Ownership Perspective implicit in the FCFE Approach

Under the free cash flow to equity (FCFE) approach, the ownership perspective is that of an acquirer who can change the firm’s dividend policy. This approach takes a control perspective, which assumes immediate recognition of value.

On the other hand, the discounted dividend approach takes the perspective of a minority shareholder who does not have control over a firm’s dividend policy. It assumes that value may not be realized until the dividend policy reflects the firm’s long-run profitability.

The free cash flow valuation approach may be preferred over the dividend discount model when:

1. The company does not pay dividends.
2. The company pays dividends, but it differs significantly from its ability to pay dividends.
3. Free cash flows align with profitability within a satisfactory forecast period.
4.  An investor that takes control has discretion over the use of free cash flow.

Question

Which of the following is least likely  a reason why analysts use free cash flow valuation approach over the dividend discount approach?

1. The company does not pay dividends.
2. The company is being valued from a majority interest ownership perspective.
3. The free cash flow does not align with profitability within a satisfactory forecast period.

Solution

The correct answer is C.

Analysts will use not use the free cash flow approach when the free cash flow does not align with profitability within a satisfactory forecast period.

A is incorrect. If a company does not pay dividends and it is not possible to forecast dividend payment in the future, analysts would use the free cash flow approach to value a company.

B is incorrect. If the ownership perspective is that of a majority interest, free cash flow approach is more appropriate for valuation as the investor that takes control of the firm has discretion over the use of free cash flow. 

Reading 24: Free Cash Flow Valuation

LOS 24 (b) Explain the ownership perspective implicit in the FCFE approach.