## **Learning Outcomes**

By completing this article, you will be able to compare and apply the dividend valuation model and free cash flow methods for business valuation. You will learn how these approaches estimate firm and equity value, how terminal values and growth are incorporated, and what the main benefits and limitations of each method are. On completion, you should be able to select and justify the most appropriate method in an ACCA AFM exam scenario.

## **ACCA Advanced Financial Management (AFM) Syllabus**

For ACCA Advanced Financial Management (AFM), you are required to understand how business valuation models support investment and acquisition decisions. This article focuses on the following syllabus outcomes:

- Apply dividend valuation and free cash flow methods to value equity for quoted and unquoted entities
- Analyse the use of terminal value and growth assumptions within these models
- Calculate and interpret value using cash flow and dividend-based approaches
- Advise on the suitability and limitations of each method for a given context

## **Test Your Knowledge**

_Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision._

1. According to the dividend valuation model (DVM), which two variables most significantly affect share value?
2. What is the formula for the value of equity using the free cash flow to equity (FCFE) method?
3. A company's equity cash flows are predicted to grow at 2% per year. Its cost of equity is 8%. Last year's dividend was \$3. What is the value per share using the DVM?
4. Briefly state one advantage and one limitation of using FCF-based valuation compared to DVM.

## **Introduction**

Business valuation is central to a range of financial decisions, including mergers and acquisitions, investment analysis, and performance measurement. At ACCA AFM level, two core approaches are often examined: the dividend valuation model and free cash flow methods. Each seeks to determine the value of equity or the whole firm, but the data and assumptions they use can significantly impact conclusions.

A clear understanding of how and when to apply each method, and how growth, terminal value, and risk are treated, is essential to maximise marks in your exam.

## **Dividend Valuation Model (DVM)**

The dividend valuation model calculates equity value as the present value of all future expected dividends.

> **Key Term: dividend valuation model**  
> A method for valuing shares based on the present value of anticipated future dividends, discounted at the cost of equity.

The most used form is the constant growth DVM:

$$
P_0 = \frac{D_0 (1+g)}{k_e - g}
$$

Where:

- $P_0$ = current value per share
- $D_0$ = most recent dividend
- $g$ = expected constant growth rate in dividends
- $k_e$ = shareholders' required rate of return (cost of equity)

This formula is suitable for mature companies paying regular and growing dividends.

> **Key Term: cost of equity**  
> The minimum return required by ordinary shareholders to compensate for risk, often estimated using CAPM or DVM.

### **Worked Example 1.1**

A listed company has just paid a \$0.50 dividend per share and expects dividends to grow at 4% per year. If its cost of equity is 10%, what is the share value using the DVM?

> **Answer:**  
> $$
> P_0 = \frac{0.50 \times 1.04}{0.10 - 0.04} = \frac{0.52}{0.06} = \$8.67
> $$  
> The model suggests a value of \$8.67 per share.

### **Revision Tip**

Always check that $ k_e > g $ in the DVM formula. If not, the result is not valid as the denominator would be zero or negative.

### **Exam Warning**

The DVM assumes dividends will be paid and grow at a constant rate. If the company pays irregular or no dividends, this approach is not suitable.

## **Free Cash Flow Methods**

Free cash flow valuation estimates the value of the entire firm or its equity by discounting cash flows available to all capital providers (FCFF) or equity holders (FCFE).

> **Key Term: free cash flow**  
> Cash generated by a business after all expenses, tax, and necessary reinvestment, which is available for debt repayment, dividends, or growth investments.
>
> **Key Term: free cash flow to equity (FCFE)**  
> The cash flow available for distribution to shareholders after all expenses, interest, tax, and net investment are deducted, and new debt issues added.

### Types of Free Cash Flow Methods

- **FCFF (Free cash flow to the firm):** Values the enterprise (debt plus equity), then subtracts net debt to find equity value.
- **FCFE (Free cash flow to equity):** Values equity directly by discounting future FCFE at the cost of equity.

Both methods handle periods of explicit cash flow forecasts (the planning horizon) followed by a terminal value reflecting ongoing, steady-state operations.

### Terminal Value

> **Key Term: terminal value**  
> The estimated value at the end of the forecast period representing the present value of all subsequent cash flows, usually assuming perpetual growth.

Terminal values are often calculated using a perpetuity formula:

$$
\text{Terminal Value} = \frac{\text{FCF at end of horizon} \times (1+g)}{r - g}
$$
Where $r$ is WACC (for firm value) or cost of equity (for equity value).

### **Worked Example 1.2**

A business forecasts FCFE of \$8 million in five years, expected to grow at 3% thereafter. The cost of equity is 9%. What is the terminal value at year five?

> **Answer:**  
> $$
> \text{Terminal Value} = \frac{8 \times 1.03}{0.09 - 0.03} = \frac{8.24}{0.06} = \$137.33\ \text{million}
> $$

## **Growth Assumptions and Model Selection**

Both DVM and FCF models require an estimate of long-term growth. Growth is typically estimated using historical trends, market analysis, or via the retention model:

$$
g = b \times r
$$

Where $b$ is the retention ratio and $r$ the return on equity.

When selecting a model:

- Use DVM if company reliably pays dividends linked to profit growth.
- Use FCFE if dividends are irregular, or for unlisted companies.
- Use FCFF when valuing the business as a whole, especially for leveraged firms or M&A.

### **Worked Example 1.3**

A private firm generates FCFE of \$500,000, expected to grow at 5% per year. Cost of equity is 12%. Calculate the equity value.

> **Answer:**  
> $$
> \text{Equity Value} = \frac{500,000 \times 1.05}{0.12 - 0.05} = \frac{525,000}{0.07} = \$7,500,000
> $$

## **Strengths and Limitations**

| Approach    | Strengths                                              | Limitations                                |
| ----------- | ------------------------------------------------------ | ------------------------------------------ |
| DVM         | Simple, based on observed cash return to shareholders  | Only for dividend-paying, steady companies |
| FCF Methods | Focuses on cash generation; applies to most businesses | Relies on forecasting; sensitive to inputs |

## **Summary**

Dividend and free cash flow valuation methods provide frameworks for estimating equity or business value based on future cash flows. Their appropriateness depends on dividend policy, capital structure, data availability, and company maturity. Understanding when and how to apply each is essential for ACCA AFM.

## **Key Point Checklist**

_This article has covered the following key knowledge points:_

- Explain how the dividend valuation model estimates share value, with formula and assumptions
- Define and calculate free cash flow, FCFF, and FCFE
- Apply perpetuity and terminal value concepts within valuation
- Identify when to use dividend model or free cash flow methods for business valuation
- Understand the impact of growth and discount rate assumptions on value
- Recognise limitations and strengths of each approach

## **Key Terms and Concepts**

- dividend valuation model
- cost of equity
- free cash flow
- free cash flow to equity (FCFE)
- terminal value

Valuation approaches - Dividend models and free cash flow methods