Advanced Financial Management · Security Valuation

Equity Valuation: Dividend Discount Models for CA Final AFM

Updated 5 October 2026 · Fact-checked

The dividend discount model values a share as the present value of all future dividends, discounted at the cost of equity. For constant growth use P0 = D1 ÷ (Ke − g). For multistage growth, discount each dividend in the high-growth phase, then add the discounted terminal value found with the Gordon formula.

Understand Equity Valuation: Dividend Discount Models

A share gives you a stream of dividends. If you hold it forever, its worth today is what that stream is worth today. So you discount each expected dividend at the cost of equity (Ke), the return shareholders demand for the risk. The sum is the intrinsic value.

Forever is hard to forecast, so we assume a pattern. If dividends stay flat, the share is a perpetuity. If they grow at a constant rate g forever, we get the Gordon growth model. It needs Ke to be greater than g, otherwise the value is meaningless.

Many firms do not grow at one rate forever. A young firm may grow fast for a few years and then settle to a stable rate. For this, use a multistage model: forecast dividends year by year for the high-growth period, then at the start of stable growth apply the Gordon formula to get a terminal value. Discount that value back too.

Compare intrinsic value with market price. If intrinsic value is higher, the share looks undervalued and is a buy. If lower, it looks overvalued. The model is only as good as your Ke, g and dividend inputs.

When growth is not given, you can estimate it as g = b × r, where b is the retention ratio and r is the return on equity (ROE). This links valuation to the firm's dividend policy.

Key rules to remember

General dividend discount model: P0 = Σ Dt ÷ (1 + Ke)^t, for t = 1 to ∞; Value today is the present value of all future dividends.
Zero growth: P0 = D ÷ Ke; Dividend stays the same every year forever.
Constant growth (Gordon model): P0 = D1 ÷ (Ke − g) = D0 × (1 + g) ÷ (Ke − g); Valid only when Ke > g. D1 is next year's dividend, not the last one paid.
Implied cost of equity: Ke = (D1 ÷ P0) + g; Use when market price is given and you need the return expected.
Growth rate from retention: g = b × r, where b = 1 − payout ratio; r is return on equity. Assumes constant b and r.
Gordon value with retention: P0 = E1 × (1 − b) ÷ (Ke − b × r); This is Gordon's model. E1 is next year's EPS. Same as Gordon with D1 = E1 × (1 − b) and g = b × r.
Two-stage model: P0 = Σ Dt ÷ (1 + Ke)^t (t = 1 to n) + [Dn+1 ÷ (Ke − gn)] ÷ (1 + Ke)^n; gn is the stable growth rate after year n. Terminal value is at end of year n.
Holding period model: P0 = Σ Dt ÷ (1 + Ke)^t (t = 1 to n) + Pn ÷ (1 + Ke)^n; Use when the expected selling price Pn at year n is given.

How to solve Equity Valuation: Dividend Discount Models questions

Use this sequence for any dividend discount question. It keeps the timing of dividends right, which is where most marks are lost.

1Identify what is given: last dividend D0 or next dividend D1, EPS, payout, ROE, Ke, growth rates and the length of each stage.
2Fix Ke. If it is not given, compute it, for example by CAPM: Ke = Rf + β × (Rm − Rf).
3Decide the pattern: zero growth, constant growth, or multistage. Check Ke > g for any stage you capitalise.
4Build the dividend timeline year by year. Grow D0 at the right rate for each year.
5Find the terminal value at the end of the high-growth stage using Dn+1 ÷ (Ke − g).
6Discount each dividend and the terminal value at (1 + Ke)^t. Use the same year count for both.
7Add the present values to get intrinsic value P0.
8Compare with market price and state the conclusion: undervalued, overvalued or fairly priced.

Quickest way: Gordon first, then discount the terminal value

When to use it: Use when a question has a short high-growth phase of 2 to 5 years followed by stable growth, and time is short.

Write D0, Ke, and each growth rate in one line at the top.
Compute dividends for the high-growth years only and note the last one, Dn.
Compute Dn+1 = Dn × (1 + stable g) and terminal value TV = Dn+1 ÷ (Ke − g).
Use a discount factor column: 1 ÷ (1 + Ke)^t for t = 1 to n. Multiply each dividend and TV by the right factor.
Sum and write one line of conclusion against market price.

