Understanding the Three Core Valuation Approaches
CFA Level 2 candidates must master three fundamental approaches: the income approach, market approach, and asset-based approach. Each applies best to different company types and situations.
Income Approach: Valuing Future Cash Flows
The income approach values companies based on present value of future cash flows or earnings. It includes three key models:
- Dividend Discount Models (DDM): Best for mature, stable companies with predictable dividend policies like utilities and REITs. The two-stage DDM assumes different growth rates for an explicit forecast period and terminal period.
- Free Cash Flow Models: Apply more broadly and work well for companies without dividends or irregular dividend policies. Use this for growth companies reinvesting earnings.
- Residual Income Models: Focus on economic profit and suit companies with accounting-based metrics. Highlight the relationship between competitive advantages and premium valuations.
Market Approach: Comparing Similar Companies
The market approach (comparable company analysis) values firms by comparing multiples like price-to-earnings, EV/EBITDA, and price-to-book ratios to peer companies. This method requires careful selection of true comparables and adjustment for differences in growth rates, risk, and capital structure.
EV/EBITDA multiples prove more robust than equity multiples because they eliminate capital structure effects. However, comparable analysis reflects current market prices, which can perpetuate systematic mispricing.
Asset-Based Approach: Net Asset Valuation
The asset-based approach uses net asset value and applies primarily to holding companies, financial institutions, or liquidation scenarios. This method rarely drives CFA Level 2 analysis but appears in specific contexts.
Applying the Right Model
Understanding when to apply each approach and recognizing their limitations constitutes essential Level 2 knowledge. DDM sensitivity to terminal growth rates and comparable analysis vulnerability to market mispricing require careful judgment. Candidates must practice calculating these models repeatedly while building intuition about which approach fits different industries and company characteristics.
Mastering Free Cash Flow Models and Projection Frameworks
Free cash flow analysis forms the backbone of equity valuation for most non-financial companies. You need to master both FCFE and FCFF methodologies to succeed at Level 2.
Understanding FCFF vs. FCFE
FCFF (free cash flow to firm) represents cash available to all investors before debt payments. Calculate it as:
EBIT (1 - Tax Rate) + Depreciation and Amortization - Capital Expenditures - Change in Net Working Capital
FCFE adjusts for net borrowing to show cash remaining for equity holders only. The critical distinction: FCFF uses weighted average cost of capital (WACC) as the discount rate. FCFE uses the cost of equity.
Mastering this distinction determines how you handle discount rates and terminal value calculations correctly.
Building Two-Stage Growth Models
The two-stage growth model is standard for Level 2 analysis. You explicitly forecast financial statements through a detailed period (typically 5-10 years), then estimate terminal growth.
Terminal value calculations present a major source of exam complications. Use the perpetual growth model assuming stable growth at 2-3 percent, reflecting long-term GDP growth expectations. Errors in terminal assumptions lead to dramatically misstated valuations.
Building Complete Projection Models
Complete three-statement forecasting requires understanding:
- Operating margins and their sustainability
- Tax rate expectations and changes
- Capital intensity requirements
- Working capital needs
Building from revenue projections through free cash flow requires mechanical fluency and practical judgment.
Sensitivity Analysis and Stress Testing
Sensitivity analysis becomes increasingly important at Level 2. Demonstrate how valuation changes with different assumptions about growth rates, discount rates, or operating margins. Practicing these projections with real company data builds exam-ready skills while developing professional capabilities.
Residual Income Models and Embedded Growth Opportunities
The residual income model (RIM), also called the Edwards-Bell-Ohlson model, offers an alternative valuation framework bridging accounting-based analysis and discounted cash flow approaches.
How RIM Works
RIM values a company as current book value plus the present value of expected residual incomes. Residual income equals:
Net Income - (Cost of Equity x Beginning Book Value)
This approach appeals because it directly incorporates accounting information and provides intuitive results. A company trading below book value has negative expected residual incomes. Premium valuations reflect expectations for above-average returns on equity.
