Calculating Free Cash Flow to the Firm: Method #2: Cash Flow From Operations
February 12, 2025
What is HFT or High Frequency Trading ? HFT or High Frequency Trading is a process where trading in equities, bonds, derivatives, and just about all financial instruments is done through computers driven by algorithms that determine the trading patterns rather than humans trading on the basis of information. In other words, HFT means that […]
In the past module, we concentrated on calculating the returns part of the project. All our articles were focused on calculating cash flows and we saw the various special cases that arise while determining cash flows and determined how we must deal with them. This module is all about the other component i.e. risk. The […]
One can never really understand a subject, unless they know where it came from. Therefore, a short history of the subject of accounting may be of interest to students of accounting. Here is a very brief history of how accounting evolved: Single Entry Accounting System Accounting is as old as financial transactions themselves. As soon […]
Investors who are new to cryptocurrencies tend to find the entire ecosystem confusing and deceptive. When investors try to educate themselves on topics related to cryptocurrencies, they feel like they are attending more of a technical subject course instead of learning about finance. This is the reason why traditional investors have been avoiding cryptocurrencies for […]
Corporate income tax is collected when there is corporate income i.e. when the revenue collected by the corporation exceeds the expenses incurred by this. However, this need not always be the case. It is equally possible that a corporation may incur more expenses than it earns in revenue, thereby incurring a loss. This is truer […]
The next step towards understanding the dividend discount model is to extend the conclusions derived from the single step dividend model. This brings us to the two period dividend discount model. In this model we will use the same logic. However, we will extend the assumption regarding the holding period. Instead of selling his stock at the end of period 1, the investor holds on to the stock and only sells it at the end of period two. The question arises, how the investor should value the stock this time.
Once again, we will understand this with the help of an example:
An investor is confident that a certain stock can be sold off for $100 if it is held on to for 2 years. He has a required rate of return of 10%.He is also confident that the company will pay a $4 dividend in the first year and a $6 dividend in the second year. However, he is not certain about what the price of the stock should be today?
Calculation:
Once again, the value of the stock is only equal to the present value of all future cash flows that can be derived from that stock. In this case, we will receive three different cash flows.
Also, note that the first cash flow will be received at the end of year 1. However, the second and third cash flows will be simultaneously received at the end of year 2.
Hence, we will discount the first dividend of $4 at 10% for 1 period only. However, second dividend plus the final sale proceeds i.e. $6 and $100 are to be received after two years, therefore they will be discounted for 2 periods.
The formula for the two period dividend discount model is:
= [D1/(1+r)]+ [D2+P2/(1+r)2 ]
= [$4/(1.1)]+ [$6+$100/(1.1)2 ]
= $3.7 + $87.6
=$91.3
Thus, from the given assumptions the value of this investment should be equal to $91.3 in present value terms
Once again,
This model too cannot be used on its own for very accurate results. Once again the reason is that it uses hard to predict variables like future price and future dividends as inputs. However, the two step dividend discount model is proof that the concept of discounting dividends can be extended to several years.
This proof will be used in the next article, to finally arrive at the generic dividend discount model. The assumptions in the generic model are comparably more realistic which makes it usable. In fact it is amongst the most preferred equity valuation models used by cautious investors.
Your email address will not be published. Required fields are marked *