Question

Theoretically, should the dividend discount model and free cash flow model yield the same stock price? Explain. What are the advantages and disadvantages of the free cash flow valuation model relative to the dividend growth model? What situation is ideally suited to valuation with the dividend growth model

Answer 1

No, stock price as per dividend discount model and free cash flow methodshould not yield same method.

Advantages of Free cash flow valuation -

Free cash flow method takes into consideration the all expected revenue and costs which a fir expects to earn. It reduces an investment to a single figure. If the net present value is positive, the investment is expected to be favourable for the company and if it's negative, the investment is a loser. This method allows the company to make choice among different investment opportunities availvable. The one with the highest net present value is the most profitable alternative.

Whereas dividend discount model takes into consideration only the dividends which a company expects to pay to its shareholders.

Disadvantages of Free cash flow valuation -

Discounted cash flow valuation require accurate and reliable estimates that are used. If etimates are not correctly made, the net present value will be inaccurate, and the company may make bad investment decision. All projected cash flows are just the projections. The discounting formula which is used to convert those cash flows to present value includes more estimates about the discount rate, which is the rate by which you assume a certain sum of money will change in value over time.

Ideal situation for using dividend discount Model

Dividend discount model is generally used in situation where company cannot estimate the future cash flows with accuracy. Dividend discount model is also used in situation where future dividends and growth in dividend is known to the company.

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