Advanced Financial Management · Valuation and the use of free cash flows

Business Valuation Methods and Free Cash Flow Compared

Updated 11 October 2026 · Fact-checked

Business valuation methods estimate what a company or its shares are worth. Asset-based methods value what the firm owns, P/E and EV/EBITDA use multiples of earnings, the dividend model values dividends, and free cash flow discounts future cash. In AFM, compute the value, then compare the methods and explain which is most suitable.

Understand Other Valuation Methods and Comparison with Free Cash Flow

A valuation puts a number on a business. No single method is right. Each method looks at the business from a different angle, so each gives a different answer. AFM asks you to calculate and then judge.

Asset-based methods value what the company owns. Net asset value is assets minus liabilities. Replacement cost or realisable values can be used instead of book values. This works for asset-rich or break-up situations, such as property companies. It ignores future earnings and most intangibles, so it undervalues service and technology firms.

Earnings-based methods apply a multiple to a profit figure. The P/E method gives equity value = earnings × P/E. The EV/EBITDA method gives enterprise value = EBITDA × multiple. You then deduct net debt to reach equity value. Multiples are quick and market-linked. But they come from peers, which are never identical, and they rely on one year's profit.

Dividend valuation values a share as the present value of its future dividends. It suits a minority shareholder who cannot control dividends. It breaks down when the firm pays no dividends or when payout is a policy choice rather than a measure of performance.

Free cash flow valuation discounts the cash a business can pay to its capital providers. FCFF is discounted at WACC to give enterprise value. FCFE is discounted at the cost of equity to give equity value. It captures growth, reinvestment and risk explicitly. Its weakness is sensitivity: a small change in growth rate or discount rate moves value a lot, and terminal value is often most of the total.

In the exam, the best answer links method to context. An acquirer wanting control and with access to forecasts favours free cash flow. A quick cross-check uses multiples. A break-up or distressed case favours assets.

Key rules to remember

Net asset value: Equity value = Total assets − Total liabilities; Adjust assets to fair value or realisable value if the question gives figures. Exclude or adjust items as instructed.
P/E valuation: Equity value = Earnings attributable to ordinary shareholders × P/E ratio; Per share: EPS × P/E. Use a P/E from a comparable company, adjusted for risk, growth and gearing differences.
Earnings yield: Earnings yield = EPS ÷ Share price = 1 ÷ P/E; Value = Earnings ÷ earnings yield.
EV/EBITDA valuation: Enterprise value = EBITDA × EV/EBITDA multiple; Equity value = Enterprise value − Net debt; Net debt = debt − cash. Add back any other claims given, such as preference shares.
Dividend valuation model with growth: P0 = D0 × (1 + g) ÷ (Ke − g); Needs constant growth g, and Ke > g. The value is ex-dividend, so D0 is the dividend just paid.
Gordon growth estimate: g = b × r; b = proportion of earnings retained, r = return on new investment. Use it if the question gives these.
FCFF valuation: Enterprise value = Σ FCFFt ÷ (1 + WACC)^t + Terminal value ÷ (1 + WACC)^n; Terminal value with growth g = FCFF(n+1) ÷ (WACC − g). Equity value = EV − debt (+ cash if not netted).
FCFE valuation: Equity value = Σ FCFEt ÷ (1 + Ke)^t + Terminal value ÷ (1 + Ke)^n; FCFE = FCFF − interest × (1 − tax) + net new borrowing.

How to solve Other Valuation Methods and Comparison with Free Cash Flow questions

Use this order for any question that asks you to value a business and compare methods.

1Read the requirement. Note whether it wants equity value or enterprise value, and whether it wants calculation, comment or both.
2List what data the question gives: balance sheet, earnings, EBITDA, dividends, forecast cash flows, peer multiples, WACC, Ke, growth. The data tells you which methods are expected.
3Calculate each method asked for. Label the result clearly as enterprise or equity value.
4Convert enterprise value to equity value by deducting net debt. Convert equity value to a per-share figure if the question asks.
5Check that the method and discount rate match: FCFF with WACC, FCFE and dividends with Ke, P/E and EBITDA with peer multiples.
6Compare the results. Explain why they differ, for example different time horizons, growth assumptions or treatment of intangibles.
7Recommend the most suitable method or a value range, given the purpose: takeover, minority stake, flotation or break-up.
8State key assumptions and limits, such as peer comparability, terminal value share and forecast reliability, to earn professional skills marks.

Quickest way: Value, bridge, compare in three lines

When to use it: Use when time is short and the question asks for several valuations and a short comment.

Write each value on its own line with a label: EV or equity, and the method.
Do the net debt bridge straight away so every figure is on an equity basis.
Add one comment per method: one strength, one weakness, one reason it suits or does not suit this scenario.
Finish with a single recommendation sentence tied to the purpose of the valuation.

