Mastering Dividend Discount Models and Beyond | CFA Level I Equity Investments

We finally dive into equity valuation models, starting with dividend discount models. We shall also learn the free cash flow to equity models, how the required rate of return can be estimated, as well as valuation for preferred stock.

Understanding Dividend Discount Models

Present value models, also known as discounted cash flow models, estimate the intrinsic value of a stock based on the present value of the future benefits expected to be received. The dividend discount model defines such benefits as the expected future dividends to be distributed to shareholders.

PV of stock = ∑(PV of Dividends) + PV of terminal value

Alternative: Free Cash Flow to Equity (FCFE) Model

An alternative to the dividend discount model is the free cash flow to equity model (FCFE). FCFE represents the amount of cash collected during the period that is available for distribution to common shareholders, reflecting the firm’s capacity to pay dividends.

Formula: FCFE = Net CFO – Fixed Capital Investments + Net Borrowings

The FCFE model is to sum up the present value of expected future FCFE with the present value of the terminal value.

Determining the Required Rate of Return

Be it the dividend discount model or the FCFE model, the required rate of return for the stock is needed as the discount rate for the future cash flows. The most straightforward answer is to use the capital asset pricing model (CAPM).

Required Rate of Return = Risk-Free Rate + Beta * (Expected Market Return – Risk-Free Rate)

An analyst will need to estimate the applicable risk-free rate for the market, which is usually obtained from government bond yields, the beta which can be estimated from the volatility of returns of the stock, and the expected return of the market which is estimated from past broad market index returns. Every analyst will have different assumptions and ways of calculating, so there is no single number that is correct. Moreover, these parameters can change over time.

Valuation for Preferred Stock

Like common stock, we can use the dividend discount model to value preferred stock. However, we don’t have to estimate future dividends for preferred stock, as the dividend is fixed and is paid at regular intervals for perpetuity.

Intrinsic Value of Preferred Stock = Dividend / Required Rate of Return

And that concludes this lesson on dividend discount models and the FCFE models. You probably still have some unanswered questions. We’ll answer more of these questions in the next lesson, so hold your horses!