Equity Valuation Methods | Series 65 Study Guide

Quick Answer

Two schools value stocks: fundamental analysis (financials, earnings, intrinsic value, long-term) and technical analysis (price and volume, short-term). Within fundamental analysis, ratios like price-to-earnings and price-to-book measure value, while the dividend discount model and discounted cash flow translate future cash flows into a present-value estimate of what a share is worth.

The whole unit on one sheet: the two analysis schools, the valuation ratios, the dividend discount model, and discounted cash flow.

Which One-Liners Win Points?

Fundamental analysis examines the company (financials, earnings, assets) to find intrinsic value; it is long-term. It can work top-down (economy to sector to company) or bottom-up (company first, sector considered later).
Technical analysis examines only price and volume; it is short-term and assumes price already reflects all known information.
Price-to-earnings (P/E) and price-to-book (P/B) are fundamental tools, never technical.
Dividend yield (annual dividend / market price) is not the same as the dividend payout ratio (dividends / EPS). An unusually high yield can be a yield trap signaling dividend-cut risk, not a bargain.
A high P/E signals expected growth (growth stock) or overvaluation; a low P/E signals a value stock or undervaluation. P/E is relative: compare within the same industry.
P/B below 1 means the stock trades below its net asset value (potentially undervalued); most useful for asset-heavy industries like banking and real estate.
Head and shoulders is a REVERSAL pattern (bullish to bearish); cup and handle is a BULLISH CONTINUATION pattern (the uptrend persists rather than reversing).
Golden cross (short-term average crosses above long-term) is bullish; death cross (crosses below) is bearish.
The dividend discount model (DDM) values a stock as the present value of all expected future dividends; best for stable dividend payers like utilities.
Discounted cash flow (DCF) is the broader model: it uses free cash flow, so it works for any company, including non-dividend payers. DDM is a special case of DCF.

Which Numbers Matter Most?

Earnings per share (EPS):

\text{EPS} = \frac{\text{Net Income} - \text{Preferred Dividends}}{\text{Common Shares Outstanding}}

Price-to-earnings (P/E) ratio:

\text{P/E Ratio} = \frac{\text{Market Price per Share}}{\text{EPS}}

Book value per common share:

\text{Book Value per Common Share} = \frac{\text{Total Assets} - \text{Total Liabilities} - \text{Preferred Stock}}{\text{Common Shares Outstanding}}

Price-to-book (P/B) ratio:

\text{P/B Ratio} = \frac{\text{Market Price per Share}}{\text{Book Value per Share}}

Dividend payout ratio:

\text{Dividend Payout Ratio} = \frac{\text{Dividends per Share}}{\text{EPS}}

Dividend yield:

\text{Dividend Yield} = \frac{\text{Annual Dividend per Share}}{\text{Market Price per Share}}

Basic dividend discount model (no growth):

\text{Stock Value} = \frac{D}{r}

Gordon Growth Model (constant-growth DDM), where D1 is next year's expected dividend, r is the required return, and g is the growth rate:

\text{Stock Value} = \frac{D_1}{r - g}

Discounted cash flow (DCF) intrinsic value:

\text{Intrinsic Value} = \sum_{t=1}^{n} \frac{\text{Cash Flow}_t}{(1 + r)^t}

Terminal value (post-forecast cash flows as a growing perpetuity):

\text{Terminal Value} = \frac{\text{FCF}_{\text{final}} \times (1 + g)}{r - g}

Which Gotchas Trip Students Up?

Sort the tools by school. If a question mentions charts, volume, support/resistance, or moving averages, the answer is technical. If it mentions financial statements, earnings, book value, or intrinsic value, the answer is fundamental.
The Gordon model breaks when g is greater than or equal to r. It produces a negative or undefined value; the model is inappropriate, not "infinitely valuable."
Watch D0 versus D1. D0 is the dividend just paid; D1 is next year's expected dividend. If given D0, compute D1 = D0 x (1 + g) before applying the Gordon formula.
Book value subtracts preferred stock first (preferred holders have a priority claim); if there is no preferred stock, that term is zero.
A higher discount rate lowers intrinsic value. Raise the required return without changing cash flows and the DCF valuation must fall; this is the most commonly tested DCF sensitivity.
Terminal value is usually the largest DCF component. Both g and r sit in the denominator, so small changes move it a lot. It's a value as of the END of the forecast period, so it still has to be discounted back to today before adding it to the explicit-period cash flows.
If a company pays no dividends, use DCF, not DDM. DDM needs a dividend stream; DCF uses free cash flow.
A high dividend yield is not automatically a bargain. It can be a yield trap: the market has priced in risk to the dividend's sustainability, not proof the stock is cheap.
Match the sequence to top-down or bottom-up. "Economy, then sector, then company" is top-down; "company first" is bottom-up.

One-Breath Recap

Two schools value stocks: fundamental analysis studies the company's financials (top-down or bottom-up) to find intrinsic value long-term, while technical analysis studies only price and volume for short-term direction, so sort each tool to its school. Fundamental ratios include price-to-earnings and price-to-book, plus book value per share (subtract preferred stock first), the dividend payout ratio, and dividend yield (watch for yield traps). The dividend discount model values a stock as the present value of future dividends, with the Gordon Growth Model dividing next year's dividend by required return minus growth (and breaking when growth meets or exceeds return). Discounted cash flow is the broader model, where a higher discount rate lowers value and terminal value dominates the total.

Need more than the recap? Read the full Equity Valuation Methods unit.