Investment Analysis and Valuation
Investment Analysis and Valuation tests intrinsic value estimation, required-return logic, and relative valuation. Expect DCF, dividend discount models, free cash flow to firm and equity, terminal value, and multiples discipline. The exam also tests the difference between enterprise value and equity value.
Core rules
- FCFF = EBIT × (1 - tax rate) + depreciation - capex - increase in net working capital. FCFF discounts at WACC to enterprise value; subtract net debt to get equity value.
- FCFE = net income + depreciation - capex - working capital change + net borrowing. FCFE discounts at the cost of equity.
- Gordon growth: value = D1 / (r - g). The model requires g < r and a sustainable growth rate tied to ROE × retention.
- Terminal value dominates DCF output; use a perpetuity growth rate at or below long-run GDP growth, or an exit multiple consistent with the forecast.
- Relative valuation: P/E is distorted by leverage and accounting; EV/EBITDA is capital-structure neutral but ignores capex and tax; P/B suits financial firms.
Worked example
A firm expects FCFF of 50 million next year, growing 3% forever. WACC is 9%. Terminal value at year one is 50 / (0.09 - 0.03) = 833.3 million. If net debt is 150 million, equity value is 833.3 - 150 = 683.3 million. With 100 million shares, value per share is 6.83. If the analyst used 6% growth instead, terminal value would be 50 / 0.03 = 1,666.7 million, and value per share would more than double, showing how sensitive the output is to g.
Traps
- Do not discount FCFF at the cost of equity or FCFE at WACC; the cash flow and discount rate must match.
- A terminal growth rate above nominal GDP is usually unsupportable.
- Mixing trailing and forward multiples distorts comparison; match the numerator and denominator periods.
- EV/EBITDA ignores working capital and capex, so a capital-intensive firm can look cheap.
- In DDM, a payout ratio above 100% is not sustainable unless assets are being liquidated.