CFA Level I Exam · Introduction to Equity Valuation

Absolute vs Relative Valuation Models for CFA Level I

Updated 7 October 2026 · Fact-checked

Absolute valuation estimates a share's intrinsic value from its own cash flows, using models such as the DDM or FCFE. Relative valuation compares price multiples such as P/E with those of peers. Asset-based valuation values assets minus liabilities. Choose the model by the company's dividends, cash flows, comparables and asset types.

Understand Valuation Models: Absolute and Relative Valuation

Valuation means estimating what a share is worth. You then compare that estimate with the market price. If value is above price, the share looks undervalued. If it is below, it looks overvalued.

Absolute valuation (also called intrinsic valuation) values a company on its own fundamentals. The main tools are present value models. These discount expected future cash flows at the required return. The dividend discount model (DDM) discounts dividends. The free cash flow to equity (FCFE) model discounts the cash left for shareholders after reinvestment and debt flows. A third version discounts free cash flow to the firm (FCFF) at the WACC to get firm value, then subtracts debt.

Relative valuation (also called multiplier or market-based valuation) values a company by comparing it with similar companies. You take a price multiple such as P/E, P/B, P/S or an enterprise value multiple such as EV/EBITDA. You apply a benchmark multiple to the company's own earnings, book value or sales. The benchmark can be a peer group average or the company's own history. It tells you how the share is priced relative to others, not what it is worth in isolation.

Asset-based valuation values equity as the fair value of assets minus liabilities. It works best when assets are tangible and easy to value, such as a holding company, a property company or a firm near liquidation. It works poorly for firms whose value comes from intangibles and future growth.

No single model is best. Present value models are rigorous but sensitive to inputs: a small change in growth or discount rate moves value a lot. Multiples are quick and market-aware, but they inherit any mispricing in the peer group. Good analysts use more than one model and explain the differences.

Key formulas to remember

DDM (general form): V₀ = Σ Dₜ ÷ (1 + r)ᵗ, for t = 1 to ∞; r is the required return on equity. Use it when dividends are the cash flows to shareholders.
Gordon growth model: V₀ = D₁ ÷ (r − g); Needs constant growth forever and r > g. D₁ = D₀ × (1 + g).
FCFE valuation: Equity value = Σ FCFEₜ ÷ (1 + r)ᵗ; Discount at the cost of equity. Per-share value = equity value ÷ shares outstanding.
FCFF valuation: Firm value = Σ FCFFₜ ÷ (1 + WACC)ᵗ; Equity value = Firm value − Debt (+ cash if not already in firm value); Discount at WACC, not at cost of equity.
Justified P/E from the Gordon growth model: Justified P/E₁ = (D₁ ÷ E₁) ÷ (r − g), the leading P/E; Links the multiple to payout ratio, growth and required return.
Value from a multiple: Value per share = benchmark multiple × company's metric per share; Example: benchmark P/E × EPS. Metric and multiple must be on the same basis (trailing or forward).
Asset-based value: Equity value = Fair value of assets − Fair value of liabilities; Use fair values, not book values, where they differ.

How to solve Valuation Models: Absolute and Relative Valuation questions

For any question on choosing or applying a valuation model, work through the company's facts and match them to what each model needs.

1Identify what the question asks: intrinsic value, relative pricing, or which model is suitable.
2Classify the model: present value (DDM, FCFE, FCFF), multiplier (P/E, P/B, EV/EBITDA) or asset-based.
3Check the company facts: does it pay stable dividends, have positive predictable free cash flow, have good peers, or hold mainly tangible assets?
4Match facts to the model. Stable dividends and a minority holder point to DDM. Non-dividend payers or control perspectives point to FCFE or FCFF. Comparable listed peers point to multiples. Tangible, liquid assets point to asset-based.
5If calculating, confirm inputs are on the same basis: dividend timing (D₁ not D₀), discount rate matches the cash flow, and multiple matches the metric.
6Calculate and check the result for sense: r must exceed g, and the value should be positive and plausible against price.
7Pick the option consistent with the logic, then eliminate the other two for a stated reason.

Quickest way: Fact-to-model matching

When to use it: Use for 'which model is most appropriate' questions, where you have about 90 seconds and no calculation is needed.

Underline the key fact in the stem: dividends, negative earnings, peers, tangible assets, control.
Stable dividend policy: DDM. Negative or irregular dividends but positive FCF: FCFE or FCFF.
Many comparable firms, quick estimate needed: multiples.
Mostly tangible or liquid assets, or liquidation: asset-based.
Discard options that use a model needing data the company lacks.

