Chartered Financial Analyst (CFA) Practice Exam Level 2

What does the H-Model compute?

1. Market value of equity

2. Required rate of return

3. Discounted cash flows

4. Portfolio diversification

The correct answer is: Market value of equity

The H-Model is a valuation model used to compute the intrinsic value of a stock by estimating future cash flows, particularly focusing on the growth rates of dividends. It is particularly useful for companies that are expected to grow at a high rate initially, followed by a sustainable growth rate in the long term. In particular, the H-Model differentiates between two phases of growth: the initial higher growth period and the stable growth period that follows. It incorporates the idea that dividends will grow at a high rate for a certain period before transitioning to a more stable rate. This approach allows investors to compute the present value of expected future cash flows, thus arriving at the market value of equity. The other choices do not accurately represent what the H-Model computes. The required rate of return pertains to the expected return necessary to compensate for the risk of an investment, whereas discounted cash flows relate to the broader area of valuing projected cash flows rather than specifically focusing on equity markets. Portfolio diversification pertains to the risk management strategy of spreading investments across various assets, and it doesn’t specifically relate to the intrinsic valuation approach of the H-Model.