Common mistakes in Other Valuation Methods and Comparison with Free Cash Flow

Applying an EV/EBITDA multiple and treating the result as equity value.
Students forget that EBITDA is earned for all capital providers, not just shareholders.
Fix: Always deduct net debt after applying the multiple. Write 'EV' on the line, then 'less net debt', then 'equity value'.
Discounting FCFF at the cost of equity, or FCFE at WACC.
Students memorise one discount rate and use it for every cash flow.
Fix: Match the cash flow to the claim. FCFF goes with WACC because it is before financing. FCFE goes with Ke because it belongs to shareholders.
Using the dividend model with D0 instead of D0 × (1 + g) in the numerator.
The formula is learned loosely and the timing of the dividend is ignored.
Fix: Check whether the dividend given is the one just paid (D0) or the next one (D1). Grow D0 by (1 + g) if it is just paid.
Using a P/E ratio from a peer without adjustment and calling it reliable.
Students treat the multiple as a fact rather than an estimate from an imperfect comparison.
Fix: Comment on differences in size, growth, risk, gearing and accounting policies. Consider a discount, for example for an unquoted company, only if the question supports it.
Dismissing asset-based valuation as useless.
Students focus on cash flow methods because they dominate the syllabus.
Fix: Say when it is useful: asset-rich firms, break-up values and a floor value for negotiations. Also say what it misses: intangibles and future earnings.
Listing method features without linking them to the scenario.
Students recall a generic table of pros and cons.
Fix: Tie every comment to a fact in the case, such as no dividends paid, high growth or heavy intangibles. This earns application and professional skills marks.

Worked examples

Example 1

Zeta Ltd has EBITDA of $12 million. A listed peer trades at an EV/EBITDA multiple of 7. Zeta has debt of $20 million and cash of $4 million, and 10 million shares in issue. Estimate Zeta's enterprise value, equity value and value per share.

Show the solution

Enterprise value = EBITDA × multiple = $12m × 7 = $84m.
Net debt = $20m − $4m = $16m.
Equity value = $84m − $16m = $68m.
Value per share = $68m ÷ 10m = $6.80.

Answer: Enterprise value $84 million, equity value $68 million, $6.80 per share. The result depends on how comparable the peer is to Zeta.

Example 2

Alpha plc has just paid a dividend of $0.50 per share. Dividends are expected to grow at 4% a year indefinitely and the cost of equity is 9%. Alpha's earnings per share are $1.20. Calculate the value per share using the dividend valuation model and the P/E ratio this implies. Comment briefly on whether the dividend model suits a bidder seeking control.

Show the solution

Next dividend D1 = $0.50 × 1.04 = $0.52.
P0 = D1 ÷ (Ke − g) = $0.52 ÷ (0.09 − 0.04) = $0.52 ÷ 0.05 = $10.40.
Implied P/E = $10.40 ÷ $1.20 = 8.67 (to two decimal places).
Comment: the model values only the dividend stream a minority holder would receive.
A bidder with control can change dividend policy, investment and financing, so free cash flow better reflects the value to it.
The model is also very sensitive to g, because Ke − g is small.

Answer: Value per share is $10.40, implying a P/E of about 8.67. The dividend model suits minority holders. A bidder seeking control should rely more on free cash flow valuation, with the dividend value as a cross-check.

Exam tips

Read the requirement for the word 'compare' or 'evaluate'. These need reasoned discussion linked to the scenario, not only calculations.
Always state whether each number is enterprise or equity value. Marks are often lost on a missing net debt adjustment.
Show a value range from several methods and explain why they differ. A single number with no cross-check looks weak.
Use the data given as a hint. If no dividends are mentioned, the dividend model is unlikely to be the intended method. If forecast cash flows are given, expect free cash flow valuation.
Keep comments short and specific to the case. Spend remaining time on the recommendation and key assumptions to earn professional skills marks.

Practice questions from Valuation and the use of free cash flows

Other Valuation Methods and Comparison with Free Cash Flow in other exams

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

Other Valuation Methods and Comparison with Free Cash Flow: frequently asked questions

What is the difference between the dividend valuation model and free cash flow valuation?

The dividend model values only the dividends paid to shareholders. Free cash flow valuation values the cash available to capital providers, whether or not it is paid out. Free cash flow is better for control situations and for companies with low or no dividends.

When should I use P/E rather than DCF in AFM?

Use P/E as a quick, market-linked estimate when you have reliable peer data and stable earnings. Use DCF when you have detailed forecasts and need to reflect growth, investment and risk explicitly. Strong answers often use both and explain the gap.

Why does EV/EBITDA need a net debt adjustment?

EBITDA belongs to all providers of capital, so the multiple gives enterprise value. Shareholders own only what is left after debt holders. You deduct net debt to reach equity value.

Is asset-based valuation ever the best method?

Yes, for asset-rich companies, break-up or liquidation cases, and as a minimum price in negotiations. It is a poor choice for businesses whose value comes from intangibles or future earnings.