Overview
Equity Investments is 10-15% of the CFA Level 2 exam, one of the heaviest topics and where the deep valuation work concentrates. It has four areas. Discounted dividend valuation covers the dividend discount model in its multistage forms (two-stage, three-stage, and the H-model) for companies with changing growth. Free cash flow valuation covers valuing a company using free cash flow to the firm (FCFF) and free cash flow to equity (FCFE), computing these cash flows and discounting them. Market-based and residual income valuation cover price and enterprise multiples (P/E, P/B, EV/EBITDA and others) and the residual income model, which values equity from book value plus economic profit. Private company valuation covers valuing companies not publicly traded, including the income, market and asset-based approaches and valuation discounts.
The exam rewards applying the right valuation model within a vignette, computing FCFF and FCFE, using multiples correctly, and applying residual income and private-company methods. This is the most valuation-intensive topic on the exam.
How it's tested
CFA Level 2 Equity Investments questions give a company's data in a vignette and ask you to value it with a specified model, computing the cash flows or applying the multiple. CFA Level 2 questions sit in vignettes: a case gives facts, numbers and exhibits, and each question requires pulling the right input and applying the right model, so read the case, identify the model, and compute carefully.
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Apply the DDM
A company with changing growth is described, and you apply a multistage dividend discount model.
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Free cash flow valuation
A company's data is given, and you compute FCFF or FCFE and value the firm or equity.
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Multiples and residual income
A valuation situation is described, and you apply a multiple, the residual income model, or a private-company method.
The exam gives net income, non-cash charges, the working capital change, capital expenditure and net borrowing, and asks for free cash flow to equity. FCFE adjusts net income for non-cash charges, working capital and fixed capital and adds net borrowing, because it is the cash available to equity after debt. Adding net borrowing (unlike FCFF) is the step the exam expects.
Topic areas 4
Official topic areas from the CFA Institute outline, in outline order.
6.1 Discounted dividend valuation modelsMultistage dividend discount models.
- What it means
- This covers the dividend discount model beyond the single-stage Gordon growth model: two-stage and three-stage models for companies whose growth changes over time, the H-model (approximating a linearly declining growth rate), and estimating the required return and growth inputs.
- What to understand
- Many companies do not grow at a constant rate, so multistage models value an initial high-growth period and a terminal stable-growth period separately, discounting each. The H-model approximates a gradual decline in growth. Selecting and applying the right multistage model and estimating the inputs (required return, growth) is a core valuation skill tested in calculations.
- How it shows up
- A company with changing growth is described, and you must apply the appropriate multistage dividend discount model.
- Common confusion
- Misapplying the terminal value, or using a single-stage model where a multistage model fits.
6.2 Free cash flow valuation (FCFF and FCFE)Valuing with free cash flow to the firm and to equity.
- What it means
- This covers free cash flow valuation: free cash flow to the firm (FCFF, cash available to all capital providers) and free cash flow to equity (FCFE, cash available to equity holders), how to compute each from net income or other starting points, and discounting them, FCFF at the WACC to value the firm and FCFE at the cost of equity to value equity.
- What to understand
- FCFF is cash available to all investors before debt payments; FCFE is what remains for equity after debt. The computations adjust for non-cash charges, working capital and capital expenditure, with FCFE also reflecting net borrowing. FCFF is discounted at the WACC (giving firm value), FCFE at the cost of equity (giving equity value). Knowing how to compute and discount each correctly is heavily tested.
- How it shows up
- A company's data is given, and you must compute FCFF or FCFE and value the firm or equity.
- Common confusion
- Confusing FCFF with FCFE (especially the net-borrowing and interest adjustments), or discounting with the wrong rate.
6.3 Market-based and residual income valuationPrice and enterprise multiples and the residual income model.
- What it means
- This covers market-based valuation using multiples, price multiples (price-to-earnings, price-to-book, price-to-sales) and enterprise multiples (EV/EBITDA), including justified multiples and comparables, and the residual income model, which values equity as current book value plus the present value of future residual income (economic profit above the cost of equity).
- What to understand
- Multiples value a company relative to a fundamental and to peers, with justified multiples derived from fundamentals. The residual income model is useful when dividends or cash flows are hard to forecast, valuing equity from book value plus the economic profit the firm earns above its required return. Knowing how to apply multiples and the residual income model is tested.
- How it shows up
- A valuation situation is described, and you must apply a multiple or the residual income model.
- Common confusion
- Misusing a multiple (which earnings or EV measure), or misapplying the residual income model's book-value-plus-economic-profit structure.
