CFA Equity Valuation Notes: Dividend Discount Model, Free Cash Flow and Multiples [Level 1]

CFA Level 1 equity valuation comes down to three tools: the dividend discount model, free cash flow models, and price multiples. Each tool answers the same question in a different way: what is a share worth, given the cash it is expected to generate? This note works through each model with numbers you can follow line by line, then shows how to choose between them on exam day.

Related revision on this site: CFA Level 1 Inventory Notes: FIFO, LIFO, Write-Downs and Long-Lived Assets.

CFA Equity Valuation in One View

CFA equity valuation values a share by discounting expected dividends or free cash flow, or by comparing price multiples with peers, and the right model depends on whether the firm pays steady dividends, generates forecastable cash flow, or has comparable peers.

First, consider the logic that ties all three tools together. An absolute valuation model, such as the dividend discount model or a free cash flow model, estimates intrinsic value from the cash flows themselves. A relative valuation model, such as a price multiple, estimates value by comparing the share with similar firms. Absolute models demand more assumptions. Relative models demand better peers.

CFA Equity Valuation: The Dividend Discount Model

The dividend discount model values a share as the present value of all expected future dividends. However, the difficulty is forecasting dividends forever, which is why the exam tests simplified versions of the model.

Among these simplifications, the Gordon growth model is the most tested, also called the constant growth model. It assumes dividends grow at one constant rate forever, and that the required return exceeds the growth rate. The formula is:

V0 = D1 / (r minus g)

Here V0 is value today, D1 is the dividend expected one year from now, r is the required return on equity, and g is the constant dividend growth rate. The most common error in this formula is the dividend timing. If the question gives the dividend just paid, D0, you must grow it one year first: D1 = D0 x (1 + g). If the question already gives next year dividend, use it directly and do not grow it again.

Worked example: Gordon growth model

A firm just paid a dividend of $2.40 per share. Dividends are expected to grow at 4% per year forever. The required return on equity is 10%. What is the value of one share?

Step 1: Find next year dividend. D1 = $2.40 x 1.04 = $2.496.

Step 2: Find the denominator. r minus g = 0.10 minus 0.04 = 0.06.

Step 3: Divide. V0 = $2.496 / 0.06 = $41.60.

One share is worth $41.60 under these assumptions. In particular, notice how sensitive the answer is to the gap between r and g. If growth rose to 6% with the same required return, value would jump to $2.544 / 0.04 = $63.60. That sensitivity is why the Gordon model only suits mature, stable dividend payers.

Where the growth rate comes from

The exam often asks you to estimate g from fundamentals rather than giving it directly. The sustainable growth rate formula is g = b x ROE, where b is the retention rate, which equals 1 minus the dividend payout ratio, and ROE is return on equity. Worked example: a firm pays out 40% of earnings as dividends, so it retains 60%. ROE is 15%. Then g = 0.60 x 0.15 = 0.09, or 9%. This formula assumes the firm keeps its capital structure and profitability stable.

CFA Equity Valuation: Multistage Dividend Discount Models

Real firms rarely grow at one rate forever. A multistage model splits the future into phases: a high growth phase, then a stable phase. In a two-stage model, you forecast dividends year by year through the high growth phase, then add a terminal value at the end of that phase using the Gordon formula with the stable growth rate. The terminal value is a value at that future date, so it must be discounted back to today.

Worked example: a firm just paid $1.80 per share. Dividends will grow at 12% per year for two years, then at a stable 4% per year forever. The required return is 11%.

Step 1: Forecast the explicit dividends. D1 = $1.80 x 1.12 = $2.016. D2 = $2.016 x 1.12 = $2.25792.

Step 2: Find the terminal value at the end of year 2. First find D3 = $2.25792 x 1.04 = $2.34824. Then V2 = $2.34824 / (0.11 minus 0.04) = $2.34824 / 0.07 = $33.55, rounded to two decimal places.

Step 3: Discount everything to today. Present value of D1 = $2.016 / 1.11 = $1.82. For D2, the present value is $2.25792 / 1.11 squared = $1.83. The terminal value discounts to $33.5462 / 1.11 squared = $27.23. Add them: $1.82 + $1.83 + $27.23 = $30.88.

One share is worth $30.88. In practice, two checks keep this calculation honest. First, the terminal value must use D3, the first dividend of the stable phase, not D2. Second, the terminal value dominates the answer here, at $27.23 of the $30.88 total, which is normal for a multistage model and also a warning: if your stable growth assumption is wrong, your whole valuation is wrong.

