Advanced Financial Management · Security Analysis

Equity Valuation Models for CA Final AFM

Updated 5 October 2026 · Fact-checked

Equity valuation models estimate the intrinsic value of a share. Dividend models discount expected dividends at the cost of equity; multiples apply a P/E or EV/EBITDA ratio to earnings. To solve: pick the model, find ke by CAPM if needed, project cash flows, discount, then compare value with market price.

Understand Equity Valuation Models

A share is worth what it will pay you in future, brought to today's value. That is intrinsic value. If intrinsic value is higher than the market price, the share is undervalued and you buy. If it is lower, the share is overvalued.

The dividend discount model (DDM) takes this idea literally. Value today is the present value of all future dividends, discounted at the cost of equity (ke). If you plan to sell after some years, the expected selling price is also discounted, because that price itself reflects later dividends.

The Gordon growth model is the DDM when dividends grow at a constant rate g forever. The next dividend D1 is divided by (ke − g). It works only when ke is greater than g. Use it for stable, mature companies. Multi-stage models handle firms with high growth now and stable growth later: discount the dividends of the high-growth years one by one, then value the stable phase with Gordon at the end of that phase and discount that terminal value back.

Multiples are a shortcut. P/E multiplies EPS by a P/E ratio taken from comparable firms or the industry. EV/EBITDA values the whole firm first; you then subtract net debt to reach equity value. Multiples are quick but depend on how comparable the peers really are.

In the exam, the question usually gives growth through the plowback idea, g = b × r, or gives the cost of equity through CAPM. Read what the question gives, link it to the right model, and show clear working.

Key rules to remember

Dividend discount model (finite holding): P0 = Σ Dt ÷ (1 + ke)^t + Pn ÷ (1 + ke)^n; Pn is the expected price at the end of year n. Discount every cash flow at ke.
Gordon growth model: P0 = D1 ÷ (ke − g) = D0 × (1 + g) ÷ (ke − g); Valid for constant growth forever and ke > g. Check whether the given dividend is D0 or D1.
Cost of equity by CAPM: ke = Rf + β × (Rm − Rf); Rm − Rf is the market risk premium. If Rm is given, subtract Rf first.
Growth from retention: g = b × r, where b = 1 − payout ratio; r is return on equity (or on retained earnings). Use it when the question gives payout and ROE.
Multi-stage terminal value: Pn = Dn+1 ÷ (ke − gn); Gives the value at the end of the high-growth phase. Discount it by (1 + ke)^n.
P/E valuation: Value per share = EPS × P/E ratio; Use the same EPS basis (current or forward) as the P/E ratio.
Justified P/E under Gordon: P/E = Payout ratio × (1 + g) ÷ (ke − g); This is based on trailing EPS (E0); with forward EPS (E1) it is Payout ÷ (ke − g).
EV/EBITDA valuation: Equity value = EBITDA × multiple − Net debt; Net debt = debt − cash. Divide equity value by number of shares for value per share.

How to solve Equity Valuation Models questions

Use this order for almost any equity valuation question. It keeps your working clear and earns step marks.

1Read what is asked: intrinsic value, value per share, or whether the share is under or overvalued.
2Identify the model from the data: finite dividends and a sale price mean DDM; constant growth forever means Gordon; two growth rates mean multi-stage; EPS and peer ratio mean P/E; EBITDA and net debt mean EV/EBITDA.
3Find ke. If it is not given directly, compute it by CAPM. Find g from the data or from b × r.
4Fix the dividend timing: decide whether the dividend given is D0 or D1, and compute every year's dividend.
5Compute the present values. For multi-stage, discount high-growth dividends one by one, then add the discounted terminal value.
6For multiples, apply the multiple to the right base and adjust for debt or cash where needed.
7Compare the value with the market price and state the conclusion: buy if undervalued, sell or avoid if overvalued.
8Write the final answer with units, rupees per share, and a one-line interpretation.

Quickest way: Quick check using Gordon and a discount table

When to use it: Use when the question has constant growth after a few years, or when time is short and you need a reliable structure.

Write ke, g and all dividends in a small list first.
Compute the terminal value in one line: Dn+1 ÷ (ke − g).
Use the discount factor 1 ÷ (1 + ke)^t for each year and multiply once.
Add the discounted dividends and discounted terminal value in a single column.
Sanity check: with g below ke, the Gordon value should be a sensible multiple of D1, roughly 1 ÷ (ke − g).

