Study guide
The most heavily weighted portion of the Series 86 under FINRA's published outline asks you to turn analysis into numbers: explicit forecasts, valuation multiples, discounted cash flow models, and a view on what a stock is worth relative to its own history and its peers. This chapter covers the mechanics of each tool and the judgment calls behind them.
Forecasting the Income Statement, Cash Flow, and Balance Sheet
A research model starts with revenue drivers, not with a growth rate pulled from the air. Revenue can be modeled as units times average selling price, stores times sales per store, subscribers times revenue per subscriber, or industry demand times market share, with the industry inputs coming from the kind of analysis covered in Function 1. An analyst modeling Torval Industries, an oilfield services firm, might forecast active rigs and revenue per rig rather than total revenue directly. Costs are split into variable and fixed components so the model captures operating leverage: when volumes rise on a fixed cost base, margins expand faster than revenue. From the income statement, the model builds the balance sheet using working capital assumptions, days sales outstanding for receivables, days of inventory, and days payable, plus a capital expenditure and depreciation schedule tied to the revenue plan. The cash flow statement then falls out of the other two, and the balance sheet must balance, with cash or revolver borrowings as the plug. Good practice includes building base, upside, and downside scenarios, testing sensitivity to the two or three assumptions that matter most, and checking outputs against history: a company that has never held margins above 15 percent needs a strong argument before your model assumes 20. Forecasts should also respect mean reversion in competitive industries, since unusually high returns attract entry and tend to fade over time.
Relative Valuation: Multiples and Yield Metrics
Multiples express price in units of a fundamental. The price-to-earnings ratio divides share price by earnings per share; trailing P/E uses the last twelve months while forward P/E uses estimated earnings, and consistency matters when comparing companies. The PEG ratio divides the P/E by the expected earnings growth rate to normalize for growth differences; a lower PEG suggests more growth per dollar of valuation, though the measure is sensitive to which growth estimate you use. Price-to-book compares price with accounting equity and is most meaningful for banks and insurers, where book value approximates the economic base; companies earning returns above their cost of equity typically deserve premiums to book. Enterprise value equals equity market capitalization plus debt, preferred stock, and minority interest, minus cash. EV-based multiples such as EV/EBITDA and EV/sales are capital structure neutral, which makes them useful for comparing companies with different leverage; EV/sales serves when earnings are negative or temporarily depressed. Yield metrics invert the logic: dividend yield, free cash flow yield, and earnings yield express the return the current price implies. Each tool has traps. A cyclical company at peak earnings can look deceptively cheap on P/E just before profits collapse, which is why analysts often use normalized or mid-cycle earnings. EV/EBITDA ignores differences in capital intensity, so two companies with equal EBITDA but very different capital spending needs are not equally valuable. Match the multiple to the situation, and be able to say why.
Intrinsic Value: DCF, Dividend Discount Models, and the Cost of Capital
A discounted cash flow model values a business as the present value of the cash it will generate. Free cash flow to the firm is after-tax operating profit plus depreciation, minus capital expenditures and increases in working capital; it belongs to all capital providers and is discounted at the weighted average cost of capital. WACC blends the after-tax cost of debt with the cost of equity, weighted by the target capital structure. The cost of equity is commonly estimated with the capital asset pricing model: the risk-free rate plus beta times the equity risk premium, where beta measures the stock's sensitivity to market moves. After an explicit forecast period, a terminal value captures all later years, using either a perpetual growth formula or an exit multiple; because the terminal value often represents well over half of the total, small changes in the perpetuity growth rate or the WACC move the answer dramatically, and honest analysts show that sensitivity. The dividend discount model applies the same logic to dividends. The constant-growth version, often called the Gordon growth model, prices a stock as next year's dividend divided by the difference between the required return and the growth rate. If Castellan Foods will pay 2 dollars next year, the required return is 8 percent, and dividends grow 3 percent forever, the model value is 2 divided by 0.05, or 40 dollars. The formula requires the return to exceed growth, and multistage versions handle companies transitioning from rapid to mature growth.