CFA Equity Valuation: Free Cash Flow Models, FCFF and FCFE

Many firms pay no dividend, or pay a dividend that says little about their cash generation. Free cash flow models solve that problem by valuing the cash the business produces, whether or not it is paid out. There are two versions, and mixing them up is the single most expensive error in this topic.

FCFF = EBIT x (1 minus tax rate) + depreciation and amortization minus capital expenditure minus increase in working capital

FCFF is discounted at the weighted average cost of capital, WACC, because it belongs to all capital providers. Consequently, the result is enterprise value, the value of the whole firm. To get equity value, subtract net debt, which is total debt minus cash, and adjust for any other senior claims. Then divide by shares outstanding to get value per share.

Free cash flow to equity, FCFE, is cash available to equity holders only, after interest and net borrowing. It can be built from FCFF:

FCFE = FCFF minus interest x (1 minus tax rate) plus net borrowing

Similarly, FCFE is discounted at the cost of equity only, because it belongs to shareholders alone. The result is equity value directly, with no debt bridge needed. In addition, note the tax shield: interest enters after tax, because interest reduces taxable profit. Forgetting the (1 minus tax rate) term on interest is a classic exam trap.

Feature	FCFF	FCFE
Cash flow belongs to	Debt holders and equity holders	Equity holders only
Discount rate	WACC	Cost of equity
Direct result	Enterprise value	Equity value
Bridge to equity value	Subtract net debt	None needed
Best when	Capital structure is changing	Leverage is stable and borrowing is forecastable

Worked example: FCFF to value per share

A firm reports EBIT of $120 million, a tax rate of 25%, depreciation and amortization of $18 million, capital expenditure of $30 million, and a working capital increase of $10 million. FCFF this year is therefore $120 million x 0.75 + $18 million minus $30 million minus $10 million = $68 million.

Assume FCFF grows at 3% per year forever and WACC is 9%. Next year FCFF = $68 million x 1.03 = $70.04 million. Enterprise value = $70.04 million / (0.09 minus 0.03) = $70.04 million / 0.06 = $1,167.33 million.

The firm has debt of $300 million and cash of $40 million, so net debt is $260 million. Equity value = $1,167.33 million minus $300 million plus $40 million = $907.33 million. With 20 million shares outstanding, value per share = $907.33 million / 20 million = $45.37.

Run the trap check before you finish any FCFF question. Did you discount at WACC, not the cost of equity? Next, did you subtract net debt, not gross debt? Finally, did you use next year cash flow in the terminal formula, not this year cash flow?

CFA Equity Valuation: Price Multiples, Trailing Versus Forward

Price multiples value a share relative to peers. The exam tests four core multiples, and each one has a natural use and a natural failure mode.

Price to earnings, P/E, equals price per share divided by earnings per share. For example, it suits profitable firms with stable earnings. It misleads when earnings are negative, depressed by a one-off event, or inflated by aggressive accounting. Trailing P/E uses earnings from the past twelve months. Forward P/E uses forecast earnings for the next twelve months, so it reflects expected growth but inherits forecast error.

Enterprise value to EBITDA, EV/EBITDA, equals enterprise value divided by earnings before interest, tax, depreciation, and amortization. Enterprise value equals market value of equity plus total debt minus cash. In contrast, EV/EBITDA suits comparisons across firms with different capital structures, because it values the whole firm before financing choices. It misleads when depreciation is a real economic cost, as in asset-heavy businesses.

Price to book, P/B, equals price per share divided by book value per share. It suits asset-heavy firms such as banks, where book value means something concrete. It misleads for service and technology firms, where the most valuable assets never appear on the balance sheet at full value.

Price to sales, P/S, equals price per share divided by sales per share. In turn, it is the fallback when earnings are negative, because sales are rarely negative. It misleads because it ignores margins entirely.

Worked example: four multiples from one firm

A share trades at $63. Earnings per share for the past year are $4.20, and forecast earnings per share for next year are $4.80. Book value per share is $28. Sales per share are $90. The firm has 10 million shares, debt of $200 million, cash of $50 million, and EBITDA of $65 million.

Trailing P/E = $63 / $4.20 = 15.0. Forward P/E = $63 / $4.80 = 13.1. The forward multiple is lower because the market expects earnings growth, and the denominator is larger.

Enterprise value = ($63 x 10 million) + $200 million minus $50 million = $780 million. EV/EBITDA = $780 million / $65 million = 12.0.

