Investment Analysis and Valuation
Core concepts
Valuation asks what an asset is worth versus its price. For equities, know discounted cash flow (DCF), the dividend discount model (DDM), and relative valuation using multiples (P/E, P/B, EV/EBITDA). Understand the components: free cash flow, discount rate (cost of equity via CAPM, WACC), and terminal value. For fixed income, know yield to maturity, current yield, and the yield curve. Grasp intrinsic value versus market price and the concept of margin of safety. Be comfortable with basic financial ratios and the idea that a higher discount rate lowers present value.
Traps in questions
Examiners test the direction of effects: higher growth raises value; higher discount rate lowers value. Watch for confusing P/E with earnings yield (they are reciprocals) and for forgetting that terminal value often dominates a DCF, making assumptions critical. In DDM, the Gordon growth model requires the growth rate to be less than the discount rate, or the formula breaks down. Also watch for questions that confuse book value with market value.
Worked rule of thumb
Gordon growth model: Value = D₁ / (r − g), where D₁ is next year's dividend, r the required return, and g the growth rate. Example: D₁ = $2, r = 8%, g = 3% → Value = 2 / (0.08 − 0.03) = $40. If the market price is $35, the stock appears undervalued by the model. Note that as g approaches r, value explodes - a sign of unrealistic assumptions.
Exam strategy
Identify which variable the question changes, then trace its effect through the formula rather than guessing.