Leverage, Coverage, and Debt Ratios
Equity analysts must read credit, because financial risk shapes both the multiple a stock deserves and, in stress, whether equity holders receive anything at all. Balance sheet leverage is measured by debt-to-equity and debt-to-total-capital, while debt-to-EBITDA, often computed with net debt after subtracting cash, expresses leverage in years of cash earnings and is the language of rating agencies and loan covenants. Coverage ratios test the income statement's ability to service obligations: interest coverage divides EBIT by interest expense, and fixed-charge coverage adds lease and other mandatory payments for companies with heavy rental obligations. Leverage magnifies outcomes in both directions: it lifts return on equity when returns on assets exceed borrowing costs, and it accelerates losses when they do not. Analysts also examine the debt maturity schedule for refinancing walls, the mix of fixed and floating rates, covenant headroom, and access to undrawn credit lines. A company approaching a covenant limit may cut its dividend, issue equity, or sell assets, all of which matter to an equity thesis. Finally, remember the bridge between enterprise and equity value: equity value equals enterprise value minus net debt and other senior claims, so for a highly levered company a modest change in the value of the business produces a large percentage change in the value of the stock. That is why heavily leveraged equities trade with amplified volatility, behaving in effect like options on the underlying enterprise.
Catalysts, Technicals, Activists, and Valuation Context
A price target needs a path, so analysts identify catalysts: scheduled or probable events that could close the gap between price and value. Examples include earnings reports, new product launches, regulatory decisions such as a drug approval, contract awards, index inclusion, capital returns, asset sales, and management changes. Technical analysis studies price and volume behavior rather than fundamentals. Concepts an analyst should recognize include trends, support and resistance levels, moving averages, relative strength versus the market, and volume confirmation; some firms incorporate technical work alongside fundamental research, and the exam expects familiarity with the vocabulary even from fundamentally driven analysts. Activist investors are themselves catalysts. An investor that accumulates more than 5 percent of a voting class with intent to influence control must generally disclose the stake on Schedule 13D, and activist campaigns often push for buybacks, cost cuts, board seats, divestitures, or an outright sale of the company. Analysts assess whether the demands are feasible and value-accretive. The final discipline is context. A multiple means little in isolation: compare the current P/E or EV/EBITDA with the company's own five- or ten-year range and with a carefully chosen peer group, and ask whether differences in growth, returns, and risk justify any premium or discount. When Bluewater Retail trades at half its historical multiple, the analyst must decide whether the market is overreacting to a cyclical trough or correctly pricing a secular decline; the valuation call and the industry call are the same call.
Key terms
- Free cash flow to the firm (FCFF)
- — Cash generated after operating needs and capital spending, available to all providers of capital and discounted at the WACC.
- Weighted average cost of capital (WACC)
- — The blended after-tax cost of debt and equity, weighted by capital structure; the discount rate applied to firm-level cash flows.
- Capital asset pricing model (CAPM)
- — A cost of equity estimate equal to the risk-free rate plus beta times the equity risk premium.
- Beta
- — A measure of a stock's sensitivity to movements in the overall market.
- Terminal value
- — The value assigned to all cash flows beyond the explicit forecast period, computed with a perpetuity growth rate or an exit multiple.
- Gordon growth model
- — The constant-growth dividend discount model: price equals next year's dividend divided by the required return minus the growth rate.
- Forward P/E
- — Share price divided by estimated future earnings per share, as opposed to trailing P/E based on the last twelve months.
- PEG ratio
- — The P/E ratio divided by the expected earnings growth rate, used to compare valuations across different growth profiles.
- Enterprise value (EV)
- — Equity market capitalization plus debt, preferred stock, and minority interest, minus cash and equivalents.
- EV/EBITDA
- — A capital-structure-neutral multiple comparing enterprise value with earnings before interest, taxes, depreciation, and amortization.
- Interest coverage ratio
- — EBIT divided by interest expense; measures the ability to service debt from operating earnings.
- Catalyst
- — An identifiable event expected to move a security's price toward the analyst's estimate of value.
Exam tips
- Memorize the Gordon growth formula and its constraint that the required return must exceed the growth rate; expect a straightforward calculation.
- Know exactly what goes into enterprise value, and remember that cash is subtracted; EV questions are frequently missed on sign errors.
- Be ready to pick the right multiple for a scenario: price-to-book for banks and insurers, EV/EBITDA across different capital structures, EV/sales when earnings are negative.
- Terminal value dominates most DCF answers, so expect questions about how small changes in WACC or the perpetual growth rate swing the valuation.
- The 5 percent Schedule 13D threshold, and the distinction between an active-intent 13D and a passive 13G filing, are fair game.