usethedividendsascashflowsarecalleddividenddiscount
models.Abroaderdefinitionofcashflowstoequitywouldbe
the cash flows left over after the cash flow claims of
nonequityinvestorsinthefirmhavebeenmet(interestand
principalpaymentstodebtholdersandpreferreddividends)
andafterenoughofthesecashflowshasbeenreinvestedinto
thefirmtosustaintheprojectedgrowthincashflows.Thisis
thefreecashflowtoequity(FCFE),andmodelsthatusethese
cash flows are calledFCFE discount models.
Thecashflowtothefirmisthecumulatedcashflowtoall
claimholdersinthefirm.Onewaytoobtainthiscashflowis
to add the free cash flowsto equity to thecash flowsto
lenders(debt)andpreferredstockholders.Afarsimplerway
ofobtainingthesamenumberistoestimatethecashflows
priortodebtandpreferreddividendpayments,bysubtracting
fromtheafter-taxoperatingincomethenetinvestmentneeds
tosustaingrowth.Thiscashflowiscalledthefreecashflow
tothefirm(FCFF)andthemodelsthatusethesecashflows
are calledFCFF models.
Expected Growth
Itiswhileestimatingtheexpectedgrowthincashflowsinthe
futurethatanalystsconfrontuncertaintymostdirectly.There
arethreegenericwaysofestimatinggrowth.Oneistolookat
acompany’spastandusethehistoricalgrowthratepostedby
thatcompany.Theperilisthatpastgrowthmayprovidelittle
indicationoffuturegrowth.Thesecondistoobtainestimates
ofgrowthfrom moreinformed sources.Forsome analysts,
this translates into using the estimates provided by a
company’smanagement,whereasforothersittakestheform
ofusingconsensusestimatesofgrowthmadebyotherswho