Strategic Financial Management · Equity and Bond Valuation and Evaluation of Performance

Equity Valuation Models: Dividend Discount, P/E and FCFE

Updated 11 October 2026 · Fact-checked

Equity valuation finds the intrinsic value of a share as the present value of the cash it will give you. The dividend discount model discounts expected dividends at the cost of equity. P/E and FCFE are alternatives. Pick the model that matches the growth pattern in the question, then discount carefully.

Understand Equity Valuation Models

A share is worth what you expect to receive from it, discounted for time and risk. The cash you receive is dividends, plus a sale price at the end if you sell. The discount rate is the cost of equity (ke), the return shareholders demand for the risk they carry.

The dividend discount model (DDM) turns this into formulas. If dividends grow at a constant rate g forever, the Gordon model gives a simple price. It works only when ke is greater than g. If growth is high for some years and then settles, you use a multi-stage model: value each stage separately and add. The H-model approximates a growth rate that falls in a straight line from a high rate to a stable rate.

The earnings approach values a share as earnings multiplied by a P/E ratio. The P/E comes from comparable companies or from the industry. It is quick, but only as good as the comparison. You can also link P/E to fundamentals: P/E = payout ratio ÷ (ke − g) for a constant-growth firm.

Free cash flow to equity (FCFE) is the cash left for shareholders after operating needs, reinvestment and net borrowing. Use it when dividends do not reflect what the firm could pay out. You discount FCFE at ke in the same way as dividends.

In the exam the real task is choosing the right model and getting the timing right. Always ask: what is the dividend now (D0), what is the next one (D1), and when does growth change?

Key rules to remember

Gordon (constant growth) model: P0 = D1 ÷ (ke − g) = D0 × (1 + g) ÷ (ke − g); Valid only for ke > g and growth constant forever. D1 is next year's dividend.
Cost of equity from Gordon: ke = D1 ÷ P0 + g; Use when the price is given and you need the required return.
Growth from retention: g = b × r; b = retention ratio (1 − payout), r = return on equity (or on retained funds).
General DDM: P0 = Σ Dt ÷ (1 + ke)^t + Pn ÷ (1 + ke)^n; Pn is the expected price at the end of year n, often found by the Gordon model at that date.
Two-stage model: P0 = PV of dividends in high-growth years + [D(n+1) ÷ (ke − gn)] ÷ (1 + ke)^n; gn is the stable growth rate after year n.
H-model: P0 = [D0 × (1 + gL) + D0 × H × (gS − gL)] ÷ (ke − gL); gS = initial high growth, gL = long-term growth, H = half the years over which growth declines linearly.
P/E valuation: Value per share = EPS × P/E ratio; Use the P/E of comparable firms. Check that EPS is the same basis (current or expected).
P/E from fundamentals: P/E = Payout ratio ÷ (ke − g); Uses next year's EPS and payout for a constant-growth firm.
Free cash flow to equity: FCFE = PAT + Depreciation − Capex − Increase in working capital + Net borrowing; Value of equity = PV of FCFE at ke.

How to solve Equity Valuation Models questions

Use this sequence for any equity valuation question.

1Read the growth pattern: constant forever, high then stable, linearly declining, or no growth. This fixes the model.
2Note which dividend is given. Decide whether it is D0 (already paid) or D1 (next due). Convert if needed.
3Find ke. If it is not given, use CAPM: ke = Rf + β × (Rm − Rf), or ke = D1 ÷ P0 + g.
4Find g. If it is not given, use g = retention × ROE.
5For multi-stage cases, list dividends for the high-growth years and discount each at ke.
6Compute the terminal price at the end of the high-growth period with the Gordon model, then discount it back.
7Add the parts to get intrinsic value.
8Compare with market price if asked and state a clear buy, sell or hold view.

Quickest way: Pick the model, fix D1, then discount

When to use it: Use under time pressure when the question gives a clean growth pattern and a required return.

