Evaluating FCFE Models
TheFCFEmodelisamoregeneralversionofthedividend
discount model and allows analysts more freedom in
estimating cash flows. In a sense, it substitutes potential
dividendsfor actualdividendspaid and shouldyield more
realisticestimatesofvalueforfirmswherethetwonumbers
deviate. In this section, we consider the strengths and
weaknesses of FCFE models.
Strengths of the Model
ThemostsignificantadvantagefromusingFCFEmodelsis
thatwearenolongerboundbythejudgmentsofmanagerson
dividend policy. We can substitute thefree cash flows to
equity—whatcouldhavebeenreturnedtostockholders—for
what actually gets returned. Thus, we get more realistic
estimatesofvalueforequityforfirmsthatconsistentlypay
out less or morethanthey couldhave paidout. With the
former,thefreecashflowtoequitymodelwillyieldavalue
for equitythat is higherthanthe dividenddiscount model
value,whereaswiththelatter,itwillgenerateavaluethatis
lower.
The second advantage with FCFE models is that, unlike
dividends, FCFE are not constrained to be nonnegative
values.Thefreecashflowsto equitycanbenegative,and
usually are for growth companies with significant
reinvestmentneeds.Firmsthathavenegativefreecashflows
toequity canbe expectedtomakenewstock issuesin the
future.Theexpecteddilutionthatwilloccurisalreadybuilt
intothevalueofequitythroughthenegativefreecashflows
to equity.