{"id":1966,"date":"2019-09-27T13:33:00","date_gmt":"2019-09-27T13:33:00","guid":{"rendered":"https:\/\/analystprep.com\/cfa-level-1-exam\/?p=1966"},"modified":"2025-11-03T09:22:29","modified_gmt":"2025-11-03T09:22:29","slug":"present-value-models-value-equity","status":"publish","type":"post","link":"https:\/\/analystprep.com\/cfa-level-1-exam\/equity\/present-value-models-value-equity\/","title":{"rendered":"Present Value Models to Value Equity"},"content":{"rendered":"<p><iframe loading=\"lazy\" src=\"\/\/www.youtube.com\/embed\/GWw4je023oo\" width=\"611\" height=\"343\" allowfullscreen=\"allowfullscreen\"><\/iframe><\/p>\n<p>Present value models are based on a fundamental tenet of economics stating that individuals defer consumption to reap future benefits. Therefore, the value of an investment today should be worth the present value of expected future benefits, defined as dividends or free cash flow.<\/p>\n<h2><strong>Dividend Discount Model<\/strong><\/h2>\n<p>The dividend discount model looks at cash flows from the investor\u2019s perspective. Cash is received from distributions during the holding period and the final sale price upon liquidation of the security.<\/p>\n<p>$$ V_0=\\sum_{t=1}^n\\frac{D_t}{(1+r)^t}+\\frac{P_n}{(1+r)^n}$$<\/p>\n<p><em>V<sub>0<\/sub><\/em> = present value of a share of the stock today<\/p>\n<p><em>D<sub>t<\/sub><\/em> = expected dividend in year <em>t<\/em><\/p>\n<p><em>r<\/em> = required rate of return on the stock<\/p>\n<p>The first part of the equation is simply the sum of the next dividend payments that will occur at some point in the future, each discounted back at the required rate of return so that we arrive at a present value today.<\/p>\n<p>The second part of the equation is the discounted terminal stock value or the expected selling price at the end of the investment horizon.<\/p>\n<h2><strong>Free-cash-flow-to-equity Models<\/strong><\/h2>\n<p>Instead of measuring expected dividends, the free-cash-flow-to-equity (FCFE) model is based on the company\u2019s expected dividend-paying capacity. The calculation of FCFE starts with the cash flows from operations (CFO):<\/p>\n<p>$$ CFO = \\text{Net income} + \\text{Noncash expenses} -\\text{Net Working capital} $$<\/p>\n<p>Then, we can come up with the free-cash-flow-to-equity (FCFE) calculation:<\/p>\n<p>$$ FCFE = CFO &#8211; \\text{Fixed capital investment} + \\text{Net borrowing} $$<\/p>\n<p>Where <em>Net borrowing<\/em> is simply\u00a0<em>Borrowings<\/em> minus <em>Repayments<\/em>.<\/p>\n<blockquote>\n<h3><strong>Question<\/strong><\/h3>\n<p>The following is taken from an analyst\u2019s valuation of CBA, Inc:<\/p>\n<p>$$<br \/>\n\\begin{array}{l|r}<br \/>\n\\text{Current Price} &amp; \\$8.50 \\\\<br \/>\n\\hline<br \/>\n\\text{Expected Year 1 Dividend} &amp; \\$1.00 \\\\<br \/>\n\\hline<br \/>\n\\text{Expected Year 2 Dividend} &amp; \\$1.15 \\\\<br \/>\n\\hline<br \/>\n\\text{Expected Sale Price (End of Year 2)} &amp; \\$8.75 \\\\<br \/>\n\\end{array}<br \/>\n$$<\/p>\n<p>The analyst\u2019s required return is 8%. Based on the analyst\u2019s estimates and using the dividend discount model, the stock price of CBA, Inc. is currently:<\/p>\n<ol style=\"list-style-type: upper-alpha;\">\n<li data-tadv-p=\"keep\">Overvalued.<\/li>\n<li data-tadv-p=\"keep\">Fairly valued.<\/li>\n<li data-tadv-p=\"keep\">Undervalued.<\/li>\n<\/ol>\n<p><strong>Solution<\/strong><\/p>\n<p>The correct answer is <strong>C<\/strong>.<\/p>\n<p>Based on the given inputs, the stock\u2019s estimated value is equal to year 1 cash flows ($1.00\/1.08 = $0.93) plus year 2 cash flows (($8.75 + $1.15)\/1.08<sup>2<\/sup> = $8.49), or approximately $9.41. Because the stock\u2019s estimated value exceeds its current price, the stock is undervalued.<\/p><\/blockquote>\n","protected":false},"excerpt":{"rendered":"<p>Present value models are based on a fundamental tenet of economics stating that individuals defer consumption to reap future benefits. Therefore, the value of an investment today should be worth the present value of expected future benefits, defined as dividends&#8230;<\/p>\n","protected":false},"author":1,"featured_media":0,"comment_status":"closed","ping_status":"closed","sticky":false,"template":"","format":"standard","meta":{"_acf_changed":false,"footnotes":""},"categories":[8],"tags":[],"class_list":["post-1966","post","type-post","status-publish","format-standard","hentry","category-equity","blog-post","no-post-thumbnail","animate"],"acf":[],"yoast_head":"<!-- This site is optimized with the Yoast SEO plugin v26.9 - https:\/\/yoast.com\/product\/yoast-seo-wordpress\/ -->\n<title>Present Value Models for Equity Valuation | CFA Level 1<\/title>\n<meta name=\"description\" content=\"Explore present value models like the Dividend Discount Model (DDM) and Free Cash Flow to Equity (FCFE) for valuing equity securities.\" \/>\n<meta name=\"robots\" content=\"index, follow, max-snippet:-1, max-image-preview:large, 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