Write ke, g and the dividend with its year label at the top of your answer.
Constant growth: compute D1 and divide by (ke − g). Done.
Two-stage: compute 2 or 3 dividends, find the terminal price from the next dividend, discount all with one factor column.
Declining growth: put numbers straight into the H-model formula.
P/E question: multiply EPS by the P/E. Check that the EPS year matches.
Finish with the comparison to market price and one line of recommendation.

Common mistakes in Equity Valuation Models

Using D0 in the Gordon formula without growing it.
The question gives 'dividend just paid' and students plug it in directly.
Fix: Check the wording. 'Just paid' or 'last year' means D0, so multiply by (1 + g). 'Expected next year' means D1.
Applying the Gordon model when g is greater than or equal to ke.
High-growth rates are used in the formula without checking.
Fix: The constant-growth model works only if ke > g. Use a multi-stage model for temporary high growth.
Discounting the terminal value for the wrong number of years.
Students confuse the year of the last high-growth dividend with the year of the next dividend.
Fix: Terminal price at the end of year n uses D(n+1). Discount that price by (1 + ke)^n.
Misusing H in the H-model.
H is mistaken for the full decline period.
Fix: H is half the number of years over which growth declines. If the decline takes 6 years, H = 3.
Using a P/E from a different earnings basis.
Trailing P/E is applied to forward EPS or the reverse.
Fix: Match the P/E to the same EPS definition, and say so in your answer.
Taking g = retention ratio instead of retention × ROE.
Students forget growth also depends on the return earned.
Fix: Always compute g = b × r.

Worked examples

Example 1

A company paid a dividend of ₹4 per share last year. Dividends are expected to grow at 6% a year for ever. The cost of equity is 14%. The share trades at ₹50. Find the intrinsic value and say whether the share is undervalued or overvalued.

Show the solution

D0 = ₹4, g = 6%, ke = 14%.
D1 = 4 × 1.06 = ₹4.24.
P0 = 4.24 ÷ (0.14 − 0.06) = 4.24 ÷ 0.08 = ₹53.
Compare: intrinsic value ₹53 is above the market price ₹50.

Answer: Intrinsic value is ₹53. The share is undervalued by ₹3, so it is worth buying.

Example 2

A company paid a dividend of ₹2 per share. Dividends will grow at 20% for the next 2 years and then at 5% for ever. The cost of equity is 15%. Find the value of the share.

Show the solution

D1 = 2 × 1.20 = ₹2.40. D2 = 2.40 × 1.20 = ₹2.88.
D3 = 2.88 × 1.05 = ₹3.024.
Price at end of year 2 = 3.024 ÷ (0.15 − 0.05) = ₹30.24.
PV of D1 = 2.40 ÷ 1.15 = ₹2.087.
PV of D2 = 2.88 ÷ 1.3225 = ₹2.178.
PV of terminal price = 30.24 ÷ 1.3225 = ₹22.866.
Total = 2.087 + 2.178 + 22.866 = ₹27.13.

Answer: The intrinsic value of the share is about ₹27.13.

Exam tips

Write whether the given dividend is D0 or D1 before you calculate. Many marks are lost here.
For two-stage problems, show the dividend table, terminal value and discount factors clearly so partial marks are easy to give.
Always end with a recommendation comparing intrinsic value to market price.
In MCQs, check ke > g first. If not, the constant-growth model does not apply.
If ke is not given, look for beta, risk-free rate and market return and use CAPM.

Practice questions from Equity and Bond Valuation and Evaluation of Performance

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 model instead of a multi-stage model?

Use Gordon when dividends grow at one constant rate for ever and ke is greater than g. If growth is high for a few years and then falls, use a two-stage or H-model.

What does H mean in the H-model?

H is half the length of the period over which growth declines linearly from the high rate to the stable rate. If the decline takes 8 years, H is 4.

Is P/E valuation better than the dividend discount model?

Neither is better in all cases. P/E is quick and market-based but depends on comparable firms. DDM is based on cash flows but is sensitive to ke and g.

When do I use FCFE instead of dividends?

Use FCFE when the firm's dividends differ from what it could pay out, such as when it holds back cash or pays little. FCFE shows the cash available to shareholders after reinvestment and net borrowing.