Equity Valuation for CFA Level 2: DCF, Multiples, and Residual Income

CFA Level II pushes you beyond “plug-and-chug” into method selection and assumption defense. In equity valuation, that means knowing when to use DCF, when market multiples are more informative, and where residual income (RI) offers a cleaner bridge between accounting and value creation. Below is a practitioner-grade overview aligned to Level II’s item-set style: what each approach needs, the traps, and how to cross-check results.

1) Discounted Cash Flow (DCF)

FCFF vs. FCFE and the right discount rate

• FCFF (to the firm): Discount at WACC to get enterprise value (EV), then subtract net debt (and other non-equity claims) and add non-operating assets to arrive at equity value.

• FCFE (to equity): Discount at cost of equity (rₑ) to get equity value directly.

Consistency is everything: EV methods require enterprise cash flows and WACC; equity methods require equity cash flows and rₑ. Mixing the two is a common exam error.

Core build

1. Forecast drivers, not just line items: revenue growth, margin trajectory, reinvestment intensity (ΔWC and Capex vs. sales), and tax rate.

2. Terminal value (TV):

   • Gordon growth: TV = FCF₍T+1₎ / (r − g), with g < long-run nominal GDP growth and consistent reinvestment.

   • Exit multiple: EV/EBITDA or EV/EBIT on a normalized final-year base (justify the multiple with peer medians and cycle position).

3. Adjustments: Capitalized leases (if not in debt already), minority interests, pension/stock comp, non-operating assets, and any material one-offs.

Sanity checks that earn points

• ROIC vs. WACC: Long-run growth g > 0 requires reinvestment; if ROIC ≈ WACC, excess value creation fades—don’t model explosive growth without improved ROIC.

• Mid-year convention raises present value (cash comes mid-period); use it consistently across scenarios.

• Implied expectations: Back-solve the market price to implied g or margin to see if your thesis is aggressive or conservative.

Frequent pitfalls: Double-counting tax shields, forgetting working-capital drag in high-growth phases, and mixing nominal with real inputs.

2) Market Multiples

Multiples translate valuation into market comparables—powerful when businesses are steady and accounting is comparable.

Choosing the right ratio

• Equity multiples: P/E, P/B, P/CF—sensitive to capital structure and accounting.

• Enterprise multiples: EV/EBITDA, EV/EBIT, EV/Sales—neutralize leverage differences and are often better for cross-company comparison.

Forward vs. trailing: Level II expects you to prefer forward metrics when forecasts are credible, especially for growth or cyclical names.

Building a defensible comp set

1. Business mix: similar growth, margins, capital intensity, and competitive dynamics.

2. Accounting normalization: remove non-recurring items; align lease treatment; check revenue recognition.

3. Capital structure: if equity multiples diverge because of leverage, pivot to EV-based measures.

Using multiples well

• Anchor on the comp median/interquartile range; explain deviations with structural (not cosmetic) reasons: sustainable growth, risk (beta), returns on capital, or cyclicality.

• PEG can be a rough cross-check (P/E divided by growth), but only if growth is measured consistently and is sustainable.

• Cyclicals: Favor EV/through-cycle EBITDA or normalized margins—trailing P/E at a cyclical peak can be deceptively low.

Frequent pitfalls: Blindly applying peer medians, ignoring working-capital intensity (two firms with the same EBITDA but different reinvestment needs deserve different values), and mixing pre- and post-IFRS 16 metrics without adjustments.

3) Residual Income (RI)

RI values equity as current book value plus the present value of future residual income:

• Residual income: RIₜ = NIₜ − rₑ × BVₜ₋₁ = (ROEₜ − rₑ) × BVₜ₋₁

• Intrinsic value: V₀ = BV₀ + Σ [ RIₜ / (1 + rₑ)ᵗ ]

Why and when to use RI

• Useful when dividends and FCFE are negative or erratic, but accounting earnings and book values are available and informative.

• Naturally connects to justified P/B: higher (ROE − rₑ) and growth imply P/B > 1; if ROE ≈ rₑ in steady state, P/B → 1.

Clean surplus and adjustments

RI assumes the clean-surplus relation: all changes in book equity flow through the income statement except transactions with shareholders. Level II expects you to adjust for items that bypass NI (e.g., some OCI components, unusual revaluations) so that BV and NI reflect economic reality. Goodwill impairments, intangibles capitalization, and pension accounting often require judgment.

Persistence and terminal treatment

Beyond an explicit forecast horizon, assume residual income fades toward zero via a persistence factor (ω) or assume ROE converges to rₑ with stable growth. Be explicit about the convergence path you choose.

Frequent pitfalls: Double counting by adding both RI PV and growth premiums elsewhere, failing to reconcile book value adjustments with the income forecast, and using rₑ inconsistent with the risk profile implied by ROE.

Cross-method triangulation (how pros present)

Use at least two methods and reconcile:

• DCF sets the intrinsic anchor from fundamentals.

• Multiples test market realism and cycle positioning.

• RI explains why P/B should be above/below 1 and links accounting profitability to value creation.

If the methods disagree, diagnose the cause, not just the number: TV assumption too rich? Peer set mismatched? ROE persistence overstated?

Quick reference table

Approach	Discount Rate	Primary Driver	Strengths	Key Risks/Pitfalls
DCF (FCFF/FCFE)	WACC / rₑ	Cash flow & reinvestment	Transparent economics; flexible scenarios	TV dominates; ROIC–WACC consistency; WC/Capex realism
Multiples (EV/EBITDA, P/E, etc.)	Market-implied	Peer comps & cycle	Fast; market-anchored	Bad comps; accounting differences; cyclicality
Residual Income	rₑ	ROE − rₑ and BV path	Works with erratic FCF; ties to P/B	Clean-surplus breaks; persistence overstatement

Exam-day habits that convert to points

1. Match flows and rates: FCFF ↔ WACC; FCFE ↔ rₑ; equity vs. enterprise numerators and denominators in multiples.

2. Normalize before valuing: remove one-offs, align leases, check taxes.

3. Document terminal logic: show why g is feasible (capacity, reinvestment, market share).

4. Bridge methods: explain deviations—e.g., high justified P/B because ROE sustainably exceeds rₑ.

5. Units & signs: %, bps, after-tax vs. pre-tax, mid-year effects—small mechanics, big marks.

Bottom line: Level II rewards candidates who choose the right tool for the business model, keep assumptions economically coherent, and triangulate results with clear, defensible reasoning. Master these three lenses—DCF, multiples, and residual income—and you’ll value companies like an analyst and explain them like a portfolio manager.