Corporate Accounting and Financial Management · Security Analysis

Valuation of Equity Shares: Dividend Discount, Gordon and P/E Methods

Updated 11 October 2026 · Fact-checked

Equity share valuation finds the intrinsic value of a share. Under the dividend discount model, value is the present value of expected dividends plus the sale price. Under Gordon's model, P0 = D1 ÷ (ke − g). Under the P/E method, value = EPS × P/E ratio. Pick the method that fits the data given.

Understand Valuation of Equity Shares

The intrinsic value of a share is what it is worth based on the cash it will give you. For an equity share, that cash is the dividends you receive and the price at which you sell. You discount these to today at the investor's required rate of return, ke.

The dividend discount model (DDM) states this directly. If you hold a share for n years, value today = present value of each year's dividend + present value of the expected sale price in year n. If you hold it forever, the sale price drops out and value is the present value of all future dividends.

Gordon's growth model is the DDM when dividends grow at a constant rate g forever, and ke is greater than g. The infinite series collapses into one line: P0 = D1 ÷ (ke − g). Note that D1 is next year's dividend, not the dividend just paid. If g = 0, the formula becomes P0 = D ÷ ke, a plain perpetuity.

Earnings-based valuation uses the market's multiple. The P/E ratio is market price ÷ EPS. If a comparable company or industry trades at a given P/E, you estimate value = EPS × P/E. The inverse, EPS ÷ P0, is the earnings yield. You can also capitalise earnings: value = EPS ÷ required earnings yield.

For preference shares, dividends are fixed. Value is the present value of the fixed dividend plus the redemption value if redeemable. If irredeemable, value = dividend ÷ required return. Equity needs a growth or earnings assumption because its dividends are not fixed.

Key rules to remember

Dividend discount model (finite holding): P0 = D1 ÷ (1 + ke) + D2 ÷ (1 + ke)² + … + Dn ÷ (1 + ke)ⁿ + Pn ÷ (1 + ke)ⁿ; Use when you are given dividends for a few years and an expected selling price.
Zero growth (constant dividend): P0 = D ÷ ke; Dividend stays the same forever.
Gordon's growth model: P0 = D1 ÷ (ke − g); Valid only when ke > g. D1 = D0 × (1 + g).
Growth rate from retention: g = b × r; b is the retention ratio and r is the return on equity (ROE). Use when growth is not given directly.
Implied cost of equity: ke = D1 ÷ P0 + g; Rearranged Gordon's model, used when market price is given.
P/E valuation: Value per share = EPS × P/E ratio; P/E ratio = market price per share ÷ EPS.
Earnings capitalisation: Value per share = EPS ÷ required earnings yield; Same as using P/E = 1 ÷ earnings yield.
Irredeemable preference share: P0 = Preference dividend per share ÷ kp; Fixed dividend perpetuity.
Redeemable preference share: P0 = Σ Dt ÷ (1 + kp)ᵗ + Redemption value ÷ (1 + kp)ⁿ; Discount the dividends and the redemption amount at the required return.

How to solve Valuation of Equity Shares questions

Use this sequence for any equity valuation question. It stops you from using the wrong dividend or the wrong rate.

1Read what is asked: intrinsic value today, value after a holding period, or a comparison with the market price.
2Identify the method from the data: dividends for a few years plus sale price means DDM; constant growth means Gordon; EPS and P/E means earnings method.
3Write down ke (required return) and g. If g is not given, check for retention ratio and ROE and compute g = b × r.
4Find the right dividend. For Gordon, D1 = D0 × (1 + g). Check whether the question gives the dividend just paid or next year's expected dividend.
5Apply the formula. For DDM, discount each cash flow using (1 + ke)ⁿ and add them.
6Check that ke > g in Gordon's model. If not, the model does not work.
7If asked, compare intrinsic value with market price: undervalued if intrinsic value is higher, overvalued if lower, so buy or sell accordingly.
8State the final value with a one-line conclusion.

Quickest way: Pick the formula from the data

When to use it: Use this under time pressure when the question gives limited numbers and you must start fast.

If you see EPS and P/E, multiply them. Done.
If you see a growth rate and a last dividend, compute D1 first, then divide by (ke − g).
If you see dividends for 2 to 5 years and a sale price, build a small table: year, cash flow, discount factor, present value.
If you see retention and ROE, find g = b × r first.
If you see market price and need ke, use ke = D1 ÷ P0 + g.
Always write the formula before substituting numbers so you earn method marks.