Common mistakes in Equity Valuation: Dividend Discount Models

Using D0 in the Gordon formula instead of D1.
The question gives the dividend just paid and students plug it straight in.
Fix: Check wording. If the dividend is 'just paid' or 'last year', multiply by (1 + g) to get D1. If 'expected next year', use it as D1.
Discounting the terminal value by the wrong number of years.
Students discount it by n + 1 because the formula uses Dn+1.
Fix: The Gordon formula gives value at end of year n. Discount TV by (1 + Ke)^n, the same as the last high-growth dividend.
Applying Gordon when g ≥ Ke.
A high-growth rate is used in the perpetuity without checking.
Fix: Only capitalise a stable growth rate below Ke. Use high growth only for the explicit forecast years.
Mixing up growth rate with retention ratio.
Both are percentages and the question gives payout instead of retention.
Fix: Compute b = 1 − payout, then g = b × ROE. Write it out before using it.
Using EPS instead of dividend in the numerator.
EPS is given prominently and the payout ratio is overlooked.
Fix: Dividend = EPS × payout ratio. Only use EPS directly if the firm pays out 100% of earnings.
Forgetting to conclude on under- or overvaluation.
Students stop after finding intrinsic value.
Fix: Always compare with market price in the last line and state the action.

Worked examples

Example 1

A company just paid a dividend of ₹10 per share. Dividends are expected to grow at 6% every year forever. Shareholders require a return of 14%. The share trades at ₹120. Find the intrinsic value and say whether the share is undervalued or overvalued.

Show the solution

D0 = ₹10, g = 6%, Ke = 14%. Ke > g, so Gordon applies.
D1 = 10 × 1.06 = ₹10.60.
P0 = D1 ÷ (Ke − g) = 10.60 ÷ (0.14 − 0.06) = 10.60 ÷ 0.08 = ₹132.50.
Compare: intrinsic value ₹132.50 is higher than market price ₹120.

Answer: Intrinsic value is ₹132.50. The share is undervalued by ₹12.50, so it is a buy.

Example 2

A company has just paid a dividend of ₹2 per share. Dividends will grow at 20% for the next 3 years and then at a stable 5% forever. The cost of equity is 15%. Calculate the intrinsic value of the share.

Show the solution

Dividends: D1 = 2 × 1.20 = ₹2.40. D2 = 2.40 × 1.20 = ₹2.88. D3 = 2.88 × 1.20 = ₹3.456.
D4 = 3.456 × 1.05 = ₹3.6288.
Terminal value at end of year 3 = D4 ÷ (Ke − g) = 3.6288 ÷ (0.15 − 0.05) = 3.6288 ÷ 0.10 = ₹36.288.
Discount factors at 15%: year 1 = 0.8696, year 2 = 0.7561, year 3 = 0.6575.
PV of D1 = 2.40 × 0.8696 = ₹2.087. PV of D2 = 2.88 × 0.7561 = ₹2.178. PV of D3 = 3.456 × 0.6575 = ₹2.272.
PV of TV = 36.288 × 0.6575 = ₹23.859.
Sum = 2.087 + 2.178 + 2.272 + 23.859 = ₹30.396.

Answer: Intrinsic value is about ₹30.40 per share.

Exam tips

Read the dividend wording closely. 'Just paid' means D0. 'Expected next year' means D1. This one check protects most of your marks.
Show the timeline of dividends in a small table. Examiners give marks for method even if arithmetic slips.
If Ke is not given, look for CAPM data such as risk-free rate, beta and market return, and compute Ke first.
In case-scenario MCQs, estimate quickly: P0 ≈ D1 ÷ (Ke − g). Check the options against this before doing long working.
End every answer with a comparison to market price and a clear recommendation.

Practice questions from Security Valuation

Equity Valuation: Dividend Discount 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: Dividend Discount Models: frequently asked questions

What is the difference between the Gordon model and the dividend discount model?

The dividend discount model is the general idea that value equals the present value of all future dividends. The Gordon model is a special case where dividends grow at a constant rate forever. It reduces the infinite sum to P0 = D1 ÷ (Ke − g).

When should I use the two-stage model?

Use it when the question gives a fast growth rate for a fixed number of years and a different, lower rate afterwards. You value the first stage dividend by dividend and the second stage with the Gordon formula. Then you add both present values.

What if the company pays no dividend now?

The model needs a dividend forecast. If the firm starts paying later, discount only the dividends from that point, and apply Gordon from the year growth becomes stable. Where dividends are never paid, other models such as free cash flow to equity are used.

How do I find g if the question does not give it?

Use g = b × r, where b is the retention ratio and r is the return on equity. For example, a 40% payout gives b = 60%, and with ROE of 15% g = 9%. You can also compute it from past dividend data if given.