Equity Valuation is the topic that determines more CFA results than almost any other. At Level 2 it carries 10–15% of the exam — the single largest topic weight — and the models it covers recur at Level 3 in the context of portfolio management and performance attribution. Getting equity valuation right is not optional; it is foundational to passing at every level above the first.
Yet it is consistently one of the weakest-performing areas for candidates, particularly those without an equity research background. The reason is almost always the same: candidates learn the formulas without learning the selection logic — the judgment about which model to use and why, given the characteristics of the company in the vignette.
This guide walks through each of the five major valuation models, what they test, when they apply, and the specific mistakes that cost candidates marks in exam conditions.
Model 1: The Dividend Discount Model (DDM)
The Dividend Discount Model is the conceptual foundation of equity valuation. Its core premise is that a stock is worth the present value of all future dividends. The Gordon Growth Model — the single-stage DDM — is its most tested form: V = D1 / (r – g), where D1 is next year's expected dividend, r is the required return, and g is the constant growth rate.
The multi-stage DDM extends this to companies that are expected to grow at different rates across different periods — typically high growth in the near term, transitioning to a sustainable long-run growth rate. The H-model is a specific multi-stage version tested at Level 2 that assumes growth declines linearly from a high initial rate to a long-run sustainable rate: V = D0 × (r – gL)⁻¹ × [(1 + gL) + H × (gS – gL)], where H is the half-life of the high-growth period.
When to use it: The DDM is appropriate when the company pays dividends, has a stable and predictable dividend policy, and dividends are a reasonable proxy for the company's ability to return value to shareholders. Mature, profitable companies in regulated industries — utilities, large-cap financial firms — are classic DDM candidates.
When not to use it: Companies that pay no dividends, companies where dividends are not related to earnings capacity (e.g. a company paying out more than it earns), or fast-growing companies where dividends are minimal and reinvestment is the primary use of cash flow. Using DDM for a company that pays no dividend is one of the most common model selection errors on the exam.
Common exam mistake: Confusing D0 and D1. D0 is the dividend just paid (current year); D1 is the next dividend (future). The Gordon Growth Model requires D1. If the question gives you D0, you must calculate D1 = D0 × (1 + g) before applying the formula. Omitting this step is an extremely common error.
Model 2: Free Cash Flow to Equity (FCFE)
Tells you exactly which sub-topics to study next — and in what order.
FCFE measures the cash available to equity holders after covering operating expenses, capital expenditure, working capital changes, and net borrowing. It is the cash flow that could be paid as dividends, regardless of whether it actually is. This makes it the appropriate model when dividends are not representative of the company's true cash-generating capacity.
The core formula: FCFE = Net Income + Depreciation – Capital Expenditure – ΔWorking Capital + Net Borrowing. Alternatively, FCFE can be derived from FCFF by adjusting for the after-tax cost of debt and net borrowing.
When to use it: FCFE is preferred for companies that do not pay dividends or pay dividends that are significantly higher or lower than what the company could sustain based on its cash generation. It is also the right choice when the question explicitly asks you to value equity (rather than the whole firm).
Common exam mistake: Mixing up FCFE and FCFF. FCFF is cash flow to all capital providers (equity and debt); FCFE is cash flow to equity holders only. To get from FCFF to FCFE: FCFE = FCFF – Interest × (1 – tax rate) + Net Borrowing. Applying the FCFF discount rate (WACC) to FCFE is a model construction error that appears in vignettes designed to test whether you understand this distinction.
Model 3: Free Cash Flow to the Firm (FCFF)
FCFF represents the cash generated by the firm's operations available to all capital providers — both debt holders and equity holders — before any financing payments. It is therefore discounted at the weighted average cost of capital (WACC) to arrive at enterprise value. Subtracting the market value of debt then gives equity value.
FCFF = EBIT × (1 – tax rate) + Depreciation – Capital Expenditure – ΔWorking Capital. This can also be calculated starting from net income: FCFF = Net Income + Interest × (1 – tax rate) + Depreciation – Capital Expenditure – ΔWorking Capital.
When to use it: FCFF is preferred when the capital structure is expected to change significantly over the forecast period, making the equity cash flows (FCFE) volatile and harder to forecast. It is also the right approach when comparing firms with different leverage levels, since FCFF is independent of financing structure.
