Calculating Free Cash Flow to the Firm: Method #2: Cash Flow From Operations
February 12, 2025
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The dividend discount model also has its fair share of criticism. While some have hailed it as being indisputable and being not subjective, recent academicians and practitioners have come up with arguments that make you believe the exact opposite.
Recent studies have unearthed some glaring flaws in what was considered to be a perfect valuation model.
This article is focused on understanding these shortcomings. This knowledge will help us understand when not to apply the dividend discount model.
High growth companies, by definition face lots of opportunities in the future. They may want to develop new products or explore new markets. To do so, they may need more cash than they have on hand. Hence such companies have to raise more equity or debt. Obviously they cannot afford the luxury of having the cash to pay out dividends. These companies are therefore missed by investors who are focused too much on the dividends.
For instance, investors following the dividend discount model would never have invested in companies like Google or Facebook. Even, a global behemoth like Microsoft did not have any track record of paying dividends until very recently. Hence, according to dividend discount model, these companies cannot be valued at all!
Many investors prefer an alternate approach. They try to forecast the time when the growing company will actually evolve into a mature stable business and will start paying out dividends. However, this is extremely difficult.
The projections become more and more risky as we try to project farther and farther into the future. Thus, we can conclude that the dividend discount models have limited applicability.
There have been instances where companies have been simultaneously borrowing cash while maintaining a dividend payout. In this case, this is a clear incorrect utilization of resources and paying dividends is eroding value. Hence, assuming that dividends are directly related to value creation is a faulty assumption until it is backed by relevant data.
In these countries most of the companies will not pay out dividends because it leads to dilution of value. Any investor who only strictly believes in dividend discount model will have no option but to ignore all the shares pertaining to that particular country! This is one more reason why dividend discount model fails to guide investors.
Therefore, dividend discount model is not very useful for investors who want to invest in high risk return companies. Also, it may not be in alignment with the tax structures being followed by certain countries.
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