6.4 Private company and industry valuationValuing private companies and applying discounts.
- What it means
- This covers private company valuation: the income approach (discounted cash flow), the market approach (comparable transactions and multiples) and the asset-based approach, the challenges of valuing non-traded companies, and valuation discounts (for lack of control and lack of marketability).
- What to understand
- Private companies lack market prices, so analysts use the income, market or asset-based approaches, adjusting for the greater difficulty and applying discounts: a discount for lack of marketability (shares cannot be readily sold) and a discount for lack of control (a minority stake). Knowing the approaches and when to apply the discounts is tested.
- How it shows up
- A private-company situation is described, and you must choose the valuation approach or apply a discount.
- Common confusion
- Forgetting to apply marketability or control discounts, or confusing the valuation approaches.
High-yield concepts
The terms, rules and formulas this domain turns into questions most often.
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Multistage DDM
Values changing growth in stages.
- Remember
- High-growth then terminal.
- Tested as
- DDM questions.
- Trap
- Using a single stage.
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H-model
Approximates declining growth.
- Remember
- Linear growth decline.
- Tested as
- DDM questions.
- Trap
- Misapplying it.
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Terminal value
Value of the stable-growth period.
- Remember
- Often the bulk of value.
- Tested as
- Valuation questions.
- Trap
- Miscomputing it.
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FCFF
Cash to all capital providers.
- Remember
- Discount at WACC.
- Tested as
- FCF questions.
- Trap
- Confusing with FCFE.
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FCFE
Cash to equity holders.
- Remember
- Discount at cost of equity; add net borrowing.
- Tested as
- FCF questions.
- Trap
- Confusing with FCFF.
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Discount rate matching
FCFF at WACC, FCFE at cost of equity.
- Remember
- Match the cash flow to the rate.
- Tested as
- FCF questions.
- Trap
- Mismatching them.
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Price multiples
P/E, P/B, P/S.
- Remember
- Relative valuation.
- Tested as
- Multiple questions.
- Trap
- Misusing the measure.
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Enterprise multiples
EV/EBITDA.
- Remember
- Capital-structure neutral.
- Tested as
- Multiple questions.
- Trap
- Confusing with price multiples.
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Residual income
Book value plus economic profit.
- Remember
- Value above the cost of equity.
- Tested as
- Residual income questions.
- Trap
- Misapplying the structure.
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Private company approaches
Income, market, asset-based.
- Remember
- For non-traded firms.
- Tested as
- Private valuation questions.
- Trap
- Confusing the approaches.
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Valuation discounts
Lack of control and marketability.
- Remember
- Reduce private-company value.
- Tested as
- Private valuation questions.
- Trap
- Omitting them.
Side by side
Concepts candidates mix up, compared on the point that decides the answer.
FCFF vs. FCFE
| Concept | Meaning | Key difference | Common trap |
|---|---|---|---|
| FCFF | Cash to all capital providers | Discount at WACC for firm value | Confusing with FCFE |
| FCFE | Cash to equity holders | Discount at cost of equity; add net borrowing | Confusing with FCFF |
Price vs. enterprise multiples
| Concept | Meaning | Key difference | Common trap |
|---|---|---|---|
| Price multiples | P/E, P/B, P/S | Based on equity value | Confusing with enterprise |
| Enterprise multiples | EV/EBITDA | Capital-structure neutral | Confusing with price |
Private-company discounts
| Concept | Meaning | Key difference | Common trap |
|---|---|---|---|
| Lack of marketability | Shares not readily sold | Reduces value | Omitting it |
| Lack of control | Minority stake | Reduces value | Omitting it |
Exam traps
Each trap is an answer that looks right. Learn the clue that should change your mind.
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FCFF at the cost of equity
- What candidates pick
- Discount free cash flow to the firm at the cost of equity.
- Why it looks right
- Both are cash flows.
- Why it's wrong
- FCFF is cash to all capital providers and is discounted at the WACC to value the firm; FCFE is discounted at the cost of equity.
Clue to watch for The cash flow is FCFF, to be used for firm value.
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FCFE ignores net borrowing
- What candidates pick
- Compute FCFE without adding net borrowing.
- Why it looks right
- Borrowing seems unrelated.
- Why it's wrong
- FCFE adds net borrowing (and reflects debt flows) because it is the cash available to equity after debt, unlike FCFF.
Clue to watch for The company issues or repays debt.
