Series 162 Cheat Sheet
Cheat sheet: valuation, ratio, fixed income, equity, and securities-analysis review for FINRA Series 162 candidates.
Use the tables for a quick pre-exam check. Expand a topic’s notes for explanations, examples, and additional distinctions.
Scope and study context
The exam is not just about memorizing formulas. Expect questions that test whether you can recognize a reasonable valuation method, identify inconsistent assumptions, spot calculation traps, and apply professional judgment when reviewing securities analysis.
Practical mindset: a supervisory analyst must ask, “Is the valuation method appropriate, are the inputs supportable, are the conclusions consistent with the evidence, and are the risks clear?”
For FINRA Series 162 review, do not wait until the end to practice. Use original practice questions in short topic blocks:
Start with valuation mechanics
- Enterprise value vs equity value
- DCF inputs
- Multiples
- Bond price/yield relationships
Move to mixed judgment questions
- Which method is best?
- Which assumption is least supportable?
- Which adjustment is required?
Add timed question bank sets
- Build speed on calculations.
- Practice eliminating plausible but mismatched answers.
Review detailed explanations
- Do not only mark right or wrong.
- Identify whether the miss was formula, concept, wording, or judgment.
Finish with mock exams
- Use full-length practice to test stamina and topic integration.
Exam Use and Scope
Use this Cheat Sheet as independent review support for the FINRA Series 162 — Supervisory Analyst Qualification Examination (Part II: Valuation of Securities). It focuses on fast recall of valuation tools, financial-statement relationships, security characteristics, and judgment points that a supervisory analyst candidate may need when reviewing securities analysis.
High-yield mindset:
- Identify what security is being valued: common stock, preferred stock, bond, convertible, option, warrant, fund, or asset-backed security.
- Match the valuation method to the cash-flow claim: equity cash flows, firm cash flows, contractual bond cash flows, option payoffs, or relative market pricing.
- Check whether the model uses consistent inputs: nominal vs. real, pre-tax vs. after-tax, levered vs. unlevered, equity value vs. enterprise value.
- Watch for research-report plausibility: assumptions, peer group selection, earnings quality, nonrecurring items, conflicts, and unsupported conclusions.
Core Valuation Decision Map
flowchart TD
A[Security or issuer to value] --> B{Contractual cash flows?}
B -->|Yes| C[Fixed income / preferred / structured security]
B -->|No| D{Operating company equity?}
C --> E[Discount coupons, principal, call/put/convertible features]
D -->|Yes| F{Stable dividends or cash flows?}
D -->|No| G[Option, warrant, fund, commodity-linked, or special situation]
F -->|Stable dividends| H[Dividend discount model]
F -->|FCF visibility| I[DCF: FCFF or FCFE]
F -->|Limited forecast detail| J[Relative valuation multiples]
G --> K[Payoff, NAV, replication, or scenario analysis]
Formula Sheet: Core Time Value and Return
Time Value Basics
\[ PV = \frac{FV}{(1+r)^n} \]\[ FV = PV(1+r)^n \]\[ NPV = \sum_{t=1}^{n}\frac{CF_t}{(1+r)^t} - Initial\ Investment \]| Concept | Formula / Rule | Exam trap |
|---|---|---|
| Present value | PV = future cash flow discounted at required return | Higher discount rate lowers PV |
| Future value | FV = present amount compounded forward | Compounding frequency matters if given |
| Net present value | Sum of discounted cash flows minus initial outlay | Positive NPV means value exceeds cost |
| Internal rate of return | Discount rate that makes NPV = 0 | Multiple sign changes can create multiple IRRs |
| Holding period return | income plus price change / beginning price | Include both cash income and capital gain/loss |
| Total return | income return plus capital return | Do not confuse with yield alone |
| Real return approximation | nominal return - inflation | Exact real return uses ratio, not subtraction |
| Risk premium | expected return - risk-free rate | Use comparable maturity risk-free rate when specified |
Notes and examples
Exact real return:
\[ Real\ Return = \frac{1 + Nominal\ Return}{1 + Inflation\ Rate} - 1 \]Required Return and Cost of Capital
CAPM, WACC, and Growth
\[ Required\ Return = R_f + \beta(R_m - R_f) \]\[ WACC = w_d r_d(1-T) + w_p r_p + w_e r_e \]\[ Sustainable\ Growth = ROE \times Retention\ Ratio \]| Input | Meaning | Use | Common error |
|---|---|---|---|
| Risk-free rate | Return on default-free benchmark | CAPM, discount rate anchor | Using short-term rate for long-duration equity cash flows without reason |
| Beta | Systematic risk relative to market | CAPM cost of equity | Treating beta as total risk |
| Market risk premium | Expected market return minus risk-free rate | CAPM | Using market return itself instead of premium |
| Cost of debt | Yield required by creditors | WACC debt component | Forgetting tax shield if using after-tax WACC |
| Cost of preferred | Preferred dividend / net price | WACC preferred component | Treating preferred dividends as tax-deductible |
| Capital weights | Debt, preferred, equity proportions | WACC | Prefer market-value weights when available |
| Retention ratio | 1 - payout ratio | Sustainable growth | Using dividend payout instead of retained earnings share |
| ROE | Net income / common equity | Growth and profitability | ROE can rise because leverage rises |
Valuation Method Selection Matrix
| Method | Best for | Key inputs | Strengths | Weaknesses / traps |
|---|---|---|---|---|
| Dividend discount model | Mature dividend-paying companies | Expected dividends, required return, growth | Direct equity cash-flow model | Poor fit for no-dividend or irregular-dividend firms |
| Free cash flow to equity | Equity value after debt claims | FCFE, cost of equity | Captures cash available to common equity | Sensitive to leverage and reinvestment assumptions |
| Free cash flow to firm | Enterprise value | FCFF, WACC, terminal value | Useful when leverage may change | Must subtract net debt to get equity value |
| Comparable company multiples | Firms with relevant peers | Peer multiples, normalized metrics | Market-based and quick | Peer selection and accounting differences drive results |
| Precedent transaction multiples | M&A or control valuation | Deal values, control premiums | Reflects transaction pricing | May include synergies and takeover premiums |
| Sum-of-the-parts | Diversified companies | Segment values, segment multiples | Useful for conglomerates | Segment data may be limited |
| Asset-based valuation | Asset-heavy, liquidation, holding companies | Fair value of assets and liabilities | Useful floor value | May understate going-concern value |
| Residual income | Firms with book value relevance | Book value, ROE, cost of equity | Works when dividends are not meaningful | Accounting quality matters |
| Option pricing / scenario analysis | Embedded optionality, warrants, convertibles | Volatility, time, rates, exercise terms | Captures asymmetric payoffs | Inputs can be subjective |
Equity Valuation
Dividend Discount Models
\[ P_0 = \frac{D_1}{r-g} \]Use the Gordon growth model only when dividends are expected to grow at a stable rate and \(r > g\).
| Model | Formula / logic | Best use | Trap |
|---|---|---|---|
| Zero-growth dividend model | Value = dividend / required return | Perpetual level dividend | Assumes no growth forever |
| Gordon growth | P0 = D1 / (r - g) | Stable-growth dividend payer | Using D0 instead of D1 |
| Multi-stage DDM | PV of forecast dividends plus terminal value | Changing growth phases | Terminal value often drives most of value |
| H-model | Gradual decline from high to stable growth | Transition growth assumptions | Easy to overstate value with aggressive early growth |
Notes and examples
High-yield DDM checks:
- If growth increases, value increases, all else equal.