Common mistakes in Equity Valuation Models

Using D0 in the Gordon formula as if it were D1.
The question gives 'dividend just paid' and students plug it straight into the numerator.
Fix: If D0 is given, compute D1 = D0 × (1 + g) first. If 'expected dividend next year' is given, that is D1.
Applying Gordon when g is equal to or more than ke.
Students apply the formula mechanically without checking the inputs.
Fix: Check ke > g before using the formula. For a high-growth phase, use multi-stage and apply Gordon only to the stable phase.
Forgetting to discount the terminal value.
The terminal value looks like the final answer, so it is added directly.
Fix: Terminal value at year n is discounted by (1 + ke)^n, the same factor as the year-n dividend.
Using a wrong terminal dividend in multi-stage questions.
Students use Dn instead of Dn+1 in the terminal value.
Fix: Compute Dn+1 = Dn × (1 + g stable) and then divide by (ke − g stable).
Treating EV/EBITDA value as equity value.
The multiple gives a number and students divide it by shares directly.
Fix: Subtract net debt (and other claims if given) from enterprise value before dividing by shares.
Taking market return as the risk premium in CAPM.
Rm and (Rm − Rf) are confused when the question gives Rm.
Fix: Write ke = Rf + β(Rm − Rf) every time and read the question to see which one is given.

Worked examples

Example 1

Case: Meridian Ltd just paid a dividend of ₹4 per share. Dividends are expected to grow at 6% a year forever. The risk-free rate is 7%, the market return is 13% and the beta is 1.0. The share trades at ₹70. Is it undervalued or overvalued?

Show the solution

Cost of equity: ke = 7% + 1.0 × (13% − 7%) = 13%.
D0 is ₹4, so D1 = 4 × 1.06 = ₹4.24.
Check ke > g: 13% > 6%, so Gordon applies.
P0 = 4.24 ÷ (0.13 − 0.06) = 4.24 ÷ 0.07 = ₹60.57.
Compare: intrinsic value ₹60.57 is below market price ₹70.

Answer: The intrinsic value is about ₹60.57 per share. The share trades at ₹70, so it is overvalued and should not be bought.

Example 2

Case: Kaveri Ltd expects dividends of ₹2 in Year 1 and ₹2.50 in Year 2. From Year 3 onwards dividends will grow at 5% a year forever. The cost of equity is 15%. Find the value of the share today.

Show the solution

Year 3 dividend: D3 = 2.50 × 1.05 = ₹2.625.
Terminal value at end of Year 2: P2 = 2.625 ÷ (0.15 − 0.05) = ₹26.25.
PV of D1 = 2 ÷ 1.15 = ₹1.739.
PV of D2 = 2.50 ÷ (1.15)² = 2.50 ÷ 1.3225 = ₹1.890.
PV of P2 = 26.25 ÷ 1.3225 = ₹19.849.
Sum: 1.739 + 1.890 + 19.849 = ₹23.478.

Answer: The intrinsic value of the share is about ₹23.48.

Exam tips

Underline whether the dividend is D0 or D1 before you write anything. This single check saves marks in Gordon and multi-stage sums.
Show ke, g and the terminal value on separate lines. Examiners give step marks even if arithmetic slips.
In case-scenario MCQs, estimate first: Gordon value is roughly D1 divided by (ke − g). This helps you reject wrong options quickly.
End every valuation with a decision statement comparing intrinsic value to market price.
For written answers on multiples, mention one limit, such as dependence on comparable firms, to earn the interpretation marks.

Practice questions from Security Analysis

Equity Valuation Models in other exams

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

Equity Valuation Models: frequently asked questions

When should I use the Gordon growth model instead of multi-stage?

Use Gordon when growth is constant forever and ke is above g. If the question gives different growth rates for different periods, use multi-stage and apply Gordon only to the final stable phase.

How do I find g if it is not given?

Use g = b × r, where b is the retention ratio (1 − payout) and r is the return on equity. You can also compute it from past dividends if the question gives them.

Is the P/E valuation based on current or expected EPS?

It depends on the P/E ratio supplied. Use the EPS basis that matches the ratio: current EPS with a trailing P/E, expected EPS with a forward P/E.

How do I go from EV/EBITDA to the value per share?

Multiply EBITDA by the multiple to get enterprise value. Subtract net debt to get equity value, then divide by the number of shares.