A share’s market price is what someone will pay for it today. Its intrinsic value is an estimate of what it is really worth, based on the cash it is expected to generate for shareholders. Investors who estimate intrinsic value can judge whether a share looks cheap or expensive. This article covers the main methods — dividend discount models, price multiples and the link to discounted cash flow — and how value and growth investors use them.
What you will learn
- Value a share with the Gordon growth and two-stage dividend discount models
- Use P/E, P/B and dividend yield to compare shares
- Understand how sensitive valuations are to assumptions
- Describe value, growth and dividend investing approaches
Absolute and relative valuation
- Absolute (intrinsic) valuation estimates value from expected cash flows and a required return — dividend discount models and discounted cash flow (DCF).
- Relative valuation compares a share’s price with similar companies using multiples such as price-to-earnings.
Good analysis often uses both and investigates why they differ.
The dividend discount model
The value of a share equals the present value of all expected future dividends, discounted at the investor’s required return (the cost of equity).
Gordon growth model
P₀ = D₁ ÷ (r − g)
where D₁ is next year’s dividend, r the required return and g the constant long-term dividend growth rate (g must be less than r). The model is named after Gordon (1959).
Worked example: constant growth
A company has just paid a dividend of 5.00. Dividends are expected to grow at 6% a year forever, and investors require 12% (illustrative figures).
- Next dividend: D₁ = 5.00 × 1.06 = 5.30.
- Value: P₀ = 5.30 ÷ (0.12 − 0.06) = 88.33.
- Implied dividend yield: 5.30 ÷ 88.33 = 6.0%; the remaining 6% of the return comes from growth.
If the share trades at 100, the market is implying either a lower required return or higher growth. Rearranging, g = r − D₁ ÷ P₀ = 12% − 5.3% = 6.7%.
How sensitive is the answer?
| Value | g = 5% | g = 6% | g = 7% |
|---|---|---|---|
| r = 11% | 87.50 | 106.00 | 133.75 |
| r = 12% | 75.00 | 88.33 | 107.00 |
| r = 13% | 65.63 | 75.71 | 89.17 |
A one-percentage-point change in either input moves the value by 15–50%. Intrinsic value is a range, not a precise number — always test assumptions with sensitivity analysis.
Two-stage growth
Many companies grow quickly for a period before settling into slower, stable growth.
Worked example: two-stage dividend discount model
The current dividend is 4.00. Dividends grow at 15% for three years, then at 5% forever. The required return is 12% (illustrative figures).
| Year | Dividend | Present value at 12% |
|---|---|---|
| 1 | 4.600 | 4.107 |
| 2 | 5.290 | 4.217 |
| 3 | 6.083 | 4.330 |
| Total | 12.65 |
- Dividend in year 4: 6.083 × 1.05 = 6.388.
- Value at the end of year 3: 6.388 ÷ (0.12 − 0.05) = 91.25.
- Present value of that: 91.25 ÷ 1.123 = 64.95.
- Share value: 12.65 + 64.95 = 77.61.
Most of the value — 84% — comes from the period after year 3, which is why long-term assumptions matter so much.
For companies that pay little or no dividend, analysts value the free cash flow available to equity or to the whole firm instead — see the DCF model.
Price multiples
| Multiple | Formula | Typical use |
|---|---|---|
| Price-to-earnings (P/E) | Share price ÷ earnings per share | Most common comparison of profitable companies |
| Price-to-book (P/B) | Share price ÷ book value per share | Banks, insurers and asset-heavy companies |
| Dividend yield | Dividend per share ÷ share price | Income investing |
| EV/EBITDA | Enterprise value ÷ EBITDA | Comparing companies with different debt levels |
| PEG ratio | P/E ÷ expected earnings growth (%) | Adjusting P/E for growth |
Worked example: valuing with peer multiples
A company has earnings per share of 8.00 and book value per share of 60.00. Comparable listed companies trade at a median P/E of 12 and P/B of 1.5 (illustrative figures).
- P/E-based value: 8.00 × 12 = 96.00.
- P/B-based value: 60.00 × 1.5 = 90.00.
A range of about 90–96 can be compared with the market price and with the dividend model. Check the inputs with the P/E calculator, EPS calculator and dividend yield calculator.
Multiples are quick and reflect current market conditions, but they assume the peer group is fairly valued and genuinely comparable in growth, risk and accounting. A low P/E can signal a bargain — or a business in decline.
Value, growth and dividend investing
- Value investing, associated with Benjamin Graham, buys shares trading well below a conservative estimate of intrinsic value, leaving a margin of safety for errors.
- Growth investing pays higher multiples for companies expected to grow earnings rapidly; the risk is paying too much if growth disappoints.
- Dividend investing focuses on companies with reliable and growing dividends — see dividend policy.
All three rely on the same valuation principles; they differ in which companies they find attractive and how much uncertainty they accept.
Common mistakes
- Using a growth rate equal to or higher than the required return in the Gordon model.
- Assuming high recent growth will continue indefinitely.
- Comparing P/E ratios across companies with very different growth, risk or accounting.
- Treating a single valuation as precise rather than a range.
- Ignoring the quality of earnings — see cash flow and earnings quality.
Key terms
- Intrinsic value — an estimate of a share’s worth from its expected cash flows.
- Dividend discount model — values a share as the present value of expected dividends.
- P/E ratio — share price divided by earnings per share.
- Margin of safety — the gap between intrinsic value and the price paid.
- Relative valuation — valuing a company by comparison with similar companies.
Frequently asked questions
Which valuation method is best?
No single method is best. DCF or dividend models show what drives value; multiples show how the market prices similar companies. Use both.
Why do share prices differ from intrinsic value?
Because investors hold different expectations, and sentiment, liquidity and information all affect prices. Markets may also be more efficient than an analyst’s estimate.
What is a good P/E ratio?
It depends on growth, risk, interest rates and the industry. Compare with peers and the company’s own history rather than a fixed number.
Key takeaways
- Intrinsic value is the present value of expected cash flows to shareholders.
- The Gordon model P₀ = D₁ ÷ (r − g) is simple but highly sensitive to r and g.
- Two-stage models suit companies whose growth will slow; terminal value often dominates.
- Multiples such as P/E and P/B give a market-based cross-check, if peers are truly comparable.