- If required return increases, value decreases.
- If \(g\) approaches \(r\), model output becomes extremely sensitive.
- Dividend growth should not exceed economic growth indefinitely without a strong rationale.
Free Cash Flow Models
\[ Firm\ Value = \sum_{t=1}^{n}\frac{FCFF_t}{(1+WACC)^t} + \frac{Terminal\ Value_n}{(1+WACC)^n} \]\[ Equity\ Value = Firm\ Value - Net\ Debt - Preferred\ Stock - Minority\ Interest + Nonoperating\ Assets \]| Cash flow | Plain formula | Discount rate | Value produced |
|---|---|---|---|
| FCFF | EBIT(1 - tax rate) + depreciation and amortization - capex - change in working capital | WACC | Enterprise value |
| FCFE | Net income + depreciation and amortization - capex - change in working capital + net borrowing | Cost of equity | Equity value |
| EBITDA | Earnings before interest, taxes, depreciation, amortization | Not a cash-flow valuation by itself | Operating proxy |
| CFO | Cash flow from operations | Not a full free cash flow if capex omitted | Operating cash generation |
| FCF | Often CFO - capex | Depends on definition | Must verify definition used |
Common FCFF/FCFE traps:
- Do not discount FCFF at cost of equity; use WACC.
- Do not discount FCFE at WACC; use cost of equity.
- Do not subtract interest expense in FCFF if starting from EBIT and using WACC.
- Terminal value sensitivity is often the largest risk in a DCF.
- Use nominal cash flows with nominal discount rates and real cash flows with real discount rates.
Terminal Value
| Terminal approach | Plain formula / logic | Best for | Watch point |
|---|---|---|---|
| Perpetual growth | TV = next-period cash flow / (r - g) | Stable long-term company | Long-term g should be sustainable |
| Exit multiple | TV = terminal metric x terminal multiple | Market-comparable exit assumption | Multiple must match metric, such as EV/EBITDA |
| Liquidation value | Sale value of assets minus liabilities | Distress, runoff, asset-based cases | May ignore going-concern value |
Relative Equity Valuation Multiples
| Multiple | Formula | Best use | Interpretation / trap |
|---|---|---|---|
| P/E | price per share / EPS | Earnings-driven companies | A low P/E may reflect low growth or high risk, not undervaluation |
| Forward P/E | current price / expected EPS | Forecast-based comparison | Depends heavily on earnings estimates |
| PEG | P/E / earnings growth rate | Growth-normalized comparison | Growth rate convention must be consistent |
| P/B | price / book value per share | Banks, insurers, asset-heavy firms | Less useful when intangible assets dominate |
| P/S | price / sales per share | Low or negative earnings companies | Ignores margins and capital intensity |
| P/CF | price / cash flow per share | Cash-generative businesses | Cash flow definition must be checked |
| EV/EBITDA | enterprise value / EBITDA | Capital-structure-neutral comparison | Ignores capex, working capital, and taxes |
| EV/EBIT | enterprise value / operating income | More depreciation-aware than EBITDA | Accounting depreciation still matters |
| EV/Sales | enterprise value / sales | Early-stage or cyclical margin recovery | Very sensitive to future margin assumptions |
| Dividend yield | annual dividend / price | Income stocks | High yield may signal dividend risk |
Multiple matching rules:
| Numerator | Denominator should be | Example |
|---|---|---|
| Equity value or price | Equity metric after debt claims | P/E, P/B, P/CF |
| Enterprise value | Pre-interest operating metric | EV/EBITDA, EV/EBIT, EV/Sales |
| Market cap | Common equity value | Price multiples |
| Firm value | Operating asset cash flow | FCFF-based DCF |
Enterprise Value vs Equity Value
This is one of the most important exam distinctions.
| Concept | Includes | Used With |
|---|---|---|
| Enterprise value | Value of operating business to all capital providers | EBITDA, EBIT, revenue, FCFF |
| Equity value | Value attributable to common shareholders | Net income, EPS, book value, FCFE |
| Net debt | Debt minus cash, often adjusted for debt-like items | Bridge between enterprise value and equity value |
| Per-share equity value | Equity value divided by diluted shares | Target price calculations |
Basic bridge:
\[ \text{Equity Value} = \text{Enterprise Value} - \text{Debt} + \text{Cash} - \text{Preferred Stock} - \text{Minority Interest} + \text{Nonoperating Assets} \]Exam trap: If you apply an EV/EBITDA multiple, you get enterprise value, not equity value. You must then subtract debt-like claims and add excess cash before dividing by shares.
Discounted Cash Flow Review
DCF values a security by discounting expected future cash flows.
\[ \text{Enterprise Value} = \sum_{t=1}^{n} \frac{\text{FCFF}_t}{(1+\text{WACC})^t} + \frac{\text{Terminal Value}_n}{(1+\text{WACC})^n} \]For a Gordon growth terminal value:
\[ \text{Terminal Value}_n = \frac{\text{FCF}_{n+1}}{\text{Discount Rate} - g} \]Where \(g\) is the long-term growth rate.
FCFF vs FCFE
| Cash Flow | Belongs To | Discount Rate | Key Point |
|---|---|---|---|
| FCFF | All capital providers | WACC | Before interest payments |
| FCFE | Common equity holders | Cost of equity | After debt cash flows |
| Dividends | Common shareholders | Cost of equity | Actual cash distributions, not total equity capacity |
Plain-language formulas:
| Measure | Approximate Formula |
|---|---|
| FCFF | EBIT × (1 − tax rate) + D&A − capex − increase in net working capital |
| FCFE | Net income + D&A − capex − increase in net working capital + net borrowing |
| Equity value from FCFF | Enterprise value − net debt and other senior claims |
| Equity value from FCFE | Present value of FCFE directly |
Cost of Equity and WACC
CAPM is commonly tested conceptually.
\[ \text{Cost of Equity} = R_f + \beta(\text{Market Return} - R_f) \]WACC blends the after-tax cost of debt and cost of equity.
\[ \text{WACC} = \left(\frac{E}{D+E}\right)R_e + \left(\frac{D}{D+E}\right)R_d(1-T) \]High-yield points:
- Use market values, not book values, when weighting capital structure if available.
- Debt cost is tax-adjusted because interest is generally tax-deductible to the issuer.
- Equity cost is not tax-adjusted.
- A higher beta, higher leverage, higher credit risk, or higher risk-free rate generally increases the discount rate.
- Higher discount rates reduce present value.
Dividend Discount Models
Dividend models are most useful for companies with stable, predictable dividend policies.
For a constant-growth dividend model:
| Variable | Meaning |
|---|---|
| P0 | Current intrinsic value |
| D1 | Expected dividend next period |
| r | Required return on equity |
| g | Sustainable dividend growth rate |
Common traps:
- Use next period’s dividend, not the most recent dividend, in a constant-growth model.
- The model becomes unreliable if \(g\) is greater than or equal to \(r\).
- A non-dividend-paying growth company may still have equity value; dividend models may simply be inappropriate.
