Calculating Free Cash Flow to the Firm: Method #2: Cash Flow From Operations
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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.
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