model.Infact,onewaytodescribeafreecashflowtoequity
model is that it represents a model where we discount
potential dividends rather than actual dividends.
Consequently, the three versions of the FCFE valuation
model presentedin this sectionare simplevariants on the
dividenddiscountmodel,withonesignificantchange—free
cash flows to equity replace dividends in the models.
Underlying Principle
WhenwereplacethedividendswithFCFEtovalueequity,
we are doing more than substituting one cash flow for
another.Weareimplicitlyassuming thattheFCFEwillbe
paid out to stockholders. There are two consequences.
1.Therewillbenofuturecashbuildupinthefirm,sincethe
cashthat isavailableafterdebtpaymentsand reinvestment
needs is paid out to stockholders each period.
- The expected growth in FCFE will include growth in
incomefromoperatingassetsandnotgrowthinincomefrom
increasesinmarketablesecurities.Thisfollowsdirectlyfrom
the preceding point.
Howdoesdiscountingfreecashflowstoequitycomparewith
themodifieddividenddiscountmodel,wherestockbuybacks
are added back to dividends and discounted? You can
consider stock buybacks to be the return of excess cash
accumulated largely as a consequence of not paying out
FCFEasdividends.Thus,FCFErepresentsa smoothed-out
measureofwhatcompaniescanreturntotheirstockholders
over time in the form of dividends and stock buybacks.