FCFE VERSUS DIVIDEND DISCOUNT MODEL
VALUATION
The FCFE model can be viewed as an alternative to the
dividend discount model. Since the two approaches
sometimesprovidedifferentestimatesofvalueforequity,itis
worth examining when they provide similar estimates of
value, whentheyprovide different estimatesof value,and
what the difference tells us about the firm.
When They Are Similar
Therearetwoconditionsunderwhichthevaluefromusing
theFCFEindiscountedcashflowvaluationwillbethesame
asthevalueobtainedfromusingthedividenddiscountmodel.
Thefirstistheobviousone,wherethedividendsareequalto
theFCFE.Therearefirmsthatmaintainapolicyofpaying
out excess cash as dividends either because they have
precommittedtodoingsoorbecausetheyhaveinvestorswho
expect this policy of them.
The second condition is more subtle, where the FCFE is
greater than dividends, but the excess cash (FCFE minus
dividends)isinvestedinfairlypricedassets(i.e.,assetsthat
earnafairrateofreturnandthushavezeronetpresentvalue).
Forinstance,investinginfinancialassetsthatarefairlypriced
shouldyielda netpresentvalueof zero.To getequivalent
valuesfrom the twoapproaches, though, we haveto keep
trackof accumulatingcashin thedividend discountmodel
andaddittothevalueofequity(asshowninIllustration5.10
at the end of this section).
When They Are Different