Equity Valuation, Analysis and Investment Ratios
What this domain tests
This domain tests your ability to compute and interpret the standard equity ratios, choose the right multiple for a comparison, and explain the assumptions behind a discounted cash flow or dividend discount model. Numerical questions are common, so be precise about numerator and denominator.
Core rules and concepts
- Per-share metrics: EPS = earnings attributable to ordinary shareholders ÷ weighted average diluted shares; P/E = price ÷ EPS; PEG = P/E ÷ expected earnings growth.
- Dividend metrics: yield = dividend per share ÷ price; payout = DPS ÷ EPS; cover = EPS ÷ DPS.
- Returns and book value: ROE = net income ÷ average equity; P/B = price ÷ book value per share. P/B is most meaningful where book value approximates realisable value, so it is weak for asset-light businesses.
- Enterprise value: EV = market capitalisation + net debt + minority interests + preferred stock − cash. EV/EBITDA is capital-structure neutral but ignores capital expenditure and working capital.
- Models: Gordon growth assumes a constant dividend growth rate below the cost of equity; DCF discounts free cash flow at WACC.
Worked example
A company has 10m shares at £18, net debt £40m, EBITDA £22m and net income £12m. Market cap = £180m, so EV = £220m and EV/EBITDA = 10.0x. EPS = £1.20 and P/E = 15.0x. A 60p dividend gives a 3.3% yield, 50% payout and 2.0x cover. If peers trade at 8.0x EBITDA, implied EV is £176m, equity £136m, or £13.60 per share - about 24% below the current price.
Traps that cost marks
Use diluted EPS for P/E, and state whether the multiple is trailing or forward. P/E is meaningless with negative earnings; use EV/sales or P/B instead. EV must include debt and minorities. Dividend yield can be quoted gross or net of withholding tax. EBITDA is not cash flow.