work with assumptions about dollar debt rather than debt
ratios, you can switch to the adjusted present value approach.
In valuing equity, wecan discountdividends or freecash
flows to equity. We should consider using the dividend
discount model under the following circumstances.
- Wecannotestimatecash flowswith anydegree of
precision, either because we have insufficient or
contradictory informationaboutdebt paymentsand
reinvestmentsor because wehave trouble defining
whatcomprisesdebt.Thiswasourrationaleforusing
dividend discount models for valuing financial
services firms. - Therearesignificantrestrictions onstockbuybacks
andotherformsofcashreturn,andwehavelittleor
nocontroloverwhatthemanagementofafirmdoes
withthecash.Inthiscase,theonlycashflowswecan
expect to get from our equity investment are the
dividends that managers choose to pay out.
Inallothercases,wewillgetmuchmorerealisticestimatesof
afirm’svalueusingthefreecashflowtoequity,whichmay
be greater than or lower than the dividend.
Should We Use Current or Normalized Earnings?
In most valuations, we begin with the current financial
statementsofthefirmandusethereportedearningsinthose
statementsasthebaseforprojections.Therearesomefirms,
though,wherewemaynotbeabletodothis,eitherbecause
thefirm’searningsarenegativeorbecausetheseearningsare