Choice of Models

P.V. Viswanath

Valuation of the Firm

DDM vs FCFE
Both DDM and FCFE are focused on valuing equity directly. FCFE is defined as the residual cashflow that could be paid out to shareholders as dividends without affecting future cashflows If so, dividends should equal FCFE Then, why might the two reach different conclusions?

DDM vs FCFE
There might be various reasons why a firm might decide to pay more or less dividends than the FCFE per share. In a complete model, these uses for cash should also be incorporated. However, to the extent that the model is incomplete, these additional uses of cash should be taken into account outside the model. If an FCFE model is used for valuation, then adjustments to value should be made to compensate for deviations between potential dividends (from an FCFE perspective) and actual optimal dividends.

Reasons to pay more or less dividends

Desire for stability Future Investment Needs Tax factors Signaling Managerial Self-interest

Adjustments to FCFE Value

If dividends differ from FCFE because management chooses to keep dividends stable, this may not affect firm value, except to the extent that higher idle cash levels may be maintained . In this case, we would compute the value of the firm using a FCFE model and then adjust value downards.

Adjustments to FCFE Value

If dividends paid are lower because cash is kept aside for future investment needs, then the value to the firm of cash in hand may be greater than the actual exchange value of the cash. In this case, we could compute equity value using FCFE and then add back an additional amount to adjust for this incremental value of cash.

Adjustments to FCFE Value

If managerial self-interest causes higher than optimal values of cash to be kept on hand, and correspondingly lower levels of dividends to be paid out, an FCFE approach would overstate the value of the firm under current management. However, the FCFE valuation would be useful if the analyst believes that the firm might be ripe for a takeover. In this case, the manager would take a weighted average of the dividend and the FCFE approaches, weighting the FCFE value by the probability of the firm being acquired.

FCFE vs DDM
If we are going to use an FCFE approach and then adjust up or down, why not start with the DDM method and adjust down or up? The FCFE approach explicitly relates the cashflows to the underlying accounting decision variables, such as leverage, net working capital; marketing decisions such as higher profit margin versus higher volume; and macro variables such as the growth rate of the economy and the sector. The analyst is therefore forced to make all of his/her assumptions explicit. This ensures that no unwitting false assumptions are being made.

FCFE vs. FCFF

Basic accounting principles imply that the sum of equity and debt (interpreted broadly to include other liabilities as well) equals the value of the firm. In principle, then, the two approaches should lead to the same equity valuation. If so, how do we choose between the two?

FCFE vs FCFF
If a firm can be expected to change its capital structure in the future in an unpredictable or complex way, then FCFF might be a better approach. If the value of debt is easy to compute, then FCFF might be a simpler way to approach the value of the equity