Investment Analysis and Valuation
Domain 3: Investment analysis and valuation
This domain tests how analysts value equities and bonds, interpret financial statements and use relative valuation. Questions often require choosing the right model, applying it correctly and recognising when a model’s assumptions fail.
Equity valuation
- Discounted cash flow values an asset as the present value of expected future cash flows. Free cash flow to equity is discounted at the cost of equity; enterprise cash flow is discounted at WACC.
- The dividend discount model values equity as the present value of dividends. The Gordon growth form is P0 = D1/(r − g), where D1 is next year’s dividend, r is required return and g is sustainable growth.
- Relative valuation uses multiples such as P/E, EV/EBITDA and price-to-book. Multiples are only comparable across similar businesses, accounting policies and growth profiles.
- Profit quality matters: cash conversion, working capital, dilution and one-off items can make reported earnings misleading.
Bond and credit analysis
- Bond value is the present value of coupons and principal discounted at the required yield.
- Yield to maturity assumes coupons are reinvested at that yield and the bond is held to maturity.
- Duration measures price sensitivity: approximate percentage price change ≈ −duration × change in yield.
- Credit analysis assesses default probability, recovery and spread compensation.
Worked example
A share is expected to pay a dividend of 40p next year. The required return is 8% and sustainable growth is 3%. Gordon growth value = 0.40/(0.08 − 0.03) = £8.00. If the market price is £7.00, the model suggests undervaluation of about 14.3% (£1.00/£7.00). The conclusion depends on the inputs: if growth were 4%, value would be £10.00; if the required return were 10%, value would be £5.71. Small changes in r or g have a large effect.
Traps
- Using the current dividend D0 instead of D1 in the Gordon model.
- Applying g greater than or equal to r, which produces impossible values.
- Comparing P/E ratios without adjusting for growth, risk or accounting differences.
- Treating a bond’s coupon as its yield, or ignoring duration when yields move.
- Relying on EBITDA as a proxy for cash flow while ignoring capital expenditure and working capital.
Key points
- DCF values expected cash flows at an appropriate discount rate.
- Gordon growth: P0 = D1/(r − g); D1 is next year’s dividend.
- Multiples require like-for-like comparison and accounting adjustments.
- Duration approximates bond price sensitivity to yield changes.
- Cash conversion and dilution affect the quality of reported earnings.