FE-1 Equity common mistakes
FE-1 Equity · Understand the traps and how to avoid them.
Computing FCFF by adding after-tax interest back to net income but then discounting at WACC without checking that the resulting enterprise value is compared to total firm value rather than equity value, or subtracting only debt instead of debt plus preferred stock and minority interest to bridge to equity.
Candidates memorize the FCFF formula but never build the enterprise-to-equity bridge explicitly, so they mix up what the discounted cash flow actually values.
What to do instead
Write the bridge as a numbered line item before discounting: EV = PV(FCFF at WACC); Equity value = EV − total debt − preferred − minority interest + cash and non-operating assets; then divide by diluted shares. Do this every single time, even when the question seems to ask only for 'value per share'.
Using the current-year dividend D0 in the Gordon growth model instead of D1 = D0 × (1 + g), or using the just-reported trailing EPS as the base for a forward P/E.
The formulas are recalled as 'D over r minus g' without internalizing that the numerator must be next period's cash flow, and trailing figures are the most salient numbers in the vignette.
What to do instead
Before plugging in, label every input as time 0 or time 1. If the question gives a dividend just paid or a trailing EPS, multiply by (1 + g) first. Sanity check: for a stable firm, justified leading P/E = payout ratio / (r − g) and must be lower than the trailing version.
Applying the dividend discount model to a firm with a payout ratio far below 100% and volatile or negative free cash flow, then treating the resulting value as meaningful, or conversely forcing an FCFE model onto a stable utility with a near-constant dividend.
Candidates default to whichever model they practiced most recently rather than matching the model to the firm's cash flow characteristics and capital structure.
What to do instead
Use a decision rule: stable payout and stable leverage → DDM; FCFE when leverage is expected to change; FCFF when leverage is high or changing or when FCFF is positive while FCFE is negative. State the rule in one sentence in your notes and apply it before any calculation.
Selecting comparable companies on the basis of industry label alone, then applying a peer median P/E without adjusting for differences in expected growth, margin, or leverage, and ignoring whether the multiple is trailing, forward, or normalized.
Screeners return industry peers automatically, and the apparent precision of a median multiple creates false confidence that comparability has been established.
What to do instead
For each peer, tabulate the fundamental driver of the multiple (g for P/E and PEG, net margin for P/S, ROE for P/B), and either exclude peers that differ materially or adjust via the justified-multiple formula. Explicitly confirm the multiple definition (LTM vs NTM, diluted vs basic, calendarization) matches the target.
Treating a lower P/E or EV/EBITDA than peers as automatic evidence of undervaluation without asking why the discount exists, and failing to check that EV/EBITDA is used only for peers with similar capital intensity and tax positions.
Relative valuation is taught as 'buy the cheapest multiple', and the mechanical ranking is easy to produce, so the diagnostic step is skipped under time pressure.
What to do instead
For every apparent discount, write one sentence on whether it is explained by fundamentals (lower growth, higher risk, worse capital allocation). If explained, the stock is fairly valued; only the unexplained residual is a signal. Also verify EBITDA multiples are not distorted by differing lease, capitalization, or acquisition accounting.
Building a forecast without tying the three statements together, so revenue growth does not drive working capital, capex is not linked to depreciation and growth, and retained earnings do not reconcile to the balance sheet, leaving the model out of balance.
Candidates learn ratio analysis and forecasting as separate topics and never practice the articulation between statements that makes a forecast internally consistent.
What to do instead
Build in a fixed order: revenue drivers → margins → working capital as days of revenue → capex as a percentage of revenue or of depreciation → debt schedule → interest → net income → cash flow → balance sheet. Insert a balance check row; if it is nonzero, the error is almost always in the debt schedule, dividends, or working capital sign.
Reading reported EPS or net income at face value without adjusting for non-recurring items, stock-based compensation, or accounting policy differences, and comparing a GAAP figure to a peer's adjusted figure.
Headline numbers are what the press release emphasizes, and adjusted metrics are presented as if they were the true economic earnings.
What to do instead
Rebuild a normalized earnings figure: start from reported net income, remove genuinely non-recurring items, treat recurring 'one-offs' as recurring, and decide and document a consistent treatment of stock-based compensation across all peers. Compare like with like or restate.
Confusing the different return measures - using ROE to judge operating performance when leverage differs across peers, or computing ROIC with the wrong denominator (total assets instead of invested capital) - and then drawing a conclusion about value creation.
The formulas look similar and the distinctions between operating and financing effects are subtle, so the first remembered formula gets used.
What to do instead
Always decompose: ROE = ROIC + (ROIC − after-tax cost of debt) × D/E. Use ROIC = NOPAT / (total debt + equity − excess cash) for operating performance, and compare ROIC to WACC, not to ROE. State which question you are answering - operating quality or shareholder return - before choosing the ratio.
Writing a recommendation that states a rating and target price but never specifies the valuation method, the time horizon, the key assumptions, or the catalysts and risks that would invalidate the thesis.
Candidates treat the report as a summary of the analysis already done rather than as a standalone argument that must be defensible without the model.
What to do instead
Use a fixed template: rating and target price with implied upside; valuation method and the two or three assumptions that drive it; why the market is wrong (the mispricing thesis); catalysts and timing; risks with quantified downside. If a reader cannot reconstruct the target price from the text alone, the report is incomplete.
Reporting a portfolio's return or risk without distinguishing time-weighted from money-weighted return, or computing diversification benefit while ignoring correlation changes in stress periods, and treating a high Sharpe ratio from a short sample as robust.
Performance and risk statistics are produced by software, and candidates rarely interrogate the assumptions or the sample period behind them.
What to do instead
State explicitly which return measure answers the question (time-weighted for manager skill, money-weighted for investor experience). For risk, report correlation and volatility in both normal and stress windows, and check that Sharpe or information ratios are computed over a period at least as long as the strategy's typical cycle.