Understanding Return on Equity Relationships
RIM highlights the critical relationship between growth, return on equity, and valuation. A company earning exactly its cost of equity generates no residual income and trades at book value. Companies exceeding cost of equity trade at premiums reflecting durable competitive advantages.
Level 2 candidates must forecast residual incomes through an explicit period and estimate terminal residual income, typically assuming reversion toward cost of equity over time.
Strengths and Weaknesses
The model's elegance lies in forcing analysts to justify premium valuations with explicit assumptions about above-normal returns. However, RIM exhibits sensitivity to book value quality. Aggressive accounting, off-balance-sheet items, or unusual depreciation policies distort analysis.
Practice comparing RIM results with DCF methods to understand why differences emerge and which model best suits particular contexts. This comparison demonstrates essential Level 2 analytical sophistication.
Comparable Company Analysis and Multiple-Based Valuation
Comparable company analysis remains ubiquitous in professional practice and comprises significant Level 2 curriculum. This approach applies valuation multiples from similar companies to estimate target company value.
Selecting Comparable Companies
Identifying truly comparable companies challenges candidates. Pure industry classification proves insufficient. Evaluate comparability across:
- Geographic market and business segments
- Business model similarities
- Financial performance metrics
- Growth rates and profitability
- Risk profiles and capital structures
A pharmaceutical company's EV/EBITDA differs significantly from biotech startups, requiring systematic comparability frameworks. Effective candidates develop rigorous assessment processes rather than relying on surface-level classifications.
Using Enterprise Value Multiples
Enterprise value multiples like EV/EBITDA and EV/Sales prove more robust than equity multiples because they eliminate effects of different capital structures and accounting policies. EV/EBITDA dominates due to EBITDA's consistency across companies.
Adjusting Multiples and Building Valuation
Adjusting multiples for differences in fundamentals demonstrates analytical judgment. Add valuation to a lower-multiple company if it maintains higher growth expectations. The implied multiples approach works backward from target valuations to evaluate reasonableness against historical norms and peer groups.
Strengths and Limitations
Comparable analysis reflects market reality and incorporates peer consensus, but can perpetuate systematic mispricing or ignore idiosyncratic value drivers. Level 2 candidates must appreciate both strengths and limitations. Combining multiple valuation approaches proves most powerful: perhaps using trading comps to validate DCF conclusions or identifying which companies trade at unjustified discounts.
Building Integrated Valuation Frameworks and Exam Success Strategies
Successful Level 2 candidates develop integrated frameworks synthesizing multiple valuation models into comprehensive analyses applicable to exam case studies. The curriculum emphasizes that valuation combines science and art.
Understanding Model Selection and Judgment
Formulas and calculations provide precision, but model selection, assumption judgment, and sensitivity analysis require critical thinking. Vignette-style questions present real-world scenarios demanding you choose appropriate models, defend assumptions, and interpret results considering company context.
Building competency requires practicing full valuation analyses from financial statement interpretation through conclusion writing. Many Level 2 questions assess whether you understand model mechanics deeply enough to explain estimation choices and justify terminal assumptions.
Exam Strategy and Time Management
Time management becomes crucial since exam vignettes contain six questions per case, requiring efficient work without sacrificing rigor. Develop personal checklists for each model type:
- DDM: All components and growth rate justifications
- FCFE: Projection steps and terminal assumptions
- RIM: Sensitivity factors and book value quality considerations
Analyzing practice cases from CFA Institute sample exams and other materials provides exposure to realistic complexity and question formats.
Avoiding Common Pitfalls
Understanding common valuation pitfalls proves equally important:
- Terminal growth rates exceeding long-term GDP growth
- Insufficient comparability adjustments
- Discount rates reflecting idiosyncratic rather than systematic risk
- Incomplete working capital assessments
Studying actual analyst reports and company valuations reveals how professionals handle real-world complications like non-recurring items, business segment heterogeneity, or changing capital structures. Flashcards become particularly valuable for internalizing decision trees under high-pressure exam conditions.