Question

Justify the circumstances which are best suited for the dividend discount model versus the free cashflow model to value a firm. Provide an example of each. Create an argument for using the multistage dividend discount model for equity valuation. Provide support for your argument.

Answer 1

The dividend discount model is best suited for companies that pay a dividend and that the dividend has some relationship to the earnings. Dividend Payout Ratio (DPR) expressed as Dividend per share / Earnings per share is the most common relationship between the dividend and earnings. For example, a company could have a dividend policy stated as 40% DPR meaning for every $1 of earnings company pays out $0.4 in dividends.

The dividend discount model is not suitable for a company that has negative earnings or even if the earnings are positive but the dividend has no relationship to the earnings. Eg. paying a constant dividend of $2 regardless of the earnings.

Free cash flow model is the most preferred model to value any company because this model can be used even if the earnings are negative and the company doesn't pay dividends. The only criteria to use the free cash flow model is that the company should have positive cash flows. It is okay if the company has negative cash flows in the first few years, but the cash flows must be positive and more than compensate for the losses in the earlier years.

Example for each model is given in the attachment. Please download the image and zoom in for clarity.

A multistage dividend discount model is used if the company currently is in a high growth stage and that the growth returns to a normal level in a few years. For example, a company may have a dividend policy of paying $2 dividend per share and the growth rate for the first three years is 5%, but beyond 3 years, the company cannot sustain this high growth of dividend. So, the dividend growth rate may come down to the long-term growth of the inflation, say 2% beyond 3 years. For such companies which are in high growth stage, a multistage dividend discount model is preferred for equity valuation.