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Dividend discount models are the first type of discounted cash flow models that we will study. The model simply discounts cash flows at a given rate just like any other DCF model. The difference lies in the fact that dividend discount models consider only “dividends” as being legitimate cash flows.
Therefore, if a firm pays no dividends at all, this model cannot be applied to the firm regardless of how profitable or cash flow efficient its operations are. This is one of the most popular models used to value businesses worldwide. The popularity stems from the fact that this model has some major advantages. The purpose of this article is to discuss these advantages and bring to the student’s attention, when this model will be useful.
Justification:The primary advantage of the dividend discount model is that it is grounded in theory. The justifications are rock solid and indisputable. The logic is simple. A business is a perpetual entity. When an investor buys a share of the business, they are basically paying a price today which entitles them to enjoy the benefits of all the dividends that the corporation will pay throughout its lifetime.
Hence, the value of the firm is basically the value of a perpetual never ending stream of dividends that the buyer intends to receive later with the passage of time. Hence, many analysts believe that there is absolutely no subjectivity involved in this model and the logic is crystal clear.
Consistency: A second advantage of the dividend discount model is the fact that dividends tend to stay consistent over long periods of time. Companies experience a lot of volatility in measures like earnings and free cash flow. However, companies usually ensure that dividends are only paid out from cash which is expected to be present with the company every year. They do not set up unnecessarily high dividend expectations because not living up to those expectations makes the stock price plummet at a later date. Companies are very specific and announce any additional dividend as a one-time dividend.
No Subjectivity:There is no ambiguity regarding the definition of dividends. Whereas there is subjectivity as to what constitutes earnings and what constitutes free cash flow. Therefore, even if different analysts are asked to come up with a valuation for a company using a discounted dividend model, it is likely that they will come up with more or less the same valuation. This lack of subjectivity makes the model more reliable and hence more preferred.
No Requirement of Control: Dividends are the only measure of valuation available to the minority shareholder. While institutional investors can acquire big stakes and actually influence the dividend payout policies, minority shareholders have no control over the company. Thus, the only thing that they can be sure about is that fact that they will receive dividend year on year because they have been receiving it consistently in the past. Hence, as far as minority shareholders are concerned, dividends are really the only metric that they can use to value a corporation.
Mature Businesses:The regular payment of dividends is the sign that a company has matured in its business. Its business is stable and there is not much expectation of turbulence in the future unless something drastic happens. This information is valuable to many investors who prefer stability over possibility of quick gains. Thus, from a valuation point of view, it is far easier to arrive at a discount rate. Since consistency eliminates risk, dividends are generally discounted at a lower rate as compared to other metrics that can be used in valuation.
To sum it up, dividend discount models are preferred by two kinds of investor groups. One investor group consists of retail investors who prefer it because of their lack of control to influence the payout policies. The other investor group consists of risk averse investors who prefer it because of the stability and risk aversion which are built into this model.
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Calculating Free Cash Flow to the Firm: Method #2: Cash Flow From Operations
February 12, 2025
