Advanced Financial Management · Valuation for acquisitions and mergers

Dividend Valuation Model and Growth for ACCA AFM

Updated 11 October 2026 · Fact-checked

The dividend valuation model values a share as the present value of its future dividends. With constant growth, P0 = D0(1 + g) ÷ (Ke − g). You estimate g from past dividends or from the Gordon growth model, g = b × r, where b is the retention ratio and r is the return on retained funds.

Understand Dividend Valuation Model and Growth

A share is worth what its owner will receive from it. For a shareholder who holds the share for ever, that is the stream of future dividends. The dividend valuation model (DVM) discounts those dividends at the shareholders' required return, the cost of equity (Ke).

If dividends grow at a constant rate g every year for ever, the infinite series collapses to a simple formula: P0 = D0(1 + g) ÷ (Ke − g). The value is a share price at time 0 that is ex-div, meaning the next dividend D1 has not yet been paid. The model only works if Ke is greater than g.

You need g. There are two ways to get it. The historical method looks at past dividends and finds the average annual growth: g = (latest dividend ÷ earliest dividend)^(1 ÷ n) − 1, where n is the number of years of growth, not the number of dividends. The Gordon growth model looks forward: g = b × r. Here b is the proportion of earnings retained, and r is the return earned on the new investment (often approximated by ROE or ROCE).

In acquisition questions, you use the DVM to value the target's shares on a dividend basis. You may also use it to test the effect of synergies. A better dividend policy or higher retention at a higher return raises g, and that raises value. The model is sensitive: a small change in g or Ke makes a large change in price, so you should say this in your commentary.

The model has limits. It assumes constant growth for ever, it ignores that dividends may be a poor guide for a controlling bidder who can change the policy, and it is weak for firms paying no dividends. In AFM you earn professional skills marks by stating these limits and suggesting another method, such as free cash flow valuation.

Key rules to remember

Dividend valuation model (constant growth): P0 = D0(1 + g) ÷ (Ke − g) = D1 ÷ (Ke − g); P0 is ex-div. Valid only when Ke > g. If the dividend just due has not been paid, add it to get the cum-div value.
Cost of equity from the DVM: Ke = D1 ÷ P0 + g; Use this to find Ke when you know the share price.
Historical dividend growth: g = (D latest ÷ D earliest)^(1 ÷ n) − 1; n is the number of growth periods, i.e. number of dividends minus 1.
Gordon growth model: g = b × r; b = retention ratio = 1 − payout ratio. r = return on retained funds, usually ROE or ROCE as the question states.
Retention ratio: b = 1 − (dividends ÷ earnings); Payout ratio is dividends ÷ earnings.
Cum-div value: Cum-div value = ex-div value + dividend due; Be clear which basis the question asks for.

How to solve Dividend Valuation Model and Growth questions

Use this order for any DVM and growth question. It keeps the timing and the growth estimate right.

1Read the requirement. Decide whether you need a share price, a cost of equity, a growth rate, or a total equity value.
2Write down D0, the date it was paid, and Ke or P0. Note whether the price given is cum-div or ex-div.
3Estimate g. Use the historical method if you are given a series of dividends. Use g = b × r if you are given retention and returns. State which one you use and why.
4Compute D1 = D0 × (1 + g). Do not forget this step.
5Apply P0 = D1 ÷ (Ke − g), or Ke = D1 ÷ P0 + g. Check that Ke is greater than g.
6For an acquisition, multiply the value per share by the number of shares to get equity value. Compare with the offer price or the premium.
7Comment on limits: sensitivity to g and Ke, constant growth assumption, dividend policy under new control. Link back to the scenario.

Quickest way: Three-line DVM check

When to use it: Use this when time is short and the question gives D0, g or b and r, and Ke.

Find g first. If b and r are given, g = b × r. Write it as a percentage.
Multiply D0 by (1 + g) to get D1.
Divide D1 by (Ke − g). Sense-check: the price should be roughly D1 divided by a small percentage, so a figure far above 20 times D1 means g is close to Ke. Say that in your note.

