Valuation of Equity Securities — The One Where We Price What People Fight Over

"Market price is what you pay; intrinsic value is what it's worth."

You already know the playing field from Equity Market Structure (how trades happen) and Types of Equity Securities (common vs preferred, voting rights, etc.). You also have the corporate finance toolkit (DCF, WACC, free cash flows). Now we stitch those threads together and answer the CFA Level I sacred question: How do you value an equity share?

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Quick roadmap (because we're not wandering aimlessly)

1. Core valuation approaches you need to master
2. Key formulas and a couple of worked examples (yes, actual numbers)
3. Pros, cons, and traps — the stuff examiners love to test

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The three main approaches (big picture)

• Dividend Discount Models (DDM) — Value the share as the present value of expected dividends. Natural fit for dividend-paying firms and preferred stock.
• Free Cash Flow to Equity (FCFE) — Discount cash flows available to equity holders after debt payments. This is the equity-side DCF.
• Relative Valuation (Multiples) — Price by comparing to peers using P/E, P/B, P/S, etc.

Each approach has its time and place. Pick the one that best matches the firm's payout policy and your data quality.

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1) Dividend Discount Model (DDM)

Idea: A stock is worth the present value of the cash flows it gives you — dividends.

Basic single-stage (Gordon Growth) model — for firms with constant perpetual growth:

P0 = D1 / (r - g)

Where:

• P0 = intrinsic stock price today
• D1 = dividend expected next year (= D0 * (1+g))
• r = required return on equity
• g = constant growth rate in dividends

Worked example — Gordon Growth:

• Last dividend D0 = $2.00
• Expected constant growth g = 5% (0.05)
• Required return r = 10% (0.10)

D1 = 2.00 * 1.05 = 2.10
P0 = 2.10 / (0.10 - 0.05) = 2.10 / 0.05 = $42.00

That’s the beauty: simple, elegant — and fragile if g is close to r.

Multi-stage DDM: If growth isn't constant, you model explicit dividends for early years, then a terminal (Gordon) value.

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2) Free Cash Flow to Equity (FCFE)

Idea: Use the cash flows actually available to shareholders after paying interest, debt principal, and reinvestment.

Basic FCFE formula for a year:

FCFE = NI + Depreciation - CapEx - ΔWorkingCapital + NetBorrowing

Then discount FCFE at required return on equity:

P0 = Σ (FCFE_t / (1 + r)^t)  +  (Terminal FCFE / (r - g)) / (1 + r)^n

Quick two-stage example (abbreviated):

• FCFE1 = 5, FCFE2 = 6; stable growth g = 3% afterward; r = 9%.

Terminal value at t=2 = FCFE3 / (r - g) where FCFE3 = FCFE2*(1+g) = 6*1.03 = 6.18
TV = 6.18 / (0.09 - 0.03) = 6.18 / 0.06 = 103.00
PV of FCFE1+FCFE2 = 5/(1.09) + 6/(1.09^2) ≈ 4.587 + 5.049 = 9.636
PV of TV = 103 / (1.09^2) ≈ 86.64
P0 ≈ 9.636 + 86.64 = 96.276

FCFE is flexible and great for firms that don’t pay dividends but generate distributable cash.

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3) Relative valuation (Multiples)

Idea: The market tends to value similar firms in similar ways. Use ratios like P/E, P/B, EV/EBITDA.

• P/E = Price per share / Earnings per share — intuitive but earnings can be volatile or manipulated.
• P/B = Price per share / Book value per share — useful for financial firms or asset-heavy companies.

Procedure:

1. Select comparable firms
2. Compute median multiple
3. Multiply target firm’s metric by that multiple

Relative methods are fast and exam-friendly, but they inherit market prices' noise.

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Comparing methods (mini-table)

Method	Best when...	Weakness
DDM	Company pays predictable dividends	Not applicable for zero-dividend firms
FCFE	Firm retains or repurchases shares — accurate cash flows	Sensitive to leverage and cash flow projections
Relative	Plenty of similar comps and market data	Market may be over- or undervaluing sector

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Traps, exam bait, and practical tips

• g must be < r in Gordon Growth. If g ≥ r, formula breaks — panic mode.
• Don’t confuse g (growth rate in dividends/FCFE) with g in revenue — use consistent definitions.
• Per-share vs aggregate: if using dividends or FCFE in totals, divide by shares outstanding to get per-share value.
• For FCFE, remember to include net borrowing (new debt issued − debt repaid).
• Multiples require careful selection of comparables and normalization (e.g., adjust for non-recurring items).

Common exam traps:

• Using D0 instead of D1 in Gordon formula
• Forgetting to discount the terminal value back to present
• Mixing equity discount rates with enterprise cash flows (use FCFF + WACC for enterprise value)

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"Pick the right tool for the job: dividend model if dividends drive value; FCFE if cash flow does; multiples if you need a sanity check."

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Closing: If you remember only three things

1. Value = PV of expected cash flows to the investor — dividends for DDM, FCFE for equity cash flows, or multiples for relative value.
2. Gordon Growth is simple but fragile — check r > g, use D1 not D0. When growth isn’t constant, do multi-stage.
3. Watch inputs — small changes in r, g, or terminal year projections massively change price.

Practice: do a DDM and an FCFE valuation for the same company and compare — you’ll learn more in one afternoon than a week of lectures. Now go price something — responsibly.

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"Version stamp": Valuation with a Wink — go ace Level I.