Relative Valuation Multiples
| Multiple | Numerator | Denominator | Best Used For | Trap |
|---|---|---|---|---|
| P/E | Equity value | Net income or EPS | Profitable companies with meaningful earnings | Distorted by leverage and nonrecurring items |
| Forward P/E | Current price | Expected EPS | Companies with changing earnings | Forecast risk |
| PEG | P/E | EPS growth rate | Growth comparison | Growth estimate may be unreliable |
| EV/EBITDA | Enterprise value | EBITDA | Operating comparisons across capital structures | Ignores capex needs |
| EV/EBIT | Enterprise value | EBIT | Asset-intensive firms where depreciation matters | Sensitive to accounting depreciation |
| EV/Sales | Enterprise value | Revenue | Early-stage or low-margin firms | Ignores profitability |
| P/B | Equity value | Book equity | Banks, insurers, asset-heavy firms | Book value may not reflect market value |
| Dividend yield | Dividend per share | Price per share | Income-oriented stocks | High yield may signal dividend risk |
Multiple Selection Rules
Use this quick logic:
- Positive, stable earnings: P/E can be meaningful.
- Different leverage levels: EV/EBITDA or EV/EBIT is often more comparable than P/E.
- Negative earnings but meaningful revenue: EV/Sales may be used, but profitability risk must be addressed.
- Banks and financial companies: P/B and ROE often matter more than EBITDA.
- Capital-intensive companies: EV/EBITDA can overstate value if maintenance capex is heavy.
- Cyclical companies: use normalized earnings across a cycle, not only peak or trough earnings.
Sum-of-the-Parts Valuation
Sum-of-the-parts analysis values each business segment separately and then combines them.
Typical use cases:
- Conglomerates
- Companies with unrelated segments
- Businesses with different growth, margin, or risk profiles
- Spin-off or breakup analysis
Exam traps:
- Applying one multiple to unlike segments.
- Forgetting corporate overhead.
- Ignoring intercompany eliminations.
- Double-counting cash or debt.
- Using peer multiples that do not match segment economics.
Earnings, Dilution, and Per-Share Analysis
| Concept | Formula / rule | High-yield point |
|---|---|---|
| Basic EPS | net income available to common / weighted average common shares | Uses actual common shares outstanding |
| Diluted EPS | net income adjusted for dilutive securities / diluted shares | Includes options, warrants, convertibles if dilutive |
| Net income available to common | net income - preferred dividends | Preferred dividends reduce common EPS |
| Stock split | Adjust historical shares and per-share data | Total firm value unchanged mechanically |
| Share repurchase | Fewer shares, often higher EPS | Value depends on price paid and funding |
| Convertible debt dilution | Add back after-tax interest; add conversion shares | Include only if dilutive |
| Convertible preferred dilution | Add back preferred dividends; add conversion shares | Include only if dilutive |
| Options/warrants dilution | Treasury stock method concept | In-the-money instruments can dilute |
Notes and examples
- EPS growth can come from buybacks, not operating growth.
- Dilution can reduce EPS even if net income is unchanged.
- Nonrecurring gains can inflate EPS and valuation multiples.
- Compare same EPS basis: trailing, forward, normalized, basic, or diluted.
Financial Statement Analysis
Income Statement Quality
| Item | Analyst question | Valuation effect |
|---|---|---|
| Revenue growth | Volume, price, mix, acquisitions, currency? | Organic growth is usually higher quality than acquisition-only growth |
| Gross margin | Cost pressure or pricing power? | Margin changes affect forecast earnings and terminal value |
| SG&A | Fixed-cost leverage or underinvestment? | Expense cuts may temporarily boost earnings |
| R&D | Expensed investment or discretionary cost? | Cutting R&D may hurt future growth |
| Depreciation | Economic wear or accounting estimate? | Affects EBIT, net income, and asset values |
| Interest expense | Financing risk? | Affects net income and coverage ratios |
| Tax rate | Sustainable or unusual? | Use normalized tax rate for forward valuation |
| Nonrecurring items | Truly nonrecurring? | Adjust normalized earnings and multiples |
Notes and examples
Balance Sheet and Cash Flow Statement
| Area | What to inspect | Common valuation issue |
|---|---|---|
| Cash and equivalents | Operating vs excess cash | Excess cash may be added separately to equity value |
| Receivables | Growth vs sales growth | Aggressive revenue recognition risk |
| Inventory | Turnover, obsolescence, method | Inventory buildup may signal demand weakness |
| PP&E | Age, maintenance capex needs | Underinvestment can overstate free cash flow |
| Goodwill/intangibles | Acquisition history, impairment risk | Book value may be less meaningful |
| Debt | Maturity, fixed/floating, covenants | Refinancing and rate risk affect value |
| Working capital | Changes in receivables, inventory, payables | Can consume cash even when earnings rise |
| Operating cash flow | Conversion of earnings to cash | Weak CFO relative to net income is a warning |
| Capital expenditures | Maintenance vs growth capex | FCF depends on sustainable capex assumption |
Core Ratios
| Category | Ratio | Formula | Interpretation |
|---|---|---|---|
| Liquidity | Current ratio | current assets / current liabilities | Short-term obligation coverage |
| Liquidity | Quick ratio | cash plus marketable securities plus receivables / current liabilities | Stricter liquidity test |
| Liquidity | Cash ratio | cash and equivalents / current liabilities | Most conservative liquidity measure |
| Leverage | Debt-to-equity | total debt / total equity | Financial leverage and equity risk |
| Leverage | Debt-to-capital | debt / debt plus equity | Capital structure measure |
| Leverage | Debt-to-EBITDA | debt / EBITDA | Debt burden relative to operating cash proxy |
| Coverage | Interest coverage | EBIT / interest expense | Ability to pay interest from operating income |
| Coverage | Fixed-charge coverage | earnings available for fixed charges / fixed charges | Broader than interest-only coverage |
| Profitability | Gross margin | gross profit / sales | Pricing power and production efficiency |
| Profitability | Operating margin | operating income / sales | Core operating profitability |
| Profitability | Net margin | net income / sales | Profit after all expenses |
| Profitability | ROA | net income / average assets | Asset profitability |
| Profitability | ROE | net income / average equity | Return to common equity holders |
| Efficiency | Asset turnover | sales / average assets | Revenue generated per asset dollar |
| Efficiency | Inventory turnover | cost of goods sold / average inventory | Inventory productivity |
| Efficiency | Receivables turnover | sales / average receivables | Collection efficiency |
| Efficiency | Days sales outstanding | 365 / receivables turnover | Collection period |
| Valuation | Earnings yield | EPS / price | Inverse of P/E |
| Valuation | Book value per share | common equity / common shares | Per-share accounting equity |
DuPont ROE
\[ ROE = Net\ Margin \times Asset\ Turnover \times Equity\ Multiplier \]| Driver | Improves ROE when | Risk if overused |
|---|---|---|
| Net margin | Company earns more per sales dollar | Margin may be cyclical or temporary |
| Asset turnover | Assets generate more sales | Asset base may be underinvested |
| Equity multiplier | More assets financed by liabilities | Higher leverage increases risk |
