Damodaran on Valuation_ Security Analysis for Investment and Corporate Finance ( PDFDrive )

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.