higher value than the dividend discount model whenever
FCFE are higher than dividends and a lower value when
dividendsexceedFCFE.Inreality,thegrowthrateinFCFE
shouldbedifferentfromthegrowthrateindividends,because
thefree cash flowto equity is assumed to be paidout to
stockholders.Thiswillaffecttheequityreinvestmentrateof
thefirm.Inaddition,thereturnonequityusedintheFCFE
model should reflect the return on equity on noncash
investments, whereas the return on equity used in the
dividend discount model should be the overall return on
equity.Table5.1summarizesthedifferencesinassumptions
between the two models.
TABLE 5.1Differences between DDM and FCFE Models
Dividend Discount
Model
FCFE Model
Implicit
assumption
Onlydividendsarepaid.
Remaining portion of
earnings is invested
backintothefirm,some
in operating assets and
some in cash &
marketable securities.
The FCFEis paidout
to stockholders. The
remainingearningsare
invested only in
operating assets.
Expected
growth
Measures growth in
income from both
operating and cash
assets. In terms of
fundamentals, it is the
productoftheretention
ratio and the returnon
equity
Measures growth only
in income from
operating assets. In
termsoffundamentals,
itistheproductofthe
equity reinvestment
rate and the noncash
return on equity.