Income Statement Adjustments
| Item | Review Focus | Why It Matters |
|---|---|---|
| Revenue | Organic vs acquired growth, recurring vs one-time | Inflated revenue assumptions distort valuation |
| Gross margin | Pricing power, input cost pressure, product mix | Margin changes drive earnings and cash flow |
| SG&A | Fixed vs variable cost structure | Operating leverage affects sensitivity |
| R&D | Expense vs investment-like nature | Cutting R&D may boost short-term earnings but harm growth |
| Depreciation/amortization | Noncash charge, asset intensity | Affects EBIT, EBITDA, and free cash flow differently |
| Interest expense | Financing cost | Relevant to net income, not operating enterprise value |
| Taxes | Effective vs statutory rate, temporary differences | Overly low tax assumptions inflate value |
| Nonrecurring items | Restructuring, impairments, gains/losses | Normalize earnings before applying multiples |
Balance Sheet Review
| Item | Key Question | Valuation Relevance |
|---|---|---|
| Cash | Operating cash or excess cash? | Excess cash is usually added to equity value after enterprise value |
| Working capital | Is growth consuming cash? | Rising receivables or inventory may reduce free cash flow |
| Debt | Fixed/floating, maturity schedule, covenants | Affects credit risk and equity value |
| Leases | Operating commitments and financing-like obligations | Can affect leverage and comparability |
| Intangibles/goodwill | Acquired growth and impairment risk | Book value may be less meaningful |
| Minority interests | Who owns the cash flows? | Needed in enterprise-to-equity reconciliation |
| Pension obligations | Underfunded or overfunded? | Can act like debt-like obligation |
| Share count | Basic vs diluted | Critical for per-share valuation |
Cash Flow Statement Review
| Section | What to Watch |
|---|---|
| Operating cash flow | Quality of earnings, working capital changes, recurring cash generation |
| Investing cash flow | Maintenance vs growth capex, acquisitions, asset sales |
| Financing cash flow | Debt issuance/repayment, dividends, buybacks, equity issuance |
| Free cash flow | Cash available after reinvestment needs |
| Cash conversion | Whether accounting profits turn into cash |
Ratio Cheat Sheet
| Category | Ratio | Interpretation |
|---|---|---|
| Liquidity | Current ratio = current assets / current liabilities | Ability to meet short-term obligations |
| Liquidity | Quick ratio = liquid current assets / current liabilities | Stricter liquidity test excluding less-liquid inventory |
| Leverage | Debt / equity | Capital structure risk |
| Leverage | Debt / EBITDA | Debt burden relative to operating cash-generation proxy |
| Coverage | EBIT / interest expense | Ability to cover interest from operating profit |
| Coverage | EBITDA / interest expense | Cash-like coverage before depreciation and amortization |
| Profitability | Gross margin | Pricing power and production efficiency |
| Profitability | Operating margin | Core operating profitability |
| Profitability | Net margin | Profit after financing and taxes |
| Returns | ROE = net income / equity | Return to common shareholders |
| Returns | ROA = net income / assets | Asset productivity |
| Returns | ROIC | Return on operating invested capital |
| Efficiency | Asset turnover | Sales generated per unit of assets |
| Efficiency | Inventory turnover | Inventory management and demand quality |
| Valuation | P/E | Price paid per unit of earnings |
| Valuation | EV/EBITDA | Enterprise value relative to operating earnings proxy |
| Valuation | P/B | Price relative to book value |
| Valuation | Dividend yield | Annual dividend relative to stock price |
Accounting Adjustments and Comparability
| Issue | Effect on reported results | Analyst adjustment / exam point |
|---|---|---|
| LIFO vs FIFO | Inventory and COGS differ when prices change | In inflation, LIFO often gives higher COGS and lower income than FIFO |
| Capitalizing vs expensing | Capitalizing raises current income and assets | Aggressive capitalization can overstate profitability |
| Depreciation method | Accelerated depreciation lowers early income | Compare firms using different asset lives/methods carefully |
| Operating leases / lease obligations | Lease commitments may resemble debt | Include lease burden in leverage analysis when relevant |
| Deferred taxes | Timing differences between book and tax | Not all deferred tax balances reverse soon |
| Pension assumptions | Discount rate and return assumptions affect expense | Optimistic assumptions can inflate earnings |
| Goodwill impairment | Noncash charge after acquisition value decline | May signal overpayment or poor acquisition performance |
| Stock-based compensation | Noncash expense but dilutive | Ignoring it may overstate economic earnings |
| Restructuring charges | May be recurring in practice | Repeated “one-time” charges deserve skepticism |
| Acquisition accounting | Purchase price allocation affects depreciation/amortization | Compare organic vs acquired growth |
Fixed Income Valuation
Bond Price and Yield Relationships
\[ Bond\ Price = \sum_{t=1}^{n}\frac{Coupon_t}{(1+y)^t} + \frac{Principal}{(1+y)^n} \]| Relationship | Rule |
|---|---|
| Market yield rises | Existing bond price falls |
| Market yield falls | Existing bond price rises |
| Coupon rate equals yield | Bond trades near par |
| Coupon rate above yield | Bond trades at premium |
| Coupon rate below yield | Bond trades at discount |
| Longer maturity | More price sensitivity, all else equal |
| Lower coupon | More price sensitivity, all else equal |
| Higher credit risk | Higher required yield, lower price |
Notes and examples
Yield Measures
| Yield measure | Formula / logic | Best use | Trap |
|---|---|---|---|
| Nominal yield | coupon rate on par | Describes stated coupon | Not the investor’s market return unless bought at par |
| Current yield | annual coupon / market price | Current income approximation | Ignores maturity value and reinvestment |
| Yield to maturity | IRR if held to maturity and paid as promised | Standard bond return measure | Assumes reinvestment and no default |
| Yield to call | IRR if called on call date | Callable premium bonds | Often more relevant when call is likely |
| Yield to worst | Lowest yield among call/maturity scenarios | Conservative callable bond measure | Depends on embedded options |
| Tax-equivalent yield | tax-exempt yield / (1 - tax rate) | Compare taxable and tax-exempt yields | Use investor’s relevant tax rate if supplied |
| Real yield | nominal yield adjusted for inflation | Inflation-adjusted return | Use consistent inflation assumption |
Duration and Convexity
\[ Approximate\ Price\ Change\ \% \approx -Modified\ Duration \times Yield\ Change \]| Concept | Meaning | Exam point |
|---|---|---|
| Macaulay duration | Weighted average time to cash flows | Expressed in years |
| Modified duration | Price sensitivity to yield change | Higher duration means larger price move |
| Effective duration | Duration adjusted for embedded options | Useful for callable/putable bonds |
| Convexity | Curvature of price-yield relationship | Positive convexity helps when rates move significantly |
| Negative convexity | Price appreciation limited when rates fall | Common in callable and mortgage-backed securities |
Duration traps:
- Duration is not maturity, though related.
- A zero-coupon bond’s duration equals its maturity.
- Callable bonds may have shorter effective duration when rates fall.
- Price-yield relationship is inverse and nonlinear.
