FCFE vs. the Dividend Discount Model

The free cash flow valuation approach is preferred over the dividend discount model (DDM) because:

• Many corporations pay no or minimal cash dividends. Using the DDM would require assuming a period in the future when dividends will be paid, the amount that will be paid, and its growth rate.
• Dividends are at the discretion of the corporation’s board of directors. The dividends may therefore not signal the company’s long-run profitability.
• Dividends are cash flows going to shareholders, while FCFE is the cash flow available to shareholders without impairing the company’s operations. Therefore, it takes a minority shareholder perspective. If a company is being evaluated because it’s a takeover target, a free cash flow measure is more appropriate.

Question

Which of the following valuation models is most appropriate when valuing a company from a minority shareholder perspective?

1. FCFE model.
2. FCFF model.
3. Dividend discount model.

Solution

The correct answer is C. 

The dividend discount model is the most appropriate valuation model when valuing a company from a minority shareholders’ perspective.

A is incorrect. The FCFE model is appropriate when valuing a company from a majority shareholder’s perspective.

B is incorrect. FCFF is also be used to value the firm from a majority shareholder’s perspective.

Reading 24: Free Cash Flow Valuation

LOS 24 (f) Compare the FCFE model and dividend discount models.