projected numbers.
Reversing the two approaches. Fix: Top means the top of the chain: economy and industry. Bottom means the company's own units and segments.
Forgetting market share in a top-down revenue forecast. Fix: Always multiply industry sales by the company's expected market share.
Using D₀ instead of D₁ in the Gordon growth model. Fix: Always check the timing. If given D₀, compute D₁ = D₀ × (1 + g) before dividing by (r − g).
Discounting FCFF at the cost of equity, or FCFE at WACC. Fix: FCFF goes with WACC and gives firm value. FCFE goes with cost of equity and gives equity value directly.
Treating disclosure as a cure for every conflict. Fix: Disclosure is needed, but if independence is truly compromised, the analyst must also act, such as stepping back or removing the influence.
Confusing V(A) with V(B). Fix: V(A) is about the quality of the work behind a recommendation. V(B) is about how it is communicated to clients.

Exam tips

Read the direction carefully. Many wrong options simply reverse undervalued and overvalued.
Reject any option that calls intrinsic value certain or exactly known.
For efficiency questions, link efficient markets to price reflecting information and limited chances for mispricing.
With no penalty for wrong answers, always pick one of the three options. Eliminate the reversed-direction option first.
Memorise the five steps in order. Many items only test sequence and classification.
Match the verb in the stem to a step before reading the options.
For Porter's forces, ask whether the force is strong or weak, then link strong to lower profits.
On analyst-role items, favour options with a reasonable basis, clear assumptions and fair communication of risks.