Principles of Corporate Finance_ 12th Edition

98 Part One Value

bre44380_ch04_076-104.indd 98 09/30/15 12:46 PM

If the concatenator business were a public Concatenator Corp., with no other assets and

operations, it could pay out its free cash flow as dividends. Dividends per share would be the

free cash flow shown in Table 4.7 divided by 1 million shares: zero in periods 1 to 3, then $.42

per share in period 4, $.46 per share in period 5, etc.

We mentioned stock repurchases as an alternative to cash dividends. If repurchases are

important, it’s often simpler to value total free cash flow than dividends per share. Suppose

Concatenator Corp. decides not to pay cash dividends. Instead it will pay out all free cash

flow by repurchasing shares. The market capitalization of the company should not change,

because shareholders as a group will still receive all free cash flow.

Perhaps the following intuition will help. Suppose you own all of the 1 million Concatena-

tor shares. Do you care whether you get free cash flow as dividends or by selling shares back

to the firm? Your cash flows in each future period will always equal the free cash flows shown

in Table  4.7. Your DCF valuation of the company will therefore depend on the free cash

flows, not on how they are distributed.

Chapter 16 covers the choice between cash dividends and repurchases (including tax issues

and other complications). But you can see why it’s attractive to value a company as a whole

by forecasting and discounting free cash flow. You don’t have to ask how free cash flow will

be paid out. You don’t have to forecast repurchases.

In this chapter we have used our newfound knowledge of present values to examine the market

price of common stocks. The value of a stock is equal to the stream of cash payments discounted at

the rate of return that investors expect to receive on other securities with equivalent risks.

Common stocks do not have a fixed maturity; their cash payments consist of an indefinite

stream of dividends. Therefore, the present value of a share of common stock is

PV = ∑

t=1

∞

DIVt

______

(1 + r)t

However, we did not just assume that investors purchase common stocks solely for dividends.

In fact, we began with the assumption that investors have relatively short horizons and invest for

both dividends and capital gains. Our fundamental valuation formula is, therefore,

P 0 =

DIV 1 + P 1

_________

1 + r

This is a condition of market equilibrium. If it did not hold, the share would be overpriced or

underpriced, and investors would rush to sell or buy it. The flood of sellers or buyers would force

the price to adjust so that the fundamental valuation formula holds.

We also made use of the formula for a growing perpetuity presented in Chapter 2. If dividends

are expected to grow forever at a constant rate of g, then

P 0 =

DIV 1

_____r − g

It is often helpful to twist this formula around and use it to estimate the market capitalization

rate r, given P 0 and estimates of DIV 1 and g:

r =

DIV 1

_____

P 0

+ g

Remember, however, that this formula rests on a very strict assumption: constant dividend growth

in perpetuity. This may be an acceptable assumption for mature, low-risk firms, but for many

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SUMMARY