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Reading 1CFA L2 EquityFull chapter

DDM and FCFE/FCFF — discounted cash flow valuation

In this chapter: Gordon growth model · Two-stage and three-stage DDM · FCFE definition and projection · FCFF and unlevered DCF · Discount-rate selection (CAPM, build-up)

~4 min readLayer 4 · Professional CertificationsFree

DCF is the gold-standard valuation. CFA L2 tests both formula application and judgement (which model? which discount rate? which growth rate?).

Foundation

**Gordon (constant growth) DDM**: V0 = D1 / (r – g), where D1 = next dividend, r = required return, g = perpetual growth. Useful for stable, mature companies (utilities, consumer staples). Sensitive to g; small changes in (r-g) swing value massively. **Two-stage DDM**: high growth for n years, then perpetual stable growth. Use for growth firms transitioning to maturity. **FCFE** = NI + D&A − CapEx − ΔWC − Net debt repayment + Net debt issued. (= cash available to equity holders.) Discount at cost of equity (re). **FCFF** = EBIT(1-t) + D&A − CapEx − ΔWC. (= cash available to all capital providers.) Discount at WACC. Subtract debt market value to get equity. When to use which: - DDM: regular dividend payers in stable industries. - FCFE: firms with irregular dividends, leverage stable. - FCFF: firms with changing capital structure, high leverage, negative FCFE.

Deep Dive

Discount rate for equity (re): - **CAPM**: re = rf + β(MRP). Use for liquid public-market stocks with reliable beta. - **Build-up**: re = rf + ERP + size + specific risk premiums. For private/illiquid. - **Bond yield + risk premium**: re = company's bond yield + 3-5%. Quick check. WACC = w_d × r_d × (1-t) + w_e × r_e. Use **target** weights (market value), not book. Indian context: equity risk premium debate. Damodaran estimates ~6-8% for India (vs ~5-6% US) due to country risk. Beta typically 0.7-1.3 for established large-caps. Growth rate: - Sustainable growth = ROE × retention ratio. Use for steady-state. - Don't exceed long-run economy growth (~6-8% nominal for India long-term) for terminal stage.

Advanced

L2 vignette pattern: given assumptions, compute equity value. Then ask sensitivity (e.g., what if g = 5% instead of 4%?). Traps: - Mismatch between cash flow and discount rate (FCFE → re, FCFF → WACC). Easy mistake under exam pressure. - Using book values for WACC weights instead of market. - Terminal-stage growth too high (must be < long-run economy nominal growth). - Not subtracting debt for FCFF→equity conversion. Residual income: V0 = B0 + Σ RI / (1+r)^t, where RI = NI – r×B(t-1). Useful when cash flows volatile but ROE/book stable.

Regulatory references
  • CFA Institute Equity curriculum
Common mistakes & pitfalls
  • Mismatching cash flow with discount rate (FCFE↔re; FCFF↔WACC).
  • Using book weights in WACC instead of market.
  • Setting terminal growth above long-run economy growth.
  • Forgetting to subtract debt when converting EV to equity.

Frequently asked

Which model is best?
Depends. Stable dividend payers: DDM. Strong cash flow but irregular dividends: FCFE. Volatile cap structure: FCFF. Volatile cash flows but stable ROE: Residual income.
Why is terminal value usually >50% of total DCF value?
Most cash flows are far in future. Even with discounting, terminal contributes huge share. That's why g and r assumptions matter so much.

Practice questions

Click each question to reveal the answer and explanation.

Q 1
Gordon model V = D1/(r-g) is best for:
  1. (a)High-growth tech
  2. (b)Mature stable dividend payer
  3. (c)Cyclical commodity
  4. (d)IPO firm
Correct: (b) Mature stable dividend payer
Constant growth assumption fits mature stable firms; high-growth needs multi-stage.
Q 2
FCFE is discounted at:
  1. (a)WACC
  2. (b)Cost of equity (re)
  3. (c)Cost of debt
  4. (d)Risk-free rate
Correct: (b) Cost of equity (re)
FCFE = cash to equity → discount at cost of equity.
Q 3
WACC weights should use:
  1. (a)Book values
  2. (b)Target market values
  3. (c)Random
  4. (d)Beta-weighted
Correct: (b) Target market values
Market values reflect current capital structure decision.
Q 4
Sustainable growth =
  1. (a)ROA × retention
  2. (b)ROE × retention
  3. (c)Dividend yield
  4. (d)Beta
Correct: (b) ROE × retention
g = ROE × b (retention ratio). Theoretical max from internally generated funds.
Q 5
In terminal stage, growth should not exceed:
  1. (a)10%
  2. (b)Long-run nominal economy growth
  3. (c)Inflation
  4. (d)Last 5-year average
Correct: (b) Long-run nominal economy growth
Mathematically can't grow forever faster than economy. Cap at long-run nominal GDP growth.
Educational purposes only. The numbers, returns, and examples used in this lesson are illustrative. Past performance does not guarantee future results. Mutual fund and securities investments are subject to market risks. This lesson is not investment advice; for advice tailored to your circumstances, consult a SEBI-registered Investment Adviser. Read our full disclaimer.