A comprehensive guide examining how Dividend Discount and Free Cash Flow valuation models are applied in equity valuation, including theoretical underpinnings, practical examples, US/Canadian perspectives, and tips for CFA Level II candidates.
This section explores two vital approaches to equity valuation: the Dividend Discount Model (DDM) and the Free Cash Flow (FCF) approach. We’ll walk through their core assumptions, modeling techniques, and applications for different types of companies. Along the way, I’ll share a few personal anecdotes (including the time I first tried to apply a naive DDM for a tech growth stock—yikes, not the best idea) and highlight common pitfalls. So, let’s jump right in.
Before we dig deeper, let’s remind ourselves—valuation is part art, part science, and part guesswork. In my opinion, the trick is to make the best assumptions you can and stay flexible. Anyway, here’s the high-level distinction you’ll want to keep front and center:
• Dividend Discount Model (DDM): Best for companies that pay predictable dividends or where dividends clearly capture a firm’s earning potential.
• Free Cash Flow Models (FCFF or FCFE): Best for companies that don’t pay dividends or where dividends are not a reliable indicator of a firm’s long-term potential.
In practice, you’ll come across companies like big Canadian banks—Royal Bank of Canada (RBC) springs to mind—that pay consistent dividends and plan to keep paying them, making DDM an excellent choice. But consider an innovative tech startup that reinvests nearly all its returns into growth. Dividends? Probably not happening soon, so an FCF-based approach might be more appropriate.
The Dividend Discount Model values a company by summing the present value of future dividends. The intuition is pretty straightforward: a stock is worth the sum of all distributions you, as a shareholder, expect to receive—discounted back to today.
The Single-Stage DDM—often called the Gordon Growth Model—makes a big assumption: that dividends grow at a constant rate forever. It’s like saying, “Well, RBC has paid dividends for decades, and I expect them to keep increasing at 3% every year forever.” That’s the gist.
The Gordon Growth formula is:
where
• \( D_1 \) is the expected dividend one year from now,
• \( r \) is the required rate of return (think of it as the cost of equity), and
• \( g \) is the constant growth rate.
It’s simple and works nicely for mature, stable companies. But it can be way off if the growth pattern is more complex—like a biotech firm expecting 20% growth for the next five years, then maybe 4% for the rest of eternity.
Because companies rarely have a constant growth rate from cradle to grave, we often use a multi-stage DDM. This approach divides a firm’s dividend growth into different phases. For example, the two-stage DDM might assume:
• Phase 1: High growth for 5 years (Project each year’s dividend individually.)
• Phase 2: A smooth transition to a stable, long-term growth rate thereafter (Apply the Gordon Growth Model for the “terminal value” starting in year 6.)
A rough multi-stage formula goes like this:
where \( D_t \) are the dividends in each year, \( g_{\text{stable}} \) is the stable long-term growth rate, and the fraction after the plus sign is the present value of the “terminal value.”
Honestly, it can be a bit tricky in real life, especially if your growth rates are all over the place. But it’s a powerful tool. Maybe you’re analyzing a Canadian bank with a strong brand, stable deposit base, and a robust track record for dividend increases. A two- or three-stage DDM might be an excellent fit—particularly if you expect higher dividend growth in the next few years followed by a stable, moderate rate.
Some companies just don’t pay dividends—think about big US tech firms that do massive share buybacks or funnel boatloads of cash into R&D. In such cases, the Dividend Discount Model is basically silent: if there are no dividends, does that mean the company is worthless? Of course not. Maybe they’re generating tons of free cash flow they choose to reinvest or use for share buybacks. That’s where the free cash flow approach comes in. We typically measure either:
• Free Cash Flow to the Firm (FCFF): Cash flow available to all capital providers, including creditors and equity holders.
• Free Cash Flow to Equity (FCFE): Cash flow specifically for equity holders.
When valuing a company using FCFF, you discount these “firm-wide” cash flows using the Weighted Average Cost of Capital (WACC). The typical formula for FCFF is:
Then we discount these back to the present using:
Finally, to get equity value, we subtract net debt from Enterprise Value (EV). If a company’s capital structure changes often, or if you want to be consistent in capturing the value for both debt and equity holders, FCFF is your go-to model.
FCFE is the cash flow available after the firm has met all its obligations to creditors. So it goes directly to equity holders. We discount these equity cash flows at the required return on equity (\( r_e \)). The formula for calculating FCFE often looks like this:
And the present value formula for the equity is:
When deciding between FCFF and FCFE, I think the big question is: Are you comfortable forecasting a company’s debt levels and interest payments? Also, do you have a stable capital structure? If you’re a giant conglomerate that leverages up and pays debt off frequently, forecasting FCFE may become more complex. So you pick the approach that’s simpler or more transparent for your specific scenario.
Here’s the part that trips up many folks: estimating growth. It’s common to hear marketing teams brag about a 20% growth rate next year. But is that sustainable for 50 years? Probably not. So, we break down the growth into a few phases and then assume a stable, low growth rate for the long haul.
