Question

Explain the difference b/w the Free Cash flow stock valuation model and the Divided Discount model. What discount rate is used in the Free Cash flow model and what extra step do you need to take in order to calculate a stock price?

Answer 1

Divided Discount model	Free Cash flow stock valuation model
As we know that dividend is the reward for the provider of equity capital, the same can be used to value equity shares. Valuation of equity shares based on the dividend is based on the following assumptions: Dividend to be paid annually. Payment of the first dividend shall occur at the end of the first year. Sale of equity shares occurs at the end of the first year and that to at ex-dividend price. The value of any asset depends on the discounted value of cash streams expected from the same asset. Accordingly, the value of equity shares can be determined on the basis of a stream of dividend expected at the required rate of return or opportunity cost i.e. Ke (cost of equity).	In the case of dividend discounting valuation model (DDM), the cash flows are dividend which is to be distributed to equity shareholders. This cash flow does not take into consideration the cash flows which can be utilized by the business to meet its long term capital expenditure requirements and short term working capital requirement. Hence dividend discount model does not reflect the true free cash flow available to a firm or the equity shareholders after adjusting for its CAPEX and working capital requirement. Free cash flow Stock/Equity valuation models discount the cash flows available to equity shareholders after meeting its long term and short term capital requirements. Accordingly, the value of equity shares can be determined on the basis of stream of dividend expected at the required rate of return or opportunity cost i.e. Ke (cost of equity).
In the dividend discount model the analyst considers the stream of expected dividends to value the company’s stock. It is assumed that the company follows a consistent dividend payout ratio which can be less than the actual cash available with the firm. Dividend discount model values a stock based on the cash paid to shareholders as dividend. A stock’s intrinsic value based on the dividend discount model may not represent the fair value for the shareholders because dividends are distributed from cash. In case the company is maintaining healthy cash in its balance sheet then dividend pay-outs will be low which could result in undervaluation of the stock. In the case of free cash flow to equity model a stock is valued on the cash flow available for distribution after all the reinvestment needs of CAPEX and incremental working capital are met. Thus using the free cash flow to equity valuation model provides a better measure for valuations in comparison to the dividend discount model.
The extra step which need to take in order to calculate a stock price in the Free Cash flow model is to compute the Free Cash Flow to Equity (FCFE). Free Cash flow to equity is used for measuring the intrinsic value of the stock for equity shareholders. The cash that is available for equity shareholders after meeting all operating expenses, interest, net debt obligations and reinvestment requirements such as working capital and capital expenditure. It is computed as: Free Cash Flow to Equity (FCFE) = Net Income - Capital Expenditures +Depreciation - Change in Non- cash Working Capital + New Debt Issued - Debt Repayments