Learn how Series 86 tests cost of capital, DCF, terminal value, DDM, economic profit, sum-of-the-parts valuation, takeout logic, price targets, and risk/reward.
Series 86 expects the analyst to understand valuation methods that build value from cash flows, required returns, dividends, segment values, or strategic transaction logic. Relative valuation asks how the market values comparable companies. Intrinsic valuation asks what the company is worth based on its own expected economics and risk.
This section is also where valuation becomes a recommendation. A model output is not enough. The analyst must translate valuation results into a price target, explain the assumptions, assess risk/reward, and state what evidence would change the recommendation.
Intrinsic valuation depends heavily on required return assumptions. At an exam level, Series 86 expects the candidate to understand that cost of capital reflects inputs such as risk-free rates, equity risk premium, business risk, leverage, and capital structure. A higher discount rate lowers the present value of future cash flows. A lower discount rate raises it, but only if the lower risk assumption is justified.
The discount rate should match the cash flow being valued. Free cash flow to the firm is usually paired with a firm-wide required return such as WACC. Equity cash flows or dividends require an equity-focused required return. The exam may test whether the method and rate are consistent rather than ask for deep calculation mechanics.
| Method | Best fit | Series 86 caution |
|---|---|---|
| DCF | explicit cash-flow forecast with meaningful long-term assumptions | small changes in discount rate, terminal growth, or margins can create large value changes |
| Terminal value using perpetuity growth | mature business with defensible long-run growth | growth assumption must be realistic relative to the economy and industry |
| Terminal value using exit multiple | business with relevant market comparables | exit multiple should fit future, not just current, economics |
| DDM | stable dividend-paying company where dividends are central to value | weak fit if payout is irregular or not tied to value creation |
| Economic profit | focus on returns above cost of capital | requires clear view of invested capital and sustainable returns |
| Sum-of-the-parts | multi-segment business with different economics | segment multiples and allocation assumptions must be defensible |
| Takeout or private-equity logic | strategic or leveraged transaction context | leverage capacity and transaction assumptions must be realistic |
Series 86 valuation should be decision-oriented, not falsely exact. A DCF or SOTP output should normally be interpreted as a range because key assumptions are uncertain. Sensitivity analysis on WACC, terminal growth, margins, revenue growth, and terminal multiples helps show which assumptions matter most.
When relative valuation and intrinsic valuation disagree, the analyst should reconcile the difference. The market may be pricing in risk that the DCF underweights. The DCF may identify long-term cash-flow value that current multiples understate. Or the discrepancy may show that one method is less appropriate for the company’s stage, cyclicality, leverage, or accounting quality.
A recommendation should connect valuation, current price, risk, and catalysts. A stock with upside to the price target may still be unattractive if the downside risk is severe, the catalyst path is weak, or the assumptions are fragile. A stock with limited upside may still merit a neutral or hold view if valuation is fair and risk/reward is balanced.
Good recommendation framing includes:
An analyst produces a DCF price target that is far above the market price, but the result depends almost entirely on an aggressive terminal growth assumption. What is the strongest Series 86 response?
A. Accept the price target because DCF is always more accurate than market multiples B. Test sensitivity to terminal growth and explain whether the assumption is realistic before relying on the recommendation C. Remove the terminal value because terminal assumptions are never useful D. Ignore risk/reward because the model already produced a price target
Answer: B. Series 86 expects intrinsic valuation to be interpreted with sensitivity and assumption discipline, especially when terminal inputs drive the result.