Calculating Free Cash Flow to the Firm: Method #2: Cash Flow From Operations
February 12, 2025
In the previous articles, we have discussed that the money market has various sub-sections. One of the most important sub-markets is the commercial paper market. The commercial paper market accounts for a sizeable amount of funds that flow through the money market. In this article, we will have a closer look at the details of […]
We now have a fair understanding of what the concepts of free cash flow to the firm is. We also know how to calculate this metric under various circumstances. It is now time to use this metric to arrive at the final valuation for a given firm which is the objective of the whole exercise. […]
We live in a world which idolizes innovation. We tend to idolize companies which have produced some products which can be considered to be innovative. The underlying belief in the capitalistic system is that innovation is beneficial. It is innovation which creates more value, and since the capitalistic system allows the creator of innovation to […]
Financial modeling is not a perfect science. In fact, it would be fair to say that financial modeling is part art and part science. This is because the specific steps required to create a financial model cannot be chalked out. However, there is a broad framework which needs to be followed in order to create […]
The Black Wednesday of 1992 refers to the momentous day when the British Pound was under attack by currency speculators. This day created history in the Foreign Exchange markets because of the fact that the Pound was considered to be one of the strongest fiat currencies in the world. In fact it was the reserve […]
The dividend discount model is also used to measure the value of preference equity in addition to forecasting the value of ordinary equity.
There are certain assumptions and clarifications that need to be made regarding the use of dividend discount model for valuing preference equity.
The purpose of this article is to provide this information in an easy to understand manner.
Just to remind the readers, preference shares are securities which can be thought of as being mid-way between debt and equity. Preference shareholders do not get a variable return.
Rather they get a fixed rate of return like debt holders. Thus it does not face the risks of an equity shareholder and also does not get the slow return of a bond holder. It is somewhere in between these two extremes.
This is because payments to preference shares are not legally mandatory. If the company makes a profit, they must receive their fixed dividend before the ordinary shareholders are paid.
These defining characteristics of preference shares lead to certain implications. They are as follows:
Whether, it will be constant as in the case of the dividend discount model or whether they will grow at a constant rate like in Gordon growth model. The cash flow timings and amounts are almost certain in case of preference shares
Also, if the firm does not make a profit in any given year, then the preference shareholders will not get paid.
The valuation of preference shares is a very straightforward exercise. Usually preference shares pay a constant dividend. This dividend is the percentage of the face value of the share. For instance, a preference share with the face value of $100 which pays 5% dividend will pay $5 in dividends.
Hence, if the required rate of return of an investor is 10%, then the value of the preference share can be arrived at using the simple formula
Value (Preference Share) = D/r
Where,
D is the constant dollar amount of dividends being received
And r is the required rate of return for the investor
Hence, the value of this preference share would be $5/0.1 = $50
The risks that the firm can call the bonds back or the profits may not be paid as preferred dividends in a certain year have not been considered in this formula. Hence, if any of these risks is foreseeable, the value derived from the formula i.e. $50 in this case, needs to be reduced to account for that risk.
A plain vanilla preference share can be easily valued using the dividend discount model. A plain vanilla preferred share is nothing but perpetuity! For more exotic and complex types of preference shares, the initial value is derived from the model and then adjustments are made to account for the risks that have been missed out.
Your email address will not be published. Required fields are marked *