Credit and Structural Features
| Feature | Investor effect | Valuation impact |
|---|---|---|
| Senior secured debt | Priority claim on specific collateral | Lower required yield than subordinated debt, all else equal |
| Senior unsecured debt | Priority over subordinated but no specific collateral | Depends on issuer credit quality |
| Subordinated debt | Lower claim priority | Higher required yield |
| Callable bond | Issuer can redeem early | Investor faces reinvestment risk; price upside limited |
| Putable bond | Investor can sell back to issuer | Investor protection; lower yield than comparable nonputable |
| Sinking fund | Scheduled principal retirement | Can reduce credit risk but create reinvestment risk |
| Floating-rate note | Coupon resets with reference rate | Lower interest-rate duration than fixed-rate debt |
| Zero-coupon bond | No periodic coupon, issued at discount | High duration and reinvestment risk is absent before maturity |
| Inflation-linked bond | Principal/coupon tied to inflation measure | Protects purchasing power, but real-rate risk remains |
Bond Pricing Basics
A bond’s value is the present value of its coupon payments plus principal repayment.
\[ \text{Bond Price} = \sum_{t=1}^{n} \frac{C_t}{(1+y)^t} + \frac{\text{Par Value}}{(1+y)^n} \]Key relationships:
| If This Happens | Bond Price Effect |
|---|---|
| Market yields rise | Existing bond prices fall |
| Market yields fall | Existing bond prices rise |
| Coupon rate > market yield | Bond trades at premium |
| Coupon rate < market yield | Bond trades at discount |
| Bond approaches maturity | Price tends toward par, absent credit deterioration |
Yield Measures
| Yield Measure | Meaning | Watch For |
|---|---|---|
| Current yield | Annual coupon / market price | Ignores maturity and capital gain/loss |
| Yield to maturity | Return if held to maturity and paid as scheduled | Assumes reinvestment at YTM |
| Yield to call | Return if bond is called on call date | Important for premium callable bonds |
| Yield to worst | Lowest likely yield among call/put/maturity scenarios | Often relevant for callable structures |
| Tax-equivalent yield | Taxable-equivalent comparison for tax-advantaged income | Depends on investor tax rate |
Exam trap: For a premium callable bond, yield to call may be more relevant than yield to maturity because the issuer has incentive to call when refinancing is favorable.
Duration and Convexity
Duration measures price sensitivity to interest-rate changes.
Approximate price change:
\[ \frac{\Delta P}{P} \approx -\text{Modified Duration} \times \Delta y \]| Bond Feature | Duration Impact |
|---|---|
| Longer maturity | Higher duration |
| Lower coupon | Higher duration |
| Lower yield | Higher duration |
| Embedded call option | Can reduce upside when rates fall |
| Floating-rate coupon | Lower interest-rate sensitivity, all else equal |
Convexity refines duration by recognizing that the price/yield relationship is curved.
High-yield rules:
- Duration is a first-order estimate.
- Convexity matters more for large yield changes.
- Positive convexity benefits bondholders when rates move significantly.
- Callable bonds can exhibit negative convexity when rates fall because price appreciation is capped by call risk.
Credit Spreads
A credit spread compensates investors for risks above a benchmark rate.
| Spread Driver | Wider Spread Usually Indicates |
|---|---|
| Higher leverage | Greater default risk |
| Weaker interest coverage | Less debt service capacity |
| Volatile cash flows | Higher uncertainty |
| Subordination | Lower recovery expectation |
| Poor liquidity | Higher liquidity premium |
| Longer maturity | More exposure to credit and rate uncertainty |
Credit review focuses on both probability of default and loss given default.
Corporate Bond Credit Checklist
| Question | Why It Matters |
|---|---|
| Is debt secured or unsecured? | Affects recovery priority |
| Is debt senior or subordinated? | Affects payment priority |
| Are cash flows recurring? | Supports debt service |
| Are covenants restrictive? | Can protect lenders or constrain issuer |
| Is there refinancing risk? | Maturities may force refinancing under unfavorable conditions |
| Are assets liquid? | Impacts recovery value |
| Is the industry cyclical? | Downturns may pressure coverage |
| Is the issuer exposed to FX or commodity risk? | Adds volatility to cash flow |
Callable, Putable, and Convertible Bonds
| Feature | Benefits | Valuation Effect |
|---|---|---|
| Callable bond | Benefits issuer | Investor demands higher yield; price upside capped |
| Putable bond | Benefits investor | Investor may accept lower yield |
| Convertible bond | Benefits investor through equity option | Value includes straight bond plus conversion option |
| Sinking fund | Reduces repayment risk over time | May affect average life and reinvestment assumptions |
| Floating-rate bond | Coupon adjusts with benchmark | Lower duration than fixed-rate bond, all else equal |
Clean Price vs Dirty Price
| Term | Meaning |
|---|---|
| Clean price | Quoted bond price excluding accrued interest |
| Accrued interest | Interest earned since last coupon date |
| Dirty price | Clean price plus accrued interest; actual settlement price conceptually |
Exam trap: The buyer compensates the seller for accrued interest because the buyer will receive the full next coupon.
Preferred Stock, Convertibles, Warrants, and Options
Preferred Stock
| Preferred feature | Meaning | Valuation point |
|---|---|---|
| Fixed dividend | Stated dividend, often based on par | Value resembles perpetuity if nonmaturing |
| Cumulative | Missed dividends accrue before common dividends | More protective than noncumulative |
| Noncumulative | Missed dividends do not accrue | More issuer-friendly |
| Participating | May share in additional earnings/dividends | Upside feature |
| Convertible preferred | Can convert into common stock | Value includes income plus conversion option |
| Callable preferred | Issuer may redeem | Limits upside when rates fall |
Notes and examples
Perpetual preferred approximation:
\[ Preferred\ Value = \frac{Annual\ Dividend}{Required\ Return} \]Convertible Securities
| Concept | Formula / rule | Meaning |
|---|---|---|
| Conversion ratio | par value / conversion price | Shares received upon conversion |
| Conversion value | stock price x conversion ratio | Value if converted now |
| Conversion premium | convertible price - conversion value | Extra paid for bond value and option value |
| Parity price | convertible price / conversion ratio | Stock price at which conversion value equals convertible price |
| Investment value | value as straight bond or preferred | Downside support if conversion option is out of money |
Convertible traps:
- Convertibles combine credit risk, interest-rate risk, and equity option exposure.
- As stock price rises, convertible behaves more like equity.
- As stock price falls, convertible behaves more like a bond, subject to issuer credit quality.
- Call features can force conversion if the common stock has appreciated.
Options and Warrants
| Position | Payoff at expiration | Risk profile |
|---|---|---|
| Long call | max(0, stock price - strike) | Limited loss to premium; upside exposure |
| Short call | premium minus call payoff | Potentially large loss if uncovered |
| Long put | max(0, strike - stock price) | Downside protection or bearish exposure |
| Short put | premium minus put payoff | Obligation to buy at strike; downside risk |
| Warrant | Long-term right to buy issuer stock | Dilutive if exercised |
| Option input | Call value effect | Put value effect | Exam point |
|---|---|---|---|
| Stock price rises | Increases | Decreases | Directional exposure |
| Strike price rises | Decreases | Increases | Exercise terms matter |
| Volatility rises | Increases | Increases | Optionality benefits from volatility |
| Time to expiration rises | Usually increases | Usually increases | More time for favorable movement |
| Interest rates rise | Usually increases | Usually decreases | Cost-of-carry relationship |
| Dividends rise | Usually decreases | Usually increases | Dividends reduce stock price on ex-date |
Greeks quick check:
| Greek | Measures | Long call typical sign | Long put typical sign |
|---|---|---|---|
| Delta | Price sensitivity to underlying | Positive | Negative |
| Gamma | Change in delta | Positive | Positive |
| Theta | Time decay | Negative | Negative |
| Vega | Volatility sensitivity | Positive | Positive |
| Rho | Interest-rate sensitivity | Positive | Negative |
Preferred Stock and Hybrid Securities
Preferred stock often sits between debt and common equity in the capital structure.
| Feature | Valuation Impact |
|---|---|
| Fixed dividend | Similar to fixed-income cash flow |
| Perpetual life | Often valued like a perpetuity |
| Cumulative dividend | Missed dividends accumulate before common dividends |
| Noncumulative dividend | Missed dividends do not accumulate |
| Convertible feature | Adds equity upside |
| Callable feature | Can cap appreciation |
| Priority over common | Less risky than common, but junior to debt |
Perpetual preferred valuation concept:
\[ \text{Preferred Value} = \frac{\text{Annual Preferred Dividend}}{\text{Required Return}} \]Common trap: Preferred dividends are not interest expense. They are not treated the same as debt interest in income statement analysis.