Terminal value is the value of the business beyond the forecast period. Two main approaches stand out:
• Perpetual Growth Method: Essentially a Gordon Growth approach for the final year’s cash flow.
• Exit Multiple Method: Use a valuation multiple (like EV/EBITDA) to estimate how the market might price the company in the final forecast year.
Small changes in that terminal growth assumption or exit multiple lead to surprisingly dramatic swings in your valuation. I’ve made the mistake of toggling from 3% to 3.5% perpetual growth in a spreadsheet and—bam—the final value soared by 15%. That kind of sensitivity is normal, so handle with care.
The US often sees large tech companies (like Apple, Alphabet, or meta-somethings) favor share buybacks rather than consistent dividends. So if you rely solely on the DDM, you might be missing half the story. The FCF approach is more insightful because it captures a firm’s total capacity to generate and allocate cash.
Now, let’s talk Canada. Canadian banks—think RBC, TD, or Scotiabank—are known for stable dividend policies, even during tough times. So a multi-stage DDM that captures an initial higher-growth period followed by stable dividend growth can be a sensible method. That said, a lot of analysis on the side also focuses on FCF to validate these valuations because interest rate changes do affect banks’ net interest margins and, eventually, their dividend capacity.
My old valuation professor used to say, “The model is only as good as the assumptions inside it.” And I can’t emphasize that enough—especially on the discount rate (\( r \)) and the growth rate (\( g \)). If you push the discount rate too low or the growth rate too high, you’ll come out with valuations that might feel too good to be true.
Let’s say you’re analyzing RBC, forecasting dividends for the next five years, and then applying a 3% perpetual growth. Just see how the total valuation changes if you switch that to 2.5% or 3.5%. This is a quick test, but it helps you see how “fragile” your final valuation might be.
Scenario analysis is a more robust approach. Construct multiple scenarios such as:
• Best-Case: The economy booms, RBC’s net interest margin expands, dividend payout grows faster.
• Base-Case: Normal growth around 3%, stable discount rate, historically consistent margins.
• Worst-Case: Economic slowdown, dividend growth stalls, discount rate rises.
Comparing the valuations in each case helps you gauge the risk. If RBC’s valuation plummets in your worst-case scenario, you know you have bigger downside than your base-case might suggest.
To keep things clear, let’s use a quick Mermaid diagram that shows how cash flows might get from the company’s operations to equity holders under the FCF approach.
flowchart LR
A["Operations <br/> Generate Cash Flow"] --> B["FCFF (Available for <br/> Debt & Equity)"]
B --> C["Less: Interest + Debt Payments <br/> + Net Borrowing"]
C --> D["FCFE (Available <br/> for Equity)"]
D --> E["Dividends or <br/> Retained Earnings"]
In this diagram, we see how we move from operating cash flows to equity cash flows. Notice that if the company decides to pay dividends right away, that chunk is for shareholders. But if they decide to reinvest or pay down debt, it changes the company’s capital structure.
Imagine you’re looking at a mid-sized Canadian manufacturing firm, MapleWorks Inc. Let’s assume:
• They pay small dividends but plan to ramp them up once the new manufacturing line hits capacity.
• Growth is forecasted to be around 10% for three years, then 4% afterward.
• The company is partly financed by some stable long-term debt.
Which approach would you choose? You can do a multi-stage DDM, factoring in the small dividends now with a bigger jump after year three, then stable growth. But if the nature of MapleWorks’ new manufacturing line might cause an earnings wave that outpaces their actual dividend distribution, an FCFF approach could capture the overall cash flow potential. In many real analyses, you do both: a multi-stage DDM to see how dividends might fuel returns, and an FCFF analysis to see if the total enterprise value supports the share price.
• Overestimating Growth: Being too optimistic can inflate valuations. A good rule of thumb is to tie your growth rate to broader economic indicators and the firm’s fundamentals (like retention ratio × ROE).
• Ignoring Capital Structure Changes: If a company is set to issue more debt (or pay some off), it can drastically shift the cost of capital or net borrowing, messing up the FCFE forecast.
• Failure to Align Discount Rate and Cash Flow: If you’re discounting FCFF, you use WACC. If your cash flow is FCFE, you use the required return on equity. Mixing those can produce nonsense figures.
• Terminal Value Oversimplification: If that final perpetual growth rate is mis-specified, your entire valuation can swing dramatically. Keep it realistic.
I’ve found that for exam success—and real-world competence—your best bet is to truly understand when each model is most relevant. On the CFA exam, they love giving you a scenario: “XYZ Tech is a small, high-growth firm that just started generating earnings; which model is best?” If they’re not paying dividends, you likely pivot toward an FCF-based approach. If the firm is stable, pays consistent dividends, or is structured like a large bank with a known payout ratio, you might lean on a DDM.
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