Identify the claim being valued
Dividends and free cash flow to equity belong to equity holders and are discounted at a cost of equity. Free cash flow to the firm is available to capital providers before debt financing cash flows and is discounted using a compatible weighted average cost of capital. Moving from operating enterprise value to equity requires a bridge that considers debt, non-operating assets, and other relevant claims. Do not subtract debt again from an equity value.
An operating business is valued at 500, has 80 of debt and 20 of excess cash, with no other claims. Calculate equity value of 440 and identify the role of each adjustment.
Work a constant-growth dividend example
For a stable perpetual dividend stream with required return r greater than growth g, value is next dividend divided by (r minus g). If the dividend just paid is 2.00, growth is 4%, and required return is 9%, next dividend is 2.08 and value is 41.60. This is an illustrative model result, not a forecast guarantee. Stable growth, payout behavior, and risk must be economically plausible.
Keep the next dividend at 2.08 and increase required return to 10%, keeping growth at 4%. The value becomes about 34.67. Explain the direction before calculating.
Respect the terminal-value date
In a multistage model, explicit forecast cash flows are valued separately from the continuing value at the end of the forecast period. If terminal value is measured at time five, use a time-six cash flow in its constant-growth formula and discount that terminal value back five periods. Adding an undiscounted terminal value to present-valued early cash flows mixes dates.
A terminal value of 100 occurs at the end of year five. At a 10% discount rate, calculate its present value as 100 divided by 1.10 to the fifth power, about 62.09.
Challenge the assumptions
Small changes in the spread between required return and perpetual growth can dominate value. Report a sensitivity range and ask whether long-run growth, reinvestment, margins, and financing assumptions agree. A mathematically large answer when growth approaches required return is a warning to inspect the model rather than evidence of a bargain.
Compare values using the same next dividend of 2.08 and required return of 9%, with growth of 3%, 4%, and 5%. Explain why the changes are nonlinear.
Which pairing is internally consistent?
Keep exploring
Continue with the CFA Institute Level II outline and official candidate resources. Check the assumptions in each worked example and practise with your registered curriculum.