Common exam mistake: Using the wrong discount rate. FCFF must be discounted at WACC to get enterprise value; FCFE must be discounted at the cost of equity. Swapping these is a critical error. A related mistake is forgetting to subtract net debt from enterprise value to get equity value in the FCFF approach.
Model 4: Residual Income Model
The residual income model values equity as book value plus the present value of expected future residual incomes. Residual income in any period is the net income earned above the required return on beginning book value: RI = Net Income – (Cost of Equity × Beginning Book Value). In the single-stage version: V = BV0 + RI1 / (r – g).
This model is conceptually powerful because it directly measures value creation above the cost of capital — a positive residual income means the company is earning above its equity cost, creating value; negative residual income destroys value.
When to use it: Residual income is the model of choice when dividends and free cash flows are negative or difficult to forecast, but the company has reliable earnings and book value data. It is also preferred for financial companies (banks, insurance firms) where the balance sheet is central to the business model and book value is a meaningful anchor for valuation.
When not to use it: Companies with highly unreliable accounting data, frequent write-offs, or significant off-balance-sheet items that make book value difficult to interpret. The model assumes clean surplus accounting — comprehensive income equals net income — which can break down with frequent other comprehensive income items.
Common exam mistake: Using ending book value instead of beginning book value to calculate the equity charge. RI = Net Income – (r × BVbeginning), not BVending. This is a consistent source of errors in vignettes that give you a balance sheet at a point in time.
Model 5: Price Multiples (Relative Valuation)
Price multiples compare a stock's current price to a fundamental metric — earnings, book value, sales, or cash flow — relative to the same multiple for peers or for the stock's own history. The most common multiples at CFA Level 1 and 2 are:
- P/E (Price-to-Earnings): The most widely used multiple. Justified P/E = Payout Ratio / (r – g). High-growth companies have high justified P/E ratios because a larger fraction of value is attributed to future earnings growth rather than current earnings.
- P/B (Price-to-Book): Particularly useful for financial companies. Justified P/B = (ROE – g) / (r – g). A P/B above 1 implies ROE exceeds the cost of equity; below 1 implies value destruction.
- P/S (Price-to-Sales): Useful when earnings are negative (e.g. early-stage companies). Not affected by accounting choices around the income statement, but does not account for different profitability margins across firms.
- EV/EBITDA: An enterprise value multiple — important to remember that it values the whole firm, not just equity. Used when comparing firms with different capital structures or for capital-intensive industries where depreciation is significant.
Common exam mistake: Comparing P/E ratios across companies with significantly different growth rates or risk profiles without recognising that a higher P/E may be fully justified by higher growth. The exam frequently tests whether candidates can identify whether a stock is truly overvalued or whether the premium P/E is explained by fundamentals.
The Model Selection Framework: What the Exam Really Tests
Model selection is tested more heavily than calculation in Level 2 vignettes. The vignette will describe a company with specific characteristics — dividend history, earnings volatility, leverage, industry — and you must identify which model is most appropriate and justify why.
Here is the selection framework in plain terms:
- Company pays dividends that reflect its earnings capacity → DDM
- Company pays no dividends or dividends are not representative → FCFE or FCFF
- Capital structure is stable → FCFE (simpler)
- Capital structure is changing → FCFF (not affected by leverage changes)
- Financial company or negative free cash flows → Residual Income
- Comparing to peers or need a quick relative check → Price Multiples
The single most important preparation activity for Equity Valuation is not memorising formulas — it is working through mock vignettes that require you to make model selection decisions and then apply the chosen model correctly. Our Level 2 mock exams include a dedicated Equity Valuation section with sub-topic tracking at the model level, so you can identify whether your errors are in model selection, formula construction, or calculation mechanics.
Final Preparation Tips for Equity Valuation
Work through at least 40–50 Equity Valuation practice questions before your exam date. Allocate roughly equal time to each model, but pay extra attention to FCFE vs FCFF distinctions and the residual income model — these are where most candidates lose marks. Read the CFA Institute's equity valuation refresher readings if any conceptual gaps remain after your curriculum study.
On exam day, read the vignette carefully for signals about which model to apply: dividend history, leverage changes, negative earnings, and industry type are all deliberate clues placed by the exam writers. Never apply a model by default — always justify your selection from the information given.