Question

Explain the basics of the discounted cash flow model for valuation. Explain the key differences between this and the dividend discount model. What are different ways that we could think about measuring the FCFs? Explain a cost and benefit of each. Explain problems with implementing this model. Explain each decision that we need to make when we calculate the stock price based on the enterprise value in the DCF model

Answer 1

Dividend discount model and free cash flow method are both valuation model which is used to determine the value of stock and value for firm. In both model present value of future cash flow is calculated to determine value of stock and value of firm.

When using the Free Cash Flow method, the value of the entire firm is calculated. The amount of any LT debt must be subtracted from that value prior to calculating the stock's intrinsic value. if company have preferred stock then it also must be subtracted from value of firm to determine value of equity.

Numerator part of dividend discount model consist expected dividend and denominator part consist required rate of return minus growth rate. Similarly, Numerator part of Free Cash flow method consist expected free cash flow for future years and denominator part consist required rate of return that is WACC minus growth rate.

These both approaches are similar because both use expected future cash flow, growth rate and cost of capital to determine value of stock and firm. Both approaches are different in term of dividend discount model use future discount and cost of equity to determine value of stock while free cash flow method use expected future free cash flow and overall cost of capital that is WACC to determine value of firm.

Both method assume that future growth rate is constant this is because it is impossible to forecast long term future cash flows and valuation calculation is also to lengthy.