ACCA Applied Skills · Financial Management

Models for the Valuation of Shares in ACCA FM

Share valuation models estimate what a company's equity is worth. You pick a basis: assets, earnings multiples (P/E), dividends (DVM) or free cash flow to equity. You then apply its formula, state your assumptions, and compare results. No single model is exact, so you must judge each one's limits.

What this chapter covers

This chapter covers the main ways to put a value on a company's shares. You start with why valuation is needed, for example in a takeover, a flotation or a share-for-share deal. Then you work through four families of method: asset-based, market-based (P/E and earnings yield), dividend-based and cash flow-based. The chapter ends with the efficient market hypothesis and a comparison of the models.

Each method needs a different input. Asset models need balance sheet values. The P/E method needs earnings per share and a suitable multiple. The dividend valuation model needs a dividend, a growth rate and a cost of equity. The cash flow method needs forecast free cash flows and a discount rate. Knowing which input you have in the question tells you which model the examiner expects.

The chapter links to the rest of FM in several ways. The cost of equity from the cost of capital chapter feeds the dividend and cash flow models. Investment appraisal uses the same discounting skills. Business finance and acquisitions questions often ask you to value a target before you advise on a bid. Ratio analysis supplies the earnings and gearing figures you use in market-based valuations.

Valuation turns up in objective questions, where a single calculation such as a dividend model value or a P/E-based price is worth marks all or nothing, and in written Section C questions on acquisitions and finance. The calculations are short and rule-based, so careful practice gives reliable marks. The discussion parts, on EMH and model limits, also reward you if you explain points clearly and link them to the scenario instead of listing definitions.

Models for the valuation of shares: topics in the order to study them

1Business Valuation Basics and Valuation ApproachesIt explains when and why shares are valued and gives you the map of methods before you learn the detail.
2Asset-Based Valuation ModelsThese are the simplest calculations, built on net assets, and they give you a floor value to compare later models against.
3Market-Based Valuation: P/E Ratio and Earnings YieldIt uses earnings and a multiple, which builds on the ratios you already know, and is a very common exam calculation.
4Dividend Valuation Model and Dividend GrowthYou need the formulas for constant dividends and constant growth, and how growth is estimated, before moving to cash flows.
5Cash Flow Based Valuation and Free Cash Flow to EquityIt applies the same discounting logic as the dividend model to cash flows, so it is easier once you have done dividends.
6Efficient Market Hypothesis and Share Price BehaviourIt is a discussion topic that explains why market prices may or may not match your model values, so it comes after the models.
7Comparing Valuation Models and Their LimitationsIt ties everything together, so you can only do it well once you know each model and its inputs.

How to prepare Models for the valuation of shares

Treat this chapter as a set of tools plus a judgement skill. Learn each tool, then practise choosing between them and criticising them.

Read the first topic and write a one-line summary of each valuation approach and the input it needs.
Learn each formula and write it from memory. Check every term: for example, in the constant growth dividend model the dividend used is next year's dividend, so a current dividend must be grown first.
Do short calculation questions for each model until you can finish one in a couple of minutes. Practise objective-style questions where only the final answer is marked.
Practise estimating growth and cost of equity from the data given, and note which figures the question gives you and which you must work out.
Study EMH. Learn the weak, semi-strong and strong forms and what each means for investors and for managers, then practise applying them to short scenarios.
Write short answers comparing models. For each, give a strength, a weakness and a situation where it suits best, tied to the scenario.
Finish with mixed questions where you must pick the model yourself, state your assumptions and comment on the result.

Common mistakes in Models for the valuation of shares

Using the current dividend instead of next year's dividend in the constant growth formula.
Fix: Check the timing. If the dividend given is the latest one paid, multiply it by (1 + g) first to get D1.
Mixing up earnings yield and P/E ratio.
Fix: Remember that earnings yield is EPS ÷ price and P/E is price ÷ EPS. Each is the inverse of the other.
Applying a P/E ratio without adjusting for differences between companies.
Fix: Say whether the comparator is similar in risk, size and growth and whether the target is listed or unlisted, and adjust or comment on it.
Using the wrong discount rate for equity cash flows.
Fix: Match the rate to the cash flow. Cash flows to equity holders are discounted at the cost of equity.
Writing the EMH forms as definitions only.
Fix: For each form, say what information is already in the price and what that means for investors or managers in the scenario.
Giving one value and no comment on reliability.
Fix: Add a short note on the key assumptions, such as growth and cost of equity, and say how sensitive the value is to them.

Last-day revision: Models for the valuation of shares

Asset-based values rely on net assets, so they may ignore earnings power and unrecorded intangibles.
Share value by P/E method = EPS × P/E ratio.
Earnings yield = EPS ÷ share price, which is the inverse of the P/E ratio.
A P/E from a comparable company should be adjusted for differences such as risk, size and growth.
Dividend valuation model with constant dividend: P = D ÷ Ke.
Dividend valuation model with constant growth: P0 = D1 ÷ (Ke − g), where D1 is next year's dividend.
The constant growth formula needs Ke greater than g.
Growth can be estimated from past dividends or from retention rate × return on retained funds.
Free cash flow to equity is the cash available to shareholders after tax, reinvestment and debt servicing, and is discounted at the cost of equity.
Weak form EMH: prices reflect past price data. Semi-strong: all public information. Strong: all information, including private.
Every model depends on forecasts and assumptions, so treat results as a range, not an exact figure.
If you are asked to comment, give a reason tied to the scenario, not just a definition.

Models for the valuation of shares practice questions

Models for the valuation of shares in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Models for the valuation of shares: frequently asked questions

Which share valuation model is most important for ACCA FM?

The P/E method and the dividend valuation model are the most common calculations, so know them well. You should still understand asset-based and cash flow methods and be able to compare all of them.

How do I know which valuation model to use in a question?

Look at the data given. Earnings and a P/E ratio point to the market method. A dividend and growth rate point to the dividend model. Forecast cash flows point to the cash flow method. Net asset figures point to the asset basis.

Do I need to learn the efficient market hypothesis in detail?

You need the three forms and what each implies for investors and for company managers. Questions often give a short scenario and ask you to apply the right form, so practise that, not just the definitions.

Are valuation questions only objective test questions?

No. Calculations can appear as objective test questions, where only the final answer earns marks. Valuation can also appear in written Section C questions, for example in a takeover, where you also explain the result and the limits of the models.