Common mistakes in Dividend Valuation Model and Growth

Using D0 instead of D1 in the formula.
The last dividend is the one in the question, so it is quick to use.
Fix: Always write D1 = D0(1 + g) as a separate line before dividing.
Using the number of dividends as n when finding historical growth.
Students count the dividends instead of the gaps between them.
Fix: Four dividends mean three years of growth. n = number of dividends − 1.
Using the payout ratio instead of the retention ratio in g = b × r.
The question gives the dividend payout, and the two are easy to swap.
Fix: Compute b = 1 − payout first and write it down.
Ignoring cum-div and ex-div.
The wording is a small detail in the scenario.
Fix: Circle the word. If the price is cum-div, subtract the dividend due before using it in Ke = D1 ÷ P0 + g.
Applying the model when g is greater than or equal to Ke.
A high short-term growth rate is used as if it lasts for ever.
Fix: Check Ke > g. If not, say the model fails and use a multi-stage or free cash flow method.
Giving a number with no comment.
Students treat it as a pure calculation.
Fix: Add two or three points on limits and what the result means for the bid. These earn professional skills marks.

Worked examples

Example 1

Target Ltd paid a dividend of $0.50 per share this year. Dividends were $0.40 four years ago. Its cost of equity is 12%. Estimate the ex-div share value using the historical growth rate.

Show the solution

Growth: (0.50 ÷ 0.40)^(1 ÷ 4) − 1. 0.50 ÷ 0.40 = 1.25. The fourth root of 1.25 is about 1.0574. So g is about 5.74%.
D1 = 0.50 × 1.0574 = $0.5287.
Ke − g = 0.12 − 0.0574 = 0.0626.
P0 = 0.5287 ÷ 0.0626 = $8.45 (rounded).

Answer: The ex-div value is about $8.45 per share. It is highly sensitive to g, so you should say that the figure is an estimate.

Example 2

Victor plc earns $2.00 per share and pays out 40% as dividends. It retains the rest and earns a return of 15% on retained funds. Ke is 11%. The dividend just paid is $0.80. Value the share ex-div, and say how a bidder who raises retention to 60% at the same return would change the value.

Show the solution

Current retention b = 1 − 0.40 = 0.60. g = 0.60 × 0.15 = 9%.
D1 = 0.80 × 1.09 = $0.872.
P0 = 0.872 ÷ (0.11 − 0.09) = 0.872 ÷ 0.02 = $43.60.
Now test the bidder's case. The question gives a new retention of 60%, which is the same as the current 60%, so g is unchanged at 9% and the value does not change.
Comment: to change value, retention or return must change. If retention rose to 70%, g would be 10.5%, but the dividend would fall to 30% of earnings, so D1 would need recalculating.

Answer: The ex-div value is $43.60. Moving retention to 60% changes nothing because it is already 60%. The value only moves if retention or the return on retained funds changes, and you must recalculate D1 when the payout changes.

Exam tips

Show every step: g, D1, then the price. Marks are given for method even if g is slightly off.
State which growth method you used and why. If both are possible, calculate both and compare.
Always check Ke > g and comment if the result looks unreasonable.
In acquisition questions, link the DVM value to the offer price and say what premium is being paid.
Add the limits of the model in a short closing paragraph for professional skills marks.

Practice questions from Valuation for acquisitions and mergers

Dividend Valuation Model and Growth in other exams

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

Dividend Valuation Model and Growth: frequently asked questions

What is the dividend valuation model in ACCA AFM?

It values a share as the present value of its expected future dividends, discounted at the cost of equity. With constant growth, P0 = D0(1 + g) ÷ (Ke − g). It is often used to value a target company.

How do I calculate the dividend growth rate?

Use the historical method, g = (latest dividend ÷ earliest dividend)^(1 ÷ n) − 1, where n is the number of years of growth. Or use the Gordon growth model, g = b × r, if you are given the retention ratio and the return on retained funds.

What is the retention ratio in the Gordon growth model?

It is the share of earnings kept in the business, which equals 1 minus the payout ratio. Multiply it by the return earned on retained funds to estimate the growth rate.

When does the dividend valuation model not work?

It fails if g is equal to or higher than Ke, if the firm pays no dividends, or if growth is not constant. In those cases consider a multi-stage dividend model or free cash flow valuation.