Investment Analysis and Valuation
The Investment Analysis and Valuation domain tests whether you can build a defensible value for a security and challenge someone else's. Expect discounted cash flow arithmetic, multiple selection, ratio analysis and judgement about forecast quality.
Approaches
- DCF: forecast free cash flow to the firm, discount at WACC, subtract net debt for equity value; alternatively discount free cash flow to equity at the cost of equity.
- Dividend discount model: P = D1 / (r − g), with g sustainable only below long-run nominal growth and consistent with retention × return on equity.
- Multiples: P/E, EV/EBITDA (capital-structure neutral), P/B (useful for financials), dividend yield. Comparables must match on growth, margin, leverage and geography.
Analysis discipline
- Ratios: margins, returns (ROE, ROIC), leverage (net debt/EBITDA), interest cover, working capital and cash conversion. DuPont decomposition separates margin, turnover and leverage.
- Quality of earnings: accruals, capitalised costs, one-offs, revenue recognition timing, related-party items. Sustained cash conversion below 1.0 is a warning.
- Sensitivity: identify the two or three value drivers that matter and present a range, not a single point.
Worked example
A share last paid a dividend of 2.00. Dividends grow 4% a year indefinitely; required return is 9%. D1 = 2.00 × 1.04 = 2.08. P = 2.08 / (0.09 − 0.04) = 41.60. If the market price is 36.00, the implied return is 2.08 / 36.00 + 0.04 = 9.78%, above the required 9% - the share screens cheap. But raise the required return to 10% and the value becomes 2.08 / 0.06 = 34.67, below the market price. The conclusion rests almost entirely on the discount rate.
Traps
- Using D0 instead of D1, or letting g exceed r.
- Comparing P/E ratios across firms with different growth or leverage without adjustment.
- Double-counting net debt, or discounting equity cash flows at WACC.
- Accepting a target price without testing terminal growth and margin assumptions.
- Treating a cyclical peak margin as a sustainable one.