4.7Lesson 4.7 · Module 4

Equity Valuation Case Lab

Integrate every concept from Lessons 4.1–4.6 into one connected analyst case. Build a forecast, calculate terminal value, evaluate payout policies, stress-test assumptions, diagnose errors, and prepare an investment memo for Northstar Systems.

Build a multi-stage earnings and dividend forecast
Evaluate payout policies when ROE ≠ r and when ROE = r
Stress-test valuation under different costs of equity
Diagnose common analyst errors and prepare an investment memo

Start the Northstar Case View module map

Case brief

Northstar Systems

You are an equity analyst preparing a recommendation for the investment committee. Northstar Systems currently enjoys temporary above-normal investment opportunities. Competition is expected to reduce its ROE after three years. Your job is to value the company, evaluate policy alternatives, stress-test assumptions, and produce a defensible memo.

Assumption	Years 1–3	Year 4+
BVPS₀	$100.00	—
ROE	15%	10%
Payout ratio	30%	60%
Cost of equity (r)	10%	10%

Key economic context

During Years 1–3, ROE (15%) exceeds the cost of equity (10%), so reinvestment creates value. From Year 4 onward, ROE equals r, so mature-stage growth continues but has zero NPV. Northstar can still grow — but that growth does not add shareholder value.

Lessons 4.1–4.6 built the toolkit: equity ownership, the DDM, the Gordon model, multi-stage growth, earnings retention ( $g = b \times R O E$ ), and PVGO. Now you will apply all of them to a single company in a structured analyst workflow. This is not a collection of separate quiz questions — it is a connected case.

Try itRound 1 · Forecast Worksheet

Calculate each year's EPS, dividend, retained earnings, and ending book value. Use $E P S_{t} = R O E_{t} \times B V P S_{t - 1}$ and $D P S_{t} = p_{t} \times E P S_{t}$ . Years unlock sequentially.

Year	Begin BVPS	ROE	EPS	Payout	Dividend	Retained	End BVPS
1	100.0000	15%	input	30%	input	input	input
2	110.5000	15%	—	30%	—	—	—
3	122.1025	15%	—	30%	—	—	—

Year 1

Beginning BVPS: 100.0000

EPS

Dividend

Retained

End BVPS

★Module 4 synthesis

Equity valuation is judgment, not arithmetic

1Equity ownership → you hold a residual claim on the company's future economic benefits.

2Shareholder distributions → dividends, buybacks, acquisition proceeds, or capital gains.

3One-period valuation → P₀ = E[D₁ + P₁] / (1+r).

4DDM → P₀ = Σ E[Dₜ] / (1+r)ᵗ — the stock is worth the PV of all future distributions.

5Gordon Growth → P₀ = D₁/(r−g) — a shortcut that requires r > g and sustainable growth.

6Multi-stage growth → separate explicit forecasts from terminal value.

7Earnings and retention → g = b × ROE — growth comes from reinvesting at the firm's ROE.

8ROE vs cost of equity → growth creates value only when ROE > r.

9PVGO → P₀ = EPS₁/r + PVGO — decompose value into existing assets and future opportunities.

10P/E → P/E = 1/r + PVGO/EPS₁ — safer earnings and profitable growth both raise the multiple.

11Analyst judgment → which growth is temporary? Which earnings are sustainable? How sensitive is the conclusion?

Equity valuation is not a mechanical exercise of inserting numbers into a formula. A defensible valuation requires the analyst to determine which growth is temporary, which earnings are sustainable, whether reinvestment earns more than the cost of equity, whether terminal assumptions are economically plausible, and how sensitive the conclusion is to market-required returns.

✓Mastery

Case mastery check

Try itLesson 4.7 mastery check

Pass with 4 of 6 correct

Answer all questions, then check your work. You can retry any time — mastery is based on correctness, not speed.

01
Northstar's ROE falls to 10% (equal to r) in Year 4. What does this imply about mature-stage reinvestment?
02
Why does raising early-stage payout from 30% to 60% reduce Northstar's value slightly?
03
Why does raising mature-stage payout from 60% to 90% leave value unchanged?
04
A junior analyst computes PVGO = P₀ − EPS₁/r = 113.70 − 150 = −$36.30. What is wrong?
05
An analyst says 'dividend yield 1% + next-year EPS growth 15% = 16% expected return.' What is wrong?
06
When r − g is small, what happens to valuation sensitivity?

Lesson summary

1A defensible valuation requires separating temporary growth from sustainable growth.
2Terminal value captures all post-forecast dividends and often represents the majority of total value.
3Payout policy affects value only when ROE differs from the cost of equity.
4When ROE = r, changing payout changes dividend timing but not present value.
5A higher cost of equity reduces valuation without changing the company's cash generation.
6The simple PVGO decomposition is reliable only when the earnings baseline is sustainable.
7Temporary earnings growth cannot be used as a perpetual Gordon growth rate.
8Equity valuation is not mechanical — it requires judgment about which assumptions are plausible.

Back to PVGO and P/E Replay this lesson Continue to Risk and Return