Equity Investments and Equity Research
Domain 6 - Equity Investments and Equity Research
This domain tests market efficiency, industry analysis, dividend and free-cash-flow valuation, and relative valuation. Questions often ask whether a stock is overvalued or undervalued, or which model is appropriate given a company's dividend policy.
Core rules
- Market efficiency: Weak-form efficiency concerns past prices; semi-strong-form concerns public information; strong-form concerns all information, including private. Anomalies challenge but do not necessarily disprove efficiency.
- Dividend discount model: For a constant-growth stock, V0 = D1 / (r - g). The growth rate must be less than the required return.
- Sustainable growth: g ≈ retention ratio × return on equity. It is an internal growth estimate, not a forecast of market value.
- Free cash flow: FCFE is cash available to equity after reinvestment and net debt payments; FCFF is cash available to all capital providers.
- Relative valuation: P/E, P/B, EV/EBITDA, and similar multiples must be applied to comparable firms with similar growth, risk, and accounting.
Worked example
A stock just paid D0 = 1.92. Dividends are expected to grow 4% forever, and the required return is 10%. Next year's dividend is D1 = 1.92 × 1.04 = 2.00. The Gordon-growth value is 2.00 / (0.10 - 0.04) = 33.33. If the stock trades at 30.00, it appears undervalued by 3.33, or about 11%. Equivalently, the expected return at 30.00 is D1/P0 + g = 2.00/30.00 + 0.04 = 10.67%, above the 10% required return. If the price were 36.00, the expected return would be 9.56%, below the required return, suggesting overvaluation.
Traps that cost marks
- Using D0 instead of D1 in the Gordon-growth model.
- Applying a constant-growth model when g is greater than r.
- Comparing P/E ratios without adjusting for growth and risk.
- Treating sustainable growth as a market-implied growth rate.
- Ignoring dilution and accounting differences in relative valuation.