Convertible Securities
A convertible security has both fixed-income and equity-option characteristics.
| Term | Meaning |
|---|---|
| Conversion ratio | Number of shares received upon conversion |
| Conversion price | Par value or issue price divided by conversion ratio |
| Conversion value | Current stock price × conversion ratio |
| Straight bond value | Value if the conversion option did not exist |
| Conversion premium | Convertible price above conversion value |
| Parity | Value at which conversion and security price are economically aligned |
Convertible value is generally supported by:
- Straight bond value floor, subject to credit risk.
- Conversion value if stock price rises.
- Time value of the embedded option.
- The convertible is not automatically worth only its conversion value.
- If the stock price is far below conversion price, credit quality and coupon support become more important.
- If the stock price is far above conversion price, the convertible behaves more like equity.
- Issuer call provisions can force conversion and cap investor upside.
Warrants
Warrants give the holder the right to buy stock at a specified exercise price.
| Factor | Effect on Warrant Value |
|---|---|
| Higher stock price | Increases value |
| Lower exercise price | Increases value |
| Higher volatility | Increases time value |
| Longer time to expiration | Usually increases value |
| Higher dividends | Can reduce call-like value if stock price adjusts downward |
Key distinction: Warrants are often issued by the company and may create new shares when exercised, causing dilution.
Options Basics
| Option Concept | Call Option | Put Option |
|---|---|---|
| Right | Buy underlying | Sell underlying |
| In the money | Stock price > strike | Stock price < strike |
| Intrinsic value | Stock price − strike, if positive | Strike − stock price, if positive |
| Time value | Option premium − intrinsic value | Option premium − intrinsic value |
| Maximum loss for buyer | Premium paid | Premium paid |
Put-call parity concept for European options on non-dividend-paying stock:
\[ C + PV(K) = P + S \]Where \(C\) is call value, \(P\) is put value, \(PV(K)\) is present value of the strike price, and \(S\) is stock price.
Options Greeks Cheat Sheet
| Greek | Measures | High-Yield Meaning |
|---|---|---|
| Delta | Price sensitivity to underlying | Directional exposure |
| Gamma | Change in delta | Curvature of option exposure |
| Theta | Time decay | Option value lost as time passes |
| Vega | Sensitivity to volatility | Higher volatility generally increases option value |
| Rho | Sensitivity to interest rates | Usually less central than delta, theta, and vega |
Yield Curve, Rates, and Macro Inputs
| Indicator | Typical interpretation | Securities-analysis effect |
|---|---|---|
| Upward-sloping yield curve | Longer rates above shorter rates | Normal expansion/term premium signal |
| Flat yield curve | Little difference between short and long rates | Transition or uncertainty signal |
| Inverted yield curve | Short rates above long rates | Often associated with tighter monetary conditions |
| Rising inflation expectations | Higher nominal yields | Can pressure equity multiples and bond prices |
| Falling rates | Higher bond prices, lower discount rates | May support long-duration equities |
| Strong economic growth | Better revenues and credit conditions | Cyclical sectors may benefit |
| Weak economic growth | Earnings pressure, credit stress | Defensive sectors may outperform |
| Strong currency | Hurts exporters’ translated earnings | Helps importers and foreign purchasing power |
| Commodity price rise | Helps producers, hurts users | Margin impact depends on pass-through ability |
Nominal rate decomposition:
\[ Nominal\ Rate \approx Real\ Rate + Expected\ Inflation + Risk\ Premiums \]Industry and Company Analysis
Industry Life Cycle
| Stage | Traits | Valuation emphasis |
|---|---|---|
| Introduction | Low profits, high uncertainty | Revenue growth, addressable market, funding |
| Growth | Rapid sales expansion | Growth sustainability, margins, reinvestment |
| Maturity | Stable demand and margins | Cash flow, dividends, multiples |
| Decline | Shrinking demand | Asset value, restructuring, runoff cash flows |
Notes and examples
Sector Sensitivity
| Sector / issuer type | Sensitive to | Analysis focus |
|---|---|---|
| Banks | Credit quality, rates, capital, yield curve | Net interest margin, loan losses, book value |
| Insurers | Underwriting, reserves, investment portfolio | Combined ratio, reserve adequacy, investment yield |
| Utilities | Rates, regulation, capex, leverage | Dividend stability, allowed returns, debt burden |
| Industrials | Economic cycle, input costs, orders | Backlog, margins, operating leverage |
| Technology | Innovation, scale, competition | Growth, retention, R&D, margins |
| Energy | Commodity prices, reserves, capex | Production, reserve replacement, cash costs |
| REITs | Rates, occupancy, rent growth | Funds from operations, leverage, property type |
| Consumer staples | Volume, brand strength, input costs | Pricing power and defensive cash flows |
| Consumer discretionary | Employment, confidence, credit | Cyclical revenue and margin risk |
| Healthcare | Pipeline, reimbursement, regulation | Product concentration and R&D outcomes |
Funds, Portfolio Measures, and Risk
| Concept | Formula / definition | Use |
|---|---|---|
| NAV per share | fund assets minus liabilities / shares outstanding | Fund valuation baseline |
| Total return | distributions plus NAV change / beginning NAV | Fund performance |
| Standard deviation | Dispersion of returns | Total risk measure |
| Beta | Market sensitivity | Systematic risk measure |
| Alpha | Return above expected return for risk | Manager value-added measure |
| Sharpe ratio | excess return / standard deviation | Return per unit of total risk |
| Treynor ratio | excess return / beta | Return per unit of systematic risk |
| Tracking error | volatility of active return | Index-relative risk |
| Information ratio | active return / tracking error | Active management efficiency |
Portfolio traps:
- Diversification reduces unsystematic risk, not necessarily systematic risk.
- Correlation drives diversification benefit.
- Higher return is not better unless adjusted for risk.
- Compare manager returns to an appropriate benchmark.
Technical and Market Indicators
| Indicator | What it measures | Common interpretation |
|---|---|---|
| Moving average | Smoothed price trend | Price above average may suggest uptrend |
| Relative strength | Performance vs benchmark or peers | Identifies leadership/laggards |
| RSI | Momentum oscillator | Extreme readings may indicate overbought/oversold conditions |
| MACD | Trend and momentum | Crossovers may signal trend changes |
| Advance-decline line | Market breadth | Divergence can warn of weak participation |
| Volume | Trading activity | Price moves on high volume may carry more significance |
| Support | Price level where buying may emerge | Break below support can be bearish |
| Resistance | Price level where selling may emerge | Break above resistance can be bullish |
Exam caution: technical indicators are market-analysis tools, not guarantees of intrinsic value.