Common mistakes in Valuation Models: Absolute and Relative Valuation

Using D₀ instead of D₁ in the Gordon growth model.
The question gives the dividend just paid, and students plug it in directly.
Fix: Always check the timing. If given D₀, compute D₁ = D₀ × (1 + g) before dividing by (r − g).
Discounting FCFF at the cost of equity, or FCFE at WACC.
Students remember 'discount free cash flow' but not which rate pairs with which cash flow.
Fix: FCFF goes with WACC and gives firm value. FCFE goes with cost of equity and gives equity value directly.
Calling relative valuation 'intrinsic'.
Both give a value per share, so they look alike.
Fix: Intrinsic value comes from the company's own cash flows. A multiple only shows value relative to peers, and peers may all be mispriced.
Applying the Gordon growth model when g ≥ r or growth is not stable.
Students apply the formula without testing its conditions.
Fix: Require r > g and constant growth forever. Otherwise a multistage model is needed.
Using asset-based valuation for a growth or intangible-heavy firm.
Book value looks concrete and easy to find.
Fix: Use it only where assets are tangible and fair values can be estimated. Value from intangibles and future growth is missed.
Comparing a trailing multiple of one firm with a forward multiple of another.
Data sources mix bases.
Fix: Match the earnings basis (trailing or forward) and the accounting treatment before comparing.

Worked examples

Example 1

A company just paid a dividend of €2.00 per share. Dividends are expected to grow at 4% a year forever. The required return on equity is 9%. Which is closest to the intrinsic value per share under the Gordon growth model? A) €22.22 B) €41.60 C) €52.00

Show the solution

D₀ = €2.00, g = 4%, r = 9%, so r > g and the model applies.
D₁ = 2.00 × 1.04 = €2.08.
V₀ = D₁ ÷ (r − g) = 2.08 ÷ (0.09 − 0.04) = 2.08 ÷ 0.05 = €41.60.
Check the traps: €22.22 is 2.00 ÷ 0.09 (no growth). €52.00 is 2.08 ÷ 0.04, which divides by g instead of r − g.

Answer: B) €41.60

Example 2

An analyst values a software firm. It pays no dividend, has heavy intangibles, and has several listed peers with similar growth and risk. Which approach is most suitable as the primary method? A) Asset-based valuation using book value B) Dividend discount model with Gordon growth C) Multiplier valuation using peer multiples

Show the solution

The firm pays no dividend, so a DDM has no dividend stream to discount. This removes B.
Value comes mainly from intangibles, so assets minus liabilities will miss most of it. This removes A.
Several comparable listed peers exist, which is the condition multiples need. A price multiple such as P/E or EV/EBITDA can be applied.
An FCFE model would also be reasonable if cash flows were positive, but it is not offered.

Answer: C) Multiplier valuation using peer multiples

Exam tips

Read the company description first. Most 'which model' questions hide the answer in one fact such as 'pays no dividends' or 'holds mainly real estate'.
In Gordon growth questions, check whether the stem gives D₀ or D₁. The wrong option is usually the result of using the wrong one.
Numerical options are listed from smallest to largest. After calculating, check which option is the 'no growth' or 'wrong rate' trap and avoid it.
Remember the pairings: FCFF with WACC gives firm value, FCFE with cost of equity gives equity value.
With three options and no penalty, always answer. Eliminate any model that needs data the company does not have.

Practice questions from Introduction to Equity Valuation

Valuation Models: Absolute and Relative Valuation in other exams

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

Valuation Models: Absolute and Relative Valuation: frequently asked questions

What is the difference between absolute and relative valuation?

Absolute valuation estimates intrinsic value from the company's own expected cash flows, using models such as the DDM or FCFE. Relative valuation compares the company's price multiples with those of peers or its own history. The first asks what the share is worth. The second asks how it is priced against others.

When should I use the dividend discount model instead of P/E?

Use the DDM when the company pays dividends that are stable and predictable, or when you take a minority holder's view. Use P/E when there are comparable listed peers and you want a quick market-based estimate. A justified P/E can also be derived from the DDM, so the two are linked.

When is asset-based valuation appropriate?

It suits companies whose assets are mostly tangible and can be valued at fair value, such as property or holding companies, and firms near liquidation. It is weak for firms whose value comes from intangibles or future growth. Always use fair values, not book values, where they differ.

Why can multiples be misleading?

A multiple only shows pricing relative to the comparison group. If the whole peer group is overvalued, a company that looks cheap may still be overpriced. Differences in growth, risk and accounting also make multiples hard to compare.