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Single-stage for changing growth
- What candidates pick
- Use the Gordon growth model for a company with a high-growth phase then stable growth.
- Why it looks right
- It is simpler.
- Why it's wrong
- A company with changing growth needs a multistage model that values each growth phase separately.
Clue to watch for Growth is high initially then stabilizes.
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No marketability discount
- What candidates pick
- Value a private company's shares the same as a public company's with no discount.
- Why it looks right
- The method is the same.
- Why it's wrong
- Private-company shares warrant a discount for lack of marketability, and a minority stake a discount for lack of control.
Clue to watch for The company is private or the stake is a minority interest.
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EV/EBITDA uses equity value
- What candidates pick
- Treat EV/EBITDA as a price (equity) multiple.
- Why it looks right
- Both are multiples.
- Why it's wrong
- EV/EBITDA is an enterprise multiple based on enterprise value (capital-structure neutral), not equity value like P/E.
Clue to watch for The multiple uses enterprise value, not price.
Answer framework
For any Equity Investments item set, use these steps to find the answer the exam expects.
- Select the valuation model that fits the company: a multistage dividend discount model for changing growth, free cash flow for cash-flow-based value, multiples for relative value, or residual income when cash flows are hard to forecast.
- For free cash flow, compute FCFF or FCFE correctly (FCFE adds net borrowing) and discount at the matching rate (FCFF at WACC, FCFE at the cost of equity).
- Apply multiples using the correct measure (price versus enterprise), and the residual income model as book value plus the present value of economic profit.
- For private companies, choose the income, market or asset-based approach and apply discounts for lack of control and marketability.
- Pull the right figures from the vignette and compute the value with the specified model. Where two models seem to fit, apply the one the question specifies or that best suits the company's cash-flow and growth profile.
Practice question
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Study strategy
Give this heavy, valuation-intensive topic top priority, since it is the core of the exam and the analyst's craft. Start with the discounted-cash-flow models: the multistage dividend discount models (and the H-model) for changing growth, then free cash flow, mastering the computation of FCFF and FCFE and, crucially, matching each to its discount rate (FCFF at WACC, FCFE at the cost of equity) and remembering FCFE includes net borrowing.
Then learn relative valuation with price and enterprise multiples (keeping P/E and EV/EBITDA distinct), the residual income model (book value plus economic profit), and private-company valuation with its approaches and discounts for lack of control and marketability.
Because this topic is calculation-heavy and vignette-based, drill valuation item sets that give company data and require computing a value, practicing input selection from exhibits. Because Level 2 is tested through vignettes, practice full item sets under timed conditions (about 12 minutes per set), pulling the right figure from the right exhibit, and review misses by checking both input selection and calculation. Afterwards, move to Fixed Income.
FAQ
How much of CFA Level 2 is Equity Investments?
Equity Investments is 10-15% of the exam, one of the heaviest topics, and it is the most valuation-intensive, covering the discounted-cash-flow, multiple-based and residual-income models in depth.
What is the difference between FCFF and FCFE?
Free cash flow to the firm (FCFF) is the cash available to all capital providers (debt and equity) before debt payments, discounted at the WACC to value the firm. Free cash flow to equity (FCFE) is the cash available to equity holders after debt, which includes net borrowing, discounted at the cost of equity to value equity.
When do I use a multistage dividend discount model?
When a company's dividend growth is not constant, for example a period of high growth followed by stable growth. Multistage models (two-stage, three-stage, H-model) value each growth phase separately and discount them, rather than assuming a single constant growth rate.
What is the residual income model?
A model that values equity as the current book value plus the present value of future residual income, the economic profit a company earns above its cost of equity. It is useful when dividends or free cash flows are difficult to forecast, and it draws directly on accounting book values.
What is the difference between price and enterprise multiples?
Price multiples (such as P/E, P/B, P/S) are based on the equity value or share price. Enterprise multiples (such as EV/EBITDA) are based on enterprise value, which includes debt, making them capital-structure neutral and useful for comparing firms with different leverage.
Why apply discounts in private-company valuation?
Private companies lack a public market, so a discount for lack of marketability reflects that the shares cannot be readily sold, and a discount for lack of control reflects that a minority stake cannot direct the company. These discounts reduce the valuation relative to a comparable public or controlling stake.
How does Equity Investments connect to the rest of the Level 2 exam?
It uses the adjusted financials from financial statement analysis, the cost of capital and payout decisions from corporate issuers, and feeds the portfolio construction in portfolio management, making it the central application of several topics.
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