Common mistakes in Valuation of Equity Shares

Using D0 instead of D1 in Gordon's model
The question gives the dividend just paid and students plug it in directly.
Fix: Check the wording. If it says 'has just paid' or 'last dividend', multiply by (1 + g) first.
Forgetting to discount the sale price in the DDM
Students discount the dividends but treat the final price as a plain add-on.
Fix: Discount the expected price at year n by (1 + ke)ⁿ, the same way as the dividend of that year.
Using the growth formula when ke is not greater than g
Students apply the formula mechanically without checking the rates.
Fix: Compare ke and g before calculating. If ke ≤ g, note that Gordon's model gives no meaningful value.
Using the dividend payout as growth
Retention ratio and payout ratio get mixed up.
Fix: g = b × r where b = 1 − payout ratio. Compute retention first.
Applying the P/E ratio to dividend or to total profit
The ratio is remembered as a multiple but the base is forgotten.
Fix: Multiply P/E by EPS to get price per share. For total value, multiply by total profit after tax and preference dividend, or by number of shares.
Rounding discount factors too early
Students round to one or two decimals to save time.
Fix: Use at least three decimals or the factors given in the question.

Worked examples

Example 1

A company has just paid a dividend of ₹10 per share. Dividends are expected to grow at 5% a year forever. Investors require a return of 15%. Find the intrinsic value of the share. If the market price is ₹90, is the share undervalued or overvalued?

Show the solution

D0 = ₹10, g = 5% = 0.05, ke = 15% = 0.15.
D1 = D0 × (1 + g) = 10 × 1.05 = ₹10.50.
ke − g = 0.15 − 0.05 = 0.10.
P0 = D1 ÷ (ke − g) = 10.50 ÷ 0.10 = ₹105.
Compare: intrinsic value ₹105 is more than market price ₹90.

Answer: Intrinsic value is ₹105 per share. The share is undervalued at ₹90, so it is worth buying.

Example 2

Mehta Ltd expects to pay dividends of ₹4 in year 1 and ₹5 in year 2. You expect to sell the share at ₹60 at the end of year 2. Your required return is 10%. Find the value of the share today. Also find the value using the P/E method if EPS is ₹8 and the industry P/E is 9.

Show the solution

Year 1 dividend: PV = 4 ÷ 1.10 = ₹3.636.
Year 2 dividend: PV = 5 ÷ (1.10)² = 5 ÷ 1.21 = ₹4.132.
Sale price: PV = 60 ÷ 1.21 = ₹49.587.
DDM value = 3.636 + 4.132 + 49.587 = ₹57.355, about ₹57.36.
P/E value = EPS × P/E = 8 × 9 = ₹72.

Answer: DDM value is about ₹57.36 per share. P/E value is ₹72 per share. The two methods use different assumptions, so state which one the question requires.

Exam tips

Write the formula first, then substitute. Marks are given for method even if arithmetic slips.
Read whether the dividend given is D0 or D1. Most Gordon's model errors come from this.
When growth is not given, look for retention ratio and ROE in the question and compute g = b × r.
End with a conclusion: undervalued, overvalued or fairly priced, with the action an investor should take.
Practise ke = D1 ÷ P0 + g as well, since questions often reverse the formula.

Practice questions from Security Analysis

Valuation of Equity Shares in other exams

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

Valuation of Equity Shares: frequently asked questions

What is the Gordon growth model formula?

P0 = D1 ÷ (ke − g). P0 is the value today, D1 is next year's dividend, ke is the required return and g is the constant growth rate. It works only when ke is greater than g.

How do you value a share using the P/E ratio?

Multiply the company's EPS by a suitable P/E ratio, usually that of comparable firms or the industry. The result is the estimated price per share. Make sure EPS is after tax and after preference dividend.

Is the dividend discount model used if a company pays no dividend?

The basic model needs dividends, so it is hard to apply to a company that pays none. In such a case, you use earnings-based methods like P/E, or you estimate future dividends. In exam questions, follow the data given.

How do you value preference shares?

Discount the fixed dividend and the redemption value at the required return for a redeemable share. For an irredeemable one, divide the annual dividend by the required return.