FSA Final V2

Intrinsic Value

The value of a firm based on fundamentals (e.g. assets, earnings, cash flows) rather than market price.

Market Price

The current trading price of a stock, influenced by investor sentiment and expectations, not necessarily aligned with intrinsic value.

Keynes’ Beauty Contest

A metaphor for how investors speculate on what others think the market will value, not what is fundamentally valuable.

Shiller’s Irrational Exuberance

Investor over-optimism can inflate prices beyond intrinsic value due to herd behavior and psychological bias.

Efficient Market Hypothesis (EMH)

The theory that stock prices reflect all available information; exists in weak, semi-strong, and strong forms.

Alpha

Return above expected market return (based on CAPM); indicates outperformance due to skill or mispricing.

Beta

A measure of a stock’s sensitivity to overall market movements; β > 1 = more volatile than market, β < 1 = less volatile.

Adjusted Beta

Beta estimate adjusted toward 1.0 using the formula: 2/3 × raw beta + 1/3 × 1.0.

CAPM Formula

Re = Rf + β(Rm – Rf); calculates cost of equity based on risk-free rate, beta, and market risk premium.

WACC Formula

WACC = (E/V × Re) + (D/V × Rd × (1 – Tc)); used to discount free cash flow to the firm (FCFF).

Stock Return Formula

Return = (P1 + D – P0) / P0; calculates total return from price change and dividends.

Price-to-Earnings (P/E)

Share price divided by earnings per share; indicates how much investors are paying per euro of earnings.

Price-to-Book (P/B)

Share price divided by book value per share; used for asset-heavy firms.

EV/EBITDA

Enterprise value divided by EBITDA; removes capital structure effects to assess core operational value.

Multiples Valuation Process

Identify comparable firms → collect multiples → apply to target firm’s earnings/book value to derive value.

Limitations of Multiples

Can be distorted by non-comparable firms, accounting differences, or negative earnings.

DDM Formula

P = D1 / (r – g); values a stock based on expected dividends growing at a constant rate.

When to Use DDM

When firm has stable, predictable dividend policy and long-term growth is known.

DDM Limitation

Ignores retained earnings; fails when dividends are irregular or absent.

DCF Formula

Value = ∑ (FCFF / (1 + WACC)^t) + Terminal Value.

FCFF (Free Cash Flow to Firm)

EBIT × (1 – tax) + Depreciation – CAPEX – Change in Working Capital.

Terminal Value (Perpetuity)

TV = FCF_(T+1) / (WACC – g); represents continuing value beyond forecast horizon.

Net Debt Adjustment

Subtract net debt from firm value (FCFF model) to arrive at equity value.

When to Use DCF

Firm has positive, forecastable cash flows and a defensible long-term growth rate.

DCF Weakness

Highly sensitive to terminal value assumptions; fragile for early-stage or high-reinvestment firms.

Residual Income Formula

RI = EPS – (COE × Book Value); reflects economic profit above cost of equity.

RIM Valuation Formula

Value = Book Value + PV of Residual Income; captures assets-in-place + future value creation.

When to Use RIM

Dividends and FCF are unreliable, but accounting earnings and book value are stable.

ROCE vs COE

ROCE > COE implies value creation; ROCE < COE implies value destruction.

RIM Terminal Value

RI_t+1 / (r – g); used when residual income is expected to grow perpetually beyond forecast horizon.

DDM vs DCF

DDM values dividends; DCF values cash flows; DCF is more flexible for non-dividend payers.

RIM vs DCF

RIM uses accounting earnings; better for firms with irregular FCF but consistent profits.

Multiples vs DCF

Multiples are fast and relative; DCF is fundamental but assumption-heavy.

Market Cap

Share price × number of shares outstanding.

Terminal Value Risk

Overestimating growth (g) or underestimating WACC inflates terminal value and distorts results.

Why market value may exceed model value

Market may expect higher future ROCE, lower COE, or new strategic opportunities.

Impact of low-ROCE acquisitions (e.g., CRH)

Buying a firm with ROCE < COE reduces residual income and total value unless offset by lower risk or synergies.

Multiples Evaluation

Best used as a benchmark, but must adjust for peer differences in accounting, risk, and growth.

Use CAPM

For calculating cost of equity

Use WACC

For discounting FCFF (firm-level valuation)

Use COE

For discounting dividends or residual income (equity-level valuation)

Subtract net debt

After FCFF DCF to get to equity value

Use perpetuity formula

For terminal value in DDM, DCF, RIM

Book Value of Equity

The accounting value of shareholder equity; used in RIM and in many valuation models as a starting point for value creation.

Return on Common Equity (ROCE)

Net Income / Book Value of Equity; used to assess whether a firm is earning above its cost of equity.

Residual Earnings vs Net Income

Net income adjusted for the opportunity cost of equity capital; residual income shows true value creation.

Enterprise Value (EV)

Market value of equity + net debt; used in multiples and firm-wide DCF.

Free Cash Flow to Equity (FCFE)

Cash flow available to equity holders; DCF alternative when valuing just equity (not firm).

Abnormal Earnings Growth (AEG)

A variant of RIM based on change in residual income year-over-year; useful for understanding momentum.

Alpha Investors

Active managers who aim to outperform the market through security selection.

Beta Investors

Passive investors who aim to match the market return (indexing).

Limitation of RIM

Sensitive to accounting assumptions and book value projections; assumes clean accrual accounting.

Cost of Equity vs WACC Usage

Re used for equity-level models (RIM, DDM, FCFE), WACC for firm-level (FCFF).

Residual Value (in CRH example)

Value added beyond book value from future expected RI (can be small if ROCE ≈ COE).