EQUITY VALUATION — CFA Level II Cheat Sheet

PORTER'S FIVE FORCES & COMPETITIVE ANALYSIS

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→ High barriers to entry + low buyer/supplier power + few substitutes = sustainable margins

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INDUSTRY LIFE CYCLE STAGES

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REVENUE DECOMPOSITION & QUALITY

Revenue = Units × Average Selling Price (ASP)

Decompose growth:

• Volume growth (unit increase) = higher quality, sustainable

• Price growth (ASP increase) = quality if due to pricing power; lower quality if inflationary

• Mix shift (% toward premium/discount products) = affects both volume and ASP

Market Share Analysis: → If company revenue growth > industry growth → market share gain → competitive strength → If company revenue growth < industry growth → market share loss → competitive weakness

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OPERATING LEVERAGE & COST STRUCTURE

Degree of Operating Leverage (DOL): $$\text{DOL} = \frac{\text{Contribution Margin}}{\text{EBIT}} = \frac{\text{Revenue} - \text{Variable Costs}}{\text{EBIT}}$$

→ DOL tells you %Δ in EBIT per 1% Δ in Revenue

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Fixed costs = depreciation, rent, base salaries (don't change with volume) Variable costs = raw materials, direct labor, commissions (scale with output)

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FINANCIAL PROJECTION (5 KEY TASKS)

Revenue projection → top-down (macro → industry → company) OR bottom-up (units × ASP)

COGS & OpEx → as % of revenue (simple) OR explicit cost drivers (preferred for high-leverage businesses)

Working capital → DSO, inventory days, DPO applied to receivables/payables

CapEx → % of revenue OR capacity expansion plans

Free Cash Flow (FCF):

$$\text{FCF} = \text{EBIT} \times (1-t) + \text{Depreciation} - \text{CapEx} - \Delta\text{WC}$$

→ Sensitivity analysis: vary revenue growth, margin, WACC → range of intrinsic values, identify key drivers

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HIGH-YIELD DISTINCTIONS

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QUICK DECISION RULES

✓ High barriers to entry + growing market → Above-WACC returns likely; premium valuation ✓ High fixed costs + volume growth → EBIT will accelerate (positive leverage) ✓ Shakeout stage → Test margin assumptions; identify survivors; price compression likely ✓ Subscription transition → Use ARR (annual recurring revenue), not GAAP revenue; monitor churn ✓ Mature + declining growth → Shift valuation focus to stable growth DDM or FCF with terminal value; test ROIC vs. WACC ✓ Revenue quality red flag: Price-driven growth in commodity industry or mix shift to lower-margin products

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KEY FORMULAS TO MEMORIZE

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Force	High Competitive Intensity	Low Competitive Intensity
Threat of Entry	Low barriers (capital, brand, regulatory)	High barriers (patents, scale, regulation)
Buyer Power	Concentrated, high switching, commoditized	Fragmented, high switching costs, differentiated
Supplier Power	Few suppliers, high input costs	Many suppliers, low input costs
Substitutes	Many available, low switching costs	Few, high switching costs
Rivalry	Many competitors, price wars, excess capacity	Few competitors, differentiated, stable shares
Result	Below WACC returns	Above WACC returns (economic profit)
Stage	Revenue Growth	Margins	Competition	Capital	Valuation Approach
Embryonic	Rapid (50%+)	Negative/low	Low	High R&D	Revenue multiples; terminal value risk
Growth	High (20–50%)	Improving	Low to mod.	Moderate	DCF; growth rate sensitivity
Shakeout	Moderate (10–20%)	Pressure	High	High	Survivor analysis; margin stress-test
Mature	Low (0–5%)	Stable/high	Mod. to high	Lower	DCF; stable growth; dividend focus
Decline	Negative	Pressure	High	Minimal	Terminal value; ROIC vs. WACC
Characteristic	High DOL (High Fixed Costs)	Low DOL (High Variable Costs)
Example	Airlines, software (post-dev), capital-intensive mfg.	Consulting, staffing, retail
In Growth	EBIT grows 2–5× faster than revenue	EBIT grows 1–1.5× faster than revenue
In Downturns	EBIT declines rapidly; earnings volatility high	EBIT declines slowly; earnings stable
Valuation Risk	Higher; requires margin stability assumptions	Lower; more predictable
Confusion Pair	Distinction	Why It Matters
Revenue growth vs. EPS growth	Revenue growth may not translate to EPS if margins compress or CapEx/WC increases	Quality of growth assessment
Price growth vs. volume growth	Volume = sustainable; price = inflationary or competitive power	Earnings sustainability
Perpetual license vs. subscription	License = lump revenue upfront; subscription = recognition over time. Transition depresses Year 1 revenue but improves quality (recurring)	Model transition; avoid value trap
Operating leverage vs. financial leverage	Operating = revenue sensitivity due to fixed costs; financial = debt sensitivity	Risk profile; valuation stress-tests
Contribution margin vs. gross margin	Contribution = revenue minus variable costs (relevant for DOL); gross = revenue minus COGS	DOL calculation uses contribution
Formula	Use
DOL = CM / EBIT	Operating leverage; E