gettothelatter,wehavetomakeassumptionsaboutcapital
expenditures,depreciation,andworkingcapital.Togettothe
former, we can begin with dividends paid last year and
estimate a growth rate in these dividends.
Finally,itcanbearguedthatmanagerssettheirdividendsat
levels that they can sustain even with volatile earnings.
Unlike cash flows that ebb and flow with a company’s
earningsandreinvestments,dividendsremainstableformost
firms. Thus, valuations based on dividends will be less
volatile over time than valuations based on cash flows.
Limitations of the Model
Thedividenddiscountmodel’sstrictadherencetodividends
as cashflows doesexpose itto a seriousproblem. As we
notedinthepreceding chapter, manyfirms choose tohold
back cash that they can pay out to stockholders. As a
consequence, thefree cash flows to equity at these firms
exceed dividends,and largecash balances buildup.While
stockholders may not have a direct claim on the cash
balances,theydoownashareofthesecashbalancesandtheir
equityvaluesshouldreflectthem.In thedividenddiscount
model,weessentiallyabandonequityclaimsoncashbalances
and undervalue companies with large and increasing cash
balances.
Attheotherendofthespectrum,therearealsofirmsthatpay
farmoreindividendsthantheyhaveavailableincashflows,
oftenfundingthedifferencewithnewdebtorequityissues.
With these firms, using the dividend discount model can
generatetoooptimisticanestimateofvaluebecauseweare