FOUNDATION 08 / Markets & risk
Equity & valuation fundamentals
Distinguish price from value, enterprise claims from equity claims, and models from facts.
By the end of this lesson
- Explain an equity holder’s residual claim.
- Use a simple dividend model and valuation multiple.
- Identify growth and discount-rate sensitivity.
IBBC Capital Finance Foundations · Original content drafted with AI assistance. IBBC Capital is responsible for editorial review and content. General education, not an official CFA Institute curriculum or credential.
A residual claim, not a fixed payment
Common equity represents a residual claim after more senior obligations. Dividends are generally not the same kind of contractual promise as a plain bond coupon. Business outcomes and financing choices both affect the amount available to shareholders.
Price is the amount quoted or exchanged; value is an estimate under a model. A difference between your value estimate and a market price may reflect an opportunity, a modeling error or missing information. It does not prove mispricing.
Discount dividends consistently
For constant dividend growth, P₀ = D₁/(r−g), where D₁ is next-period dividend, r the required equity return and g perpetual growth. The model requires r>g and a sustainable stable-growth assumption.
If given the dividend just paid D₀, first calculate D₁ = D₀(1+g). A small gap between r and g makes the estimate highly sensitive. A mathematical result is not evidence that perpetual growth is plausible.
Multiples need comparable denominators
P/E = price per share/earnings per share. At price 30 and EPS 2, P/E is 15×. Low P/E might reflect low growth, high risk or temporarily inflated earnings; it is not automatically cheap. Negative earnings make ordinary P/E interpretation difficult.
Align trailing versus forecast earnings, accounting choices and capital structure. Use enterprise multiples with enterprise cash-flow measures and equity multiples with equity measures; do not mix claims without reconciling them.
From enterprise to equity, with caveats
In a simplified exercise, equity value ≈ enterprise value − debt + excess cash. Other claims and nonoperating items can require adjustments. Divide by a consistent diluted share count to estimate a per-share value.
Document the date, sources, assumptions and downside scenarios. A valuation range with explained sensitivities is often more informative than a single point presented with false precision.
A stable-dividend teaching example
- Next-year dividend D₁ = 3; required return r = 10%; perpetual growth g = 4%.
- P₀ = 3/(0.10−0.04) = 50.
- If r rises to 11% with other assumptions unchanged, value = 3/0.07 = 42.86.
- The example illustrates sensitivity, not a recommendation or a verified company forecast.
Try before looking at the explanation
Change one input in the practice tool below. Predict the direction first, calculate second, then explain why it changed.
Work the numbers
Common mistakes to catch
- Using D₀ in a formula requiring D₁.
- Applying constant growth when r≤g.
- Calling a low multiple proof of undervaluation.
Knowledge check · 6 original questions
Answer all six. At least five correct marks the lesson complete for self-study. You can retry; this is not a credential.
Keep these ideas
- Match cash flows to the correct claim and discount rate.
- Show sensitivity and the evidence behind assumptions.