CFA Level 2 equity valuation model selection
Choose an equity valuation model from the cash flow or economic claim being valued. Dividends support DDM when payouts reflect distributable earnings; FCFE values equity directly, FCFF values the firm, and residual income links book equity to returns above its required return.
The key ideas, at a glance
Dividend discount model
Read the visual, then follow the worked example below. Use the stated case assumptions.
Illustrative worked case
value per share
- 6%
- 333.33
- 7%
- 250
- 8%
- 200
- 9%
- 166.67
- 10%
- 142.86
- 12%
- 111.11
FCFE1 is 10 per share and perpetual growth is 3%. The case’s 8% required return gives 200 per share; other points vary only required return.
| Concept | Rule or decision | Common mistake |
|---|---|---|
| Dividend discount model | Use dividends and the cost of equity when payout behavior is informative. | A dividend forecast must be economically consistent with sustainable growth. |
| FCFE | Discount cash available to common equity holders at the cost of equity. | Do not discount equity cash flow at WACC. |
| FCFF | Discount firm cash flow at WACC, then bridge firm value to equity. | Do not forget debt and relevant nonoperating claims or assets in the bridge. |
| Residual income | Start with book equity and add the present value of residual income. | Accounting quality and clean-surplus adjustments affect the result. |
01Dividend discount model
Use dividends and the cost of equity when payout behavior is informative.
Watch for: A dividend forecast must be economically consistent with sustainable growth.
02FCFE
Discount cash available to common equity holders at the cost of equity.
Watch for: Do not discount equity cash flow at WACC.
03FCFF
Discount firm cash flow at WACC, then bridge firm value to equity.
Watch for: Do not forget debt and relevant nonoperating claims or assets in the bridge.
04Residual income
Start with book equity and add the present value of residual income.
Watch for: Accounting quality and clean-surplus adjustments affect the result.
Selected 2026 study concepts. Match your preparation to your registered exam-year curriculum. These notes are not complete curriculum coverage.
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Put the method to work
One worked example, from facts to answer
Given
Next year’s FCFE is 10 per share, perpetual growth is 3%, and required equity return is 8%. Assume constant growth and r > g.
Method
Equity value = FCFE1 / (r - g) = 10 / (0.08 - 0.03).
Answer and interpretation
Value is 200 per share under the assumptions. The model uses cost of equity because FCFE belongs to equity holders.
Original independent teaching example. Assumptions are stated above; this is not an official exam question or scoring key.
Apply the framework, step by step
Choose a model from the economic claim, available inputs and payout behavior, then reconcile its output to equity value. Read Equity Investments for the valuation overview and worked model calculations.
Before you start: Dividends, FCFE versus FCFF, cost of equity versus WACC, book equity and clean-surplus accounting.
METHOD 01
Dividend discount model
Use dividends and the cost of equity when payout behavior is informative.
A dividend model is useful when dividends reflect the cash that can sustainably be distributed to equity holders. The absence of a current dividend does not mean equity has no value; it may instead make a cash-flow or other model more informative. Select a growth structure that fits the expected transition in profitability and payout. For a constant-growth perpetuity, the required return must exceed the assumed perpetual growth rate.
Avoid this mistake: A dividend forecast must be economically consistent with sustainable growth.
METHOD 02
FCFE
Discount cash available to common equity holders at the cost of equity.
FCFE represents cash available to common equity holders after the relevant operating, investment and financing cash flows. Discount it at the cost of equity. Changes in borrowing can make the forecast sensitive to financing policy, so check whether the leverage assumptions are consistent over the forecast horizon. Use the first cash flow after a terminal valuation date in a perpetual-growth numerator, then discount that terminal value to today.
Avoid this mistake: Do not discount equity cash flow at WACC.
METHOD 03
FCFF
Discount firm cash flow at WACC, then bridge firm value to equity.
FCFF values operating cash flow available to the firm’s capital providers. Discount it at an appropriate WACC and then move from operating value to equity by accounting for debt, other non-equity claims and relevant nonoperating assets. The direction of each adjustment follows the claim being valued. Enterprise value divided by shares is not automatically an equity price; the financing bridge comes first.
Avoid this mistake: Do not forget debt and relevant nonoperating claims or assets in the bridge.
METHOD 04
Residual income
Start with book equity and add the present value of residual income.
Residual income starts with book equity and adds the present value of earnings above the required equity charge. Its usefulness depends on the quality and comparability of the accounting inputs and the adjustments needed for clean surplus. Relative valuation can provide another check when peers and metrics are comparable, but a convenient multiple does not repair a mismatch in growth, risk, accounting or ownership characteristics.
Avoid this mistake: Accounting quality and clean-surplus adjustments affect the result.
Apply it to a different case
- New facts
- Next-year FCFF is 30 million, WACC is 8%, perpetual growth is 2%, debt is 100 million and excess cash is 20 million. Assume no other claims.
- Working
- Operating value = 30 / (0.08 - 0.02) = 500 million. Equity value = 500 - 100 + 20.
- Conclusion
- Equity value is 420 million under these assumptions. This uses WACC because FCFF is a firm cash flow; the claim adjustments produce the equity value.
Original teaching case under the stated assumptions, rather than an official exam question.
Questions about this method
- Should FCFF be discounted at the cost of equity?
- No. FCFF is a firm cash flow and is discounted at an appropriate WACC under the model. FCFE and dividends belong to equity holders and use the cost of equity.
- Does a company without dividends have zero equity value?
- No. Value depends on future economic benefits to the equity holders. If current payouts do not represent distributable cash, an FCFE, FCFF, residual-income or other justified approach may be more informative.
- Why does model selection come before the calculation?
- The choice determines which cash flow or earnings measure to forecast, which discount rate to use and which claim the output values. A technically correct calculation with the wrong claim or discount rate answers a different question.
Sources and curriculum scope
Official outlines establish curriculum scope. The explanations and worked examples are independent teaching material; the sources do not verify or endorse them.
- 2026 CFA Level 2 curriculum outline
- Official Level 2 format and curriculum
- 2027 CFA Level 2 curriculum outline
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