Notes and examples
Technical and Market-Based Indicators
Series 162 valuation review can include market interpretation. Technical indicators should not replace fundamental valuation, but they may appear in questions about price behavior or market sentiment.
| Indicator | Meaning | Trap |
|---|---|---|
| Support level | Price area where buying interest may emerge | Not guaranteed floor |
| Resistance level | Price area where selling pressure may emerge | Can break on volume |
| Moving average | Smoothed trend indicator | Lagging indicator |
| Relative strength | Performance versus market or peers | Not the same as fundamental value |
| Volume | Confirms or questions price moves | Low-volume moves may be less reliable |
| Breadth | Participation across securities | Narrow rallies may be fragile |
| Momentum | Rate of price change | Can reverse sharply |
Supervisory Analyst Review Lens
When reviewing valuation work, ask whether the analysis is internally consistent, supportable, and clearly distinguished from opinion.
| Review area | Questions to ask |
|---|---|
| Recommendation basis | Is the conclusion tied to data, valuation, and assumptions? |
| Price target | Is the time horizon clear? Is the method identified? |
| Assumptions | Are growth, margins, discount rates, and multiples supportable? |
| Peer group | Are peers comparable in business mix, size, growth, margins, and leverage? |
| Forecasts | Are estimates consistent with industry conditions and company capacity? |
| Risk disclosure | Are material downside risks identified? |
| Earnings quality | Are nonrecurring and accounting-driven items adjusted? |
| Conflicts | Are relevant conflicts handled under the firm’s policies and applicable standards? |
| Terminology | Are “buy,” “hold,” “sell,” “outperform,” or similar terms defined consistently? |
| Math | Do per-share values, share counts, enterprise value bridges, and multiples reconcile? |
Common Series 162 Valuation Traps
| Trap | Correct approach |
|---|---|
| Using enterprise value with net income | Match enterprise value with pre-interest operating metrics |
| Using equity value with EBITDA | Use EV/EBITDA, not P/EBITDA, unless explicitly justified |
| Discounting FCFF at cost of equity | FCFF is discounted at WACC |
| Discounting FCFE at WACC | FCFE is discounted at cost of equity |
| Mixing real cash flows with nominal discount rate | Match real with real, nominal with nominal |
| Treating accounting earnings as cash flow | Adjust for noncash charges, capex, and working capital |
| Ignoring dilution | Use diluted shares when valuing common equity if dilutive securities matter |
| Confusing coupon rate and yield | Coupon is stated interest; yield depends on market price |
| Assuming high dividend yield is safe | High yield may reflect expected dividend cut or price decline |
| Treating book value as market value | Book value is accounting-based and may differ materially |
| Ignoring capital structure | Leverage changes risk, EPS, ROE, and valuation |
| Using trailing multiples for turnaround firms without adjustment | Normalize earnings and margins when justified |
| Overweighting terminal value | Stress-test terminal growth and exit multiple assumptions |
| Comparing companies with different accounting policies | Adjust or acknowledge comparability limits |
| Confusing correlation and causation | Market relationships need economic support |
Rapid Calculation Checklist
Before answering a valuation calculation item:
- Identify claim type: debt, preferred, common equity, enterprise, option.
- Choose correct cash flow: coupon, dividend, FCFF, FCFE, EPS, EBITDA, NAV.
- Choose correct discount rate: YTM, required return, cost of equity, WACC.
- Check timing: D0 vs D1, beginning vs ending value, annual vs quarterly.
- Check units: per share vs total value, percent vs decimal, millions vs shares.
- Match numerator and denominator: EV with operating metric, price with equity metric.
- Adjust for debt and cash when bridging enterprise value to equity value.
- Use diluted shares if per-share equity value is requested and dilution is relevant.
- Normalize earnings if the question gives nonrecurring items.
- Evaluate reasonableness: sign, direction, premium/discount, and sensitivity.
Notes and examples
Final Review Checklist Before Practice
Before moving into question-bank work, make sure you can do the following without hesitation:
- Explain the difference between enterprise value and equity value.
- Match FCFF with WACC and FCFE with cost of equity.
- Identify when P/E, EV/EBITDA, EV/Sales, P/B, and DDM are appropriate.
- Adjust earnings for nonrecurring and nonoperating items.
- Explain how interest rates affect bond prices and equity discount rates.
- Recognize duration and convexity implications.
- Distinguish yield to maturity, yield to call, and yield to worst.
- Calculate basic conversion value for a convertible security.
- Identify intrinsic value and time value of an option.
- Spot inconsistent valuation assumptions.
- Explain why comparable-company analysis requires true comparability.
- Connect recommendation, price target, assumptions, and risks.
High-Yield Review Map
| Area | What to Know Cold | Common Exam Trap |
|---|---|---|
| Equity valuation | DCF, dividend models, relative multiples, sum-of-parts | Mixing equity value with enterprise value |
| Cash-flow analysis | FCFF vs FCFE, operating vs financing cash flows | Discounting levered cash flows at WACC |
| Multiples | P/E, EV/EBITDA, EV/Sales, P/B, PEG | Using numerator and denominator from different capital structures |
| Fixed income | Price/yield inverse relationship, duration, convexity, spreads | Confusing yield to maturity with yield to call |
| Credit analysis | Leverage, coverage, liquidity, cash-flow stability | Looking only at earnings instead of cash flow |
| Convertibles | Conversion value, straight bond value, option value | Treating convertible value as only parity value |
| Options/warrants | Intrinsic value, time value, volatility, Greeks | Assuming an out-of-the-money option has no value |
| Preferred stock | Perpetual dividend valuation, cumulative features | Treating preferred exactly like common equity |
| Financial statements | Normalization, nonrecurring items, working capital, quality of earnings | Using reported numbers without adjustment |
| Industry/macro analysis | Cyclicality, rates, inflation, FX, commodity sensitivity | Applying one valuation multiple across unlike businesses |
Valuation Review Workflow
Use this workflow when reviewing any security valuation question.
flowchart TD
A[Identify the security] --> B[Identify cash-flow claim]
B --> C[Normalize financial statements]
C --> D[Select valuation method]
D --> E[Check discount rate or multiple]
E --> F[Test assumptions and sensitivity]
F --> G[Reconcile to market price]
G --> H[Assess recommendation support]
H --> I[Check risks, limitations, and consistency]
Notes and examples
Core Decision Questions
Ask these in almost every valuation problem:
What cash flows does the security holder receive?
- Common equity: residual cash flows after operating needs, debt service, and reinvestment.
- Debt: contractual interest and principal, subject to credit risk.
- Preferred: dividends with equity/debt-like features.
- Convertible: debt or preferred value plus conversion option.
Is the valuation method appropriate?
- Stable dividend payer: dividend discount model may be relevant.
- High-growth operating company: DCF or revenue/EBITDA multiples may be more useful.
- Financial institution: P/B, ROE, asset quality, and capital ratios often matter.
- Distressed issuer: liquidation value, recovery analysis, and cash burn may dominate.
Are cash flows and discount rates matched?
- FCFF pairs with WACC.
- FCFE pairs with cost of equity.
- Nominal cash flows pair with nominal discount rates.
- Real cash flows pair with real discount rates.
- Pre-tax cash flows should not be discounted with after-tax rates unless adjusted.
Are the assumptions internally consistent?
- Revenue growth, margins, capex, working capital, and terminal growth should fit the business model.
- Terminal growth should not be casually set above long-term sustainable economic growth.
- A high-risk business should not receive a low-risk discount rate without support.
Securitized and Structured Products
For valuation questions involving asset-backed or mortgage-backed securities, focus on cash-flow uncertainty.
| Product/Feature | Key Valuation Issue |
|---|---|
| Mortgage-backed securities | Prepayment risk and extension risk |
| Asset-backed securities | Collateral quality and payment structure |
| Tranches | Payment priority and loss allocation |
| Credit enhancement | Subordination, reserves, guarantees, excess spread |
| Prepayment speed | Affects timing and yield |
| Extension risk | Cash flows last longer when rates rise or refinancing slows |
| Contraction risk | Principal returns faster when rates fall or refinancing increases |
- When rates fall, mortgage borrowers may refinance, increasing prepayments.
