Comparison of Present Value Models

• [a] Compare and contrast dividends, free cash flow, and residual income as variables used in discounted cash flow models and determine the investment situations that are appropriate for each measure.



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• 00:28 – Introduction to Present Value Models
• 00:46 – Dividend Discount Model (DDM)
• 03:11 – Free Cash Flow Model (FCFM)
• 05:33 – Residual Income Model (RIM)
• 06:56 – Summary: Choosing the Right Model

Comparison of Present Value Models

Introduction to Present Value Models

Present Value (PV) models, also known as discounted cash flow (DCF) models, determine a stock’s intrinsic value by estimating its future cash flows and discounting them back to their present value. The fundamental principle is that the value of an asset today is the sum of the present values of all cash flows it is expected to generate in the future.

The general formula for intrinsic value under these models is:

\[ \text{Intrinsic Value} = \sum \text{PV(Expected Future Cash Flows)} \]

The primary difference between the main PV models lies in how they define “cash flow.” The three major classes of models are:

• Dividend Discount Model (DDM): Defines cash flow as dividends paid to shareholders.
• Free Cash Flow Model (FCFM): Defines cash flow as the cash generated by the company before or after meeting its debt obligations.
• Residual Income Model (RIM): Defines cash flow as earnings in excess of the investors’ required return on capital.

1. Dividend Discount Model (DDM)

The DDM defines cash flow from the shareholder’s perspective, using the dividends they expect to receive. The value of the stock is the present value of all future dividends.

Advantages of the DDM

• Theoretically Justified: Dividends are the only cash flow that a shareholder directly receives from the company. The model is based on the sound principle that an investment is worth the present value of its future returns.
• Less Volatile: Dividends are generally more stable and predictable than earnings or free cash flows. Companies are often reluctant to cut dividends, so dividend streams tend to be smoother, leading to more stable valuation estimates. This reflects the long-term earning potential of the company.

Disadvantages of the DDM

• Not Applicable to Non-Dividend-Paying Firms: The model is difficult to implement for companies that do not currently pay dividends (e.g., many growth companies). While one can forecast when dividends might begin, this introduces significant uncertainty.
• Minority Shareholder Perspective: The DDM inherently takes the perspective of a minority shareholder who has no control over the firm’s dividend policy. The valuation is based on the dividends the company chooses to pay out, not what it could pay out.
• Dependence on Dividend Policy: The model’s usefulness is compromised if the firm’s dividend policy is not aligned with its profitability. A controlling shareholder could manipulate dividend payments, making the DDM valuation less meaningful for minority shareholders.

When to Use the Dividend Discount Model

The DDM is most appropriate when the following conditions are met:

• The company has a history of paying dividends.
• The valuation is for a minority shareholder who cannot influence dividend policy.
• The company’s dividend policy is clear and consistently related to its profitability.
• The company is in the mature stage of its life cycle, where earnings are stable and a significant portion is paid out as dividends.

2. Free Cash Flow Model (FCFM)

Free cash flow models are useful when a company does not pay dividends or when the valuation is from a control perspective. Free cash flow represents the cash that a company can generate after accounting for capital expenditures.

Types of Free Cash Flow

• Free Cash Flow to the Firm (FCFF): The cash flow available to all capital providers (both debt and equity holders). To find the value of equity using FCFF, you discount FCFF at the Weighted Average Cost of Capital (WACC) to get the firm’s value, and then subtract the market value of debt. \[ \text{Value of Equity} = \left( \sum \frac{\text{FCFF}_t}{(1 + \text{WACC})^t} \right) – \text{Market Value of Debt} \]
• Free Cash Flow to Equity (FCFE): The cash flow available to equity holders after all expenses and debt payments (principal and interest) are made. It represents the cash that could potentially be paid out as dividends. FCFE is discounted at the cost of equity (\(k_e\)) to find the value of equity directly. \[ \text{Value of Equity} = \sum \frac{\text{FCFE}_t}{(1 + k_e)^t} \]

Advantages of the FCFM

• Broad Applicability: Can be used for firms that do not pay dividends. FCFE serves as a proxy for the company’s capacity to pay dividends.
• Control Perspective: FCF models are particularly useful for a controlling shareholder, as they can influence the firm’s policies and decide how to deploy its free cash. It is also relevant for valuing a company in a potential acquisition.

Disadvantages of the FCFM

• Negative Free Cash Flow: Firms with significant capital requirements, such as startups or those in a rapid growth phase, often have negative free cash flow for extended periods. This makes valuation using FCFM difficult and less reliable, as the value is heavily dependent on a distant terminal value.

When to Use the Free Cash Flow Model

• The company does not pay dividends, or its dividend policy is not reflective of its profitability.
• The valuation perspective is that of a controlling shareholder.
• The firm’s free cash flow is positive and corresponds with its profitability (i.e., not a high-growth firm with persistently negative FCF).

3. Residual Income Model (RIM)

The Residual Income model defines value based on earnings and the cost of capital. Residual income is the net income of a firm less a charge for the opportunity cost of the capital invested by equity holders.

\[ \text{Residual Income}t = \text{Earnings}_t – (\text{Cost of Equity} \times \text{Book Value of Equity}{t-1}) \]

The intrinsic value is the current book value of equity plus the present value of all future expected residual incomes.

\[ V_0 = B_0 + \sum_{t=1}^{\infty} \frac{RI_t}{(1+k_e)^t} \]

Advantages of the RIM

• Handles Negative FCF and No Dividends: The model can be used for firms that do not pay dividends and for firms with negative free cash flow, which is a significant advantage over DDM and FCFM in those cases.
• Focus on Economic Profitability: It directly measures whether the company is generating returns in excess of its cost of capital.

Disadvantages of the RIM

• Relies on Accounting Data: The model is based on accrual accounting earnings and book value, which can be subject to management discretion and manipulation through different accounting policies.
• Requires High-Quality Reporting: The model’s reliability is heavily dependent on the transparency and quality of the firm’s financial reporting. The analyst may need to make significant adjustments to the reported accounting numbers.

When to Use the Residual Income Model

• The company does not pay dividends.
• The company has negative free cash flow for the foreseeable future (e.g., a high-growth company).
• The firm’s financial reporting is transparent and of high quality, allowing for a reliable calculation of residual income.

Summary: Choosing the Right Model

The choice of a valuation model depends on the characteristics of the company being valued and the perspective of the analyst. The following flowchart provides a general framework for selecting the most appropriate model.

Model	Best For	Key Considerations
Dividend Discount Model (DDM)	Mature, stable, dividend-paying companies from a minority shareholder perspective.	Requires a history of dividends and a dividend policy that is related to profitability. Not suitable for non-dividend payers or for a control valuation.
Free Cash Flow Model (FCFM)	Firms that don’t pay dividends or for valuations from a control (e.g., acquisition) perspective.	More versatile than DDM but can be challenging for firms with negative FCF (e.g., startups, high-growth firms).
Residual Income Model (RIM)	Firms that don’t pay dividends or have negative FCF. Also useful when financial statements are of high quality.	Relies heavily on accounting data, which can be subject to manipulation. Requires transparent and high-quality reporting.