P/B = $63 / $28 = 2.25. P/S = $63 / $90 = 0.70.

In short, read the set together, not one multiple at a time. A low forward P/E with a high P/B can mean growth is expected but the market already pays a premium for book value. A low P/S with a high P/E can mean thin margins.

CFA Equity Valuation: Choosing the Model

Situation	Best model	Why
Mature firm, steady dividend, stable payout	Gordon growth model	Dividends are a credible proxy for cash returned to shareholders
Fast growth now, stable growth later	Multistage dividend model	One growth rate cannot describe both phases
No dividend, or dividend unrelated to cash flow	FCFF or FCFE model	Values cash generated, not cash paid out
Capital structure changing	FCFF at WACC	Structure-neutral until the final debt bridge
Leverage stable, borrowing forecastable	FCFE at cost of equity	Goes straight to equity value
Good peers, need a quick cross-check	Price multiples	Fast, but only as good as the peer set
Negative earnings	P/S, or EV/EBITDA if positive	P/E and P/B can be meaningless or misleading

CFA Equity Valuation: Exam Traps

First, dividend timing. D0 must be grown to D1 before it enters the Gordon formula. Second, growth versus return. If g is equal to or greater than r, the Gordon model breaks down, and the answer is not a negative value, it is that the model does not apply. Third, discount rate matching. FCFF pairs with WACC, FCFE pairs with cost of equity, and swapping them is wrong even if the cash flow is right. Fourth, the debt bridge. FCFF gives enterprise value, so forgetting to subtract net debt overstates equity value. Fifth, trailing versus forward. A forward multiple uses forecast earnings, so a question that gives both trailing and forward earnings is testing whether you pick the right denominator. Sixth, peer quality. A multiple is only useful if the peers share similar growth, risk, and capital structure.

Revision Box: CFA Equity Valuation in One Page

• Gordon model: V0 = D1 / (r minus g). Grow D0 to D1 first. Requires r greater than g.
• Sustainable growth: g = retention rate x ROE.
• Multistage model: discount explicit dividends, add terminal value from the first stable-phase dividend, discount the terminal value too.
• FCFF = EBIT x (1 minus tax rate) + depreciation and amortization minus capex minus working capital increase. Discount at WACC, then subtract net debt for equity value.
• FCFE = FCFF minus after-tax interest plus net borrowing. Discount at cost of equity to equity value directly.
• Trailing multiples use past results. Forward multiples use forecasts.
• EV = market value of equity + debt minus cash.
• P/B suits asset-heavy firms. P/S is the fallback for negative earnings but ignores margins.
• Model choice follows the firm: steady dividends, DDM; no useful dividend, free cash flow; good peers, multiples as a cross-check.

CFA Equity Valuation FAQ

When does the Gordon growth model fail?

Specifically, it fails when dividends are not stable, when growth is not close to constant, when the firm pays no dividend, or when the growth rate approaches or exceeds the required return. In those cases use a multistage model, a free cash flow model, or multiples instead.

Why is FCFF discounted at WACC and not at the cost of equity?

Because FCFF belongs to debt holders and equity holders together. In other words, WACC blends the cost of both funding sources, so it matches the cash flow. Discounting FCFF at the cost of equity alone would mismatch the cash flow and the claimants.

What is the difference between trailing and forward P/E?

Trailing P/E divides price by earnings from the past twelve months. Forward P/E divides price by forecast earnings for the next twelve months. Trailing is factual but backward looking. On the other hand, forward is forward looking but only as reliable as the forecast.

Can a negative P/E be used?

No. A negative P/E has no sensible ranking: a more negative P/E does not mean cheaper. Therefore, when earnings are negative, switch to P/S, EV/EBITDA if EBITDA is positive, or an absolute model.

Which model should I use if the firm pays a dividend but growth is uneven?

Use a multistage dividend model. Forecast the high growth phase year by year, then apply the Gordon formula for the stable phase terminal value, and discount both parts to today.

Sources

Formulas in this note follow the standard CFA Level 1 equity valuation treatment: Gordon growth model V0 = D1 / (r minus g) and sustainable growth g = b x ROE, as set out at AnalystPrep, Gordon Growth Dividend Discount Model, CFA Level 1, and FCFF and FCFE definitions, discount rates, and the enterprise to equity bridge, as set out at Soleadea, CFA Level 1 FCFF and FCFE. All worked examples are original, with arithmetic checked line by line.