- When rates rise, prepayments may slow, extending duration.
- Senior tranches usually have priority but may offer lower yield.
- Subordinate tranches may absorb losses earlier and require higher yield.
Industry, Economic, and Market Context
Macro Drivers
| Driver | Valuation Impact |
|---|---|
| Interest rates | Affect discount rates, bond prices, equity multiples, and financing costs |
| Inflation | Can pressure margins, rates, and real returns |
| GDP growth | Influences revenue growth and cyclicality |
| Unemployment | Affects consumer demand and credit quality |
| FX rates | Affect exporters, importers, and translated earnings |
| Commodity prices | Affect producers, consumers, airlines, chemicals, energy firms |
| Credit conditions | Affect refinancing, leverage, M&A, and default risk |
| Yield curve | Signals rate expectations, lending margins, and economic outlook |
Notes and examples
Industry Analysis Checklist
| Question | Why It Matters |
|---|---|
| Is the industry cyclical or defensive? | Determines earnings volatility |
| Are barriers to entry high? | Supports margins and returns |
| Is pricing power strong? | Helps offset inflation and input costs |
| Is regulation material? | Can affect costs, growth, and risk |
| Is technology changing the business? | Can disrupt margins and terminal value |
| Are customers concentrated? | Increases revenue risk |
| Are suppliers concentrated? | Increases input cost risk |
| Is capital intensity high? | Reduces free cash flow after capex |
| Are returns above cost of capital? | Indicates value creation |
Company Life Cycle and Valuation
| Stage | Typical Traits | Valuation Focus |
|---|---|---|
| Early-stage | High growth, low or negative earnings | Revenue growth, unit economics, cash runway |
| Growth | Expanding margins, reinvestment needs | DCF, EV/Sales, EV/EBITDA, growth durability |
| Mature | Stable cash flows, dividends | DCF, P/E, dividend yield, capital returns |
| Decline | Shrinking revenue, margin pressure | Asset value, restructuring, cash flow durability |
| Distressed | Liquidity pressure, debt burden | Recovery value, solvency, refinancing risk |
Supervisory Analyst Valuation Mindset
Although this page focuses on valuation, remember the practical role behind the exam: reviewing analysis for reasonableness, consistency, and support.
Review Standards to Apply
| Review Point | What to Ask |
|---|---|
| Method suitability | Does the model fit the issuer and security? |
| Assumption support | Are growth, margin, discount rate, and multiple assumptions defensible? |
| Source consistency | Are market data, peer data, and financials used consistently? |
| Comparable selection | Are peers truly comparable in business mix, size, growth, risk, and margins? |
| Sensitivity analysis | Does the conclusion depend on one aggressive assumption? |
| Risk discussion | Are material risks clear and connected to valuation? |
| Recommendation support | Does the target price logically support the rating or conclusion? |
| Internal consistency | Do text, tables, models, and conclusions agree? |
| Timeliness | Are data and market prices current enough for the analysis? |
| Conflicts and limitations | Are relevant limitations and assumptions transparent? |
Notes and examples
Red Flags in Valuation Work
- Price target generated from one optimistic case only.
- Peer group selected because it supports the desired valuation.
- Terminal value accounts for nearly all DCF value without sensitivity discussion.
- Long-term growth assumption exceeds sustainable economic logic.
- Discount rate does not reflect business, financial, or country risk.
- EBITDA multiple used for a company with heavy recurring capex without adjustment.
- EPS estimate excludes recurring expenses labeled as “one-time” repeatedly.
- Share count ignores dilution from options, convertibles, or warrants.
- Enterprise value calculation forgets debt, preferred stock, minority interest, or excess cash.
- Bond valuation ignores call features, credit deterioration, or liquidity risk.
Calculation Traps to Practice
| Trap | Correct Approach |
|---|---|
| Using latest dividend instead of next dividend | Constant-growth DDM uses expected next dividend |
| Comparing P/E across companies with very different leverage | Consider EV-based multiples or adjust interpretation |
| Discounting FCFF with cost of equity | FCFF should be discounted at WACC |
| Discounting FCFE with WACC | FCFE should be discounted at cost of equity |
| Treating EBITDA as cash flow | EBITDA ignores taxes, working capital, and capex |
| Using book debt when market value is available | Use market values when estimating capital weights |
| Forgetting tax shield on debt in WACC | Debt cost is generally after-tax in WACC |
| Ignoring terminal value sensitivity | Small changes in g or WACC can materially change value |
| Confusing coupon rate and yield | Coupon is contractual; yield reflects market price and return |
| Assuming premium bond is always bad | Premium may reflect high coupon or lower market rates |
| Ignoring yield to call | Callable premium bonds may be called before maturity |
| Treating duration as exact | Duration is an approximation, improved by convexity |
| Saying out-of-the-money options are worthless | They may have time value |
| Ignoring dilution | Use diluted shares when calculating per-share equity value |
| Confusing clean and dirty bond price | Settlement includes accrued interest |
Fast Formula Review
DCF Terminal Value
\[ TV = \frac{FCF_{n+1}}{r-g} \]Conversion Value
\[ \text{Conversion Value} = \text{Stock Price} \times \text{Conversion Ratio} \]Current Yield
\[ \text{Current Yield} = \frac{\text{Annual Coupon}}{\text{Market Price}} \]Quick “Which Method?” Decision Table
| Situation | Likely Useful Method | Less Useful Method |
|---|---|---|
| Stable dividend-paying utility | Dividend discount model, P/E, DCF | EV/Sales alone |
| High-growth software company with limited earnings | DCF, EV/Sales, EV/Revenue growth comparisons | Trailing P/E if earnings are negative |
| Mature industrial company | DCF, EV/EBITDA, P/E | Revenue multiple without margin context |
| Bank or insurer | P/B, ROE, asset quality, capital analysis | EV/EBITDA |
| Distressed issuer | Recovery analysis, liquidity analysis, debt waterfall | Normalized P/E without solvency review |
| Conglomerate | Sum-of-the-parts | Single-company average multiple |
| Callable bond | Yield to call, yield to worst, duration with call risk | Yield to maturity alone |
| Convertible bond | Straight bond value plus conversion option | Bond-only valuation |
Common Candidate Mistakes
Conceptual Mistakes
- Memorizing formulas without knowing when to use them.
- Treating valuation output as precise instead of assumption-dependent.
- Ignoring capital structure when comparing companies.
- Assuming a low multiple always means cheap.
- Assuming a high multiple always means overvalued.
- Forgetting that high growth can destroy value if returns are below cost of capital.
- Ignoring liquidity, credit, and refinancing risk in fixed income questions.
Notes and examples
Calculation Mistakes
- Dividing enterprise value by shares before subtracting net debt.
- Using basic shares when diluted shares are required.
- Forgetting to convert percentages to decimals.
- Mixing annual and quarterly figures.
- Using old share counts after buybacks or issuance.
- Treating negative working capital changes incorrectly.
- Not checking whether a question asks for value, price, yield, spread, or return.
Judgment Mistakes
- Selecting the most complicated model when a simpler one fits better.
- Choosing peer companies based only on industry label.
- Ignoring whether earnings are peak, trough, or normalized.
- Accepting management projections without challenge.
- Overlooking risk disclosures that contradict the valuation conclusion.