robustwayofdealingwithoptionsistovaluethemasoptions
andtosubtractthisvaluefromtheaggregatevalueofequity
estimatedforafirmtoarriveatanequityvalueforcommon
stock. Dividing this value by theactual number of shares
outstanding should yield the correct value for equity per
share.Wewilldealwiththisquestionmuchmoreextensively
inChapter11,whenwelookatemployeestockoptionsand
their effects on value.
CONCLUSION
Theprimarydifferencebetweenthedividenddiscountmodels
andthefreecashflowtoequitymodelsliesinthedefinition
of cash flows. The dividend discount model uses a strict
definitionofcashflowtoequity(i.e.,theexpecteddividends
onthestock), whereas theFCFEmodelusesan expansive
definitionof cashflow toequity astheresidual cash flow
aftermeetingallfinancialobligationsandinvestmentneeds.
WhenfirmspaydividendsthataredifferentfromtheFCFE,
thevaluesfromthetwomodelswillbedifferent.Invaluing
firms for takeovers or in valuing firms where there is a
reasonable chanceof changingcorporate control,the value
from the FCFE provides the better estimate of value.
1 TheaveragepayoutratioforlargestablefirmsintheUnited
States is about 60 percent.
2 R.J. Fullerand C.Hsia, “A SimplifiedCommonStock
Valuation Model,” Financial Analysts Journal 40 (1984):
49-56.