Question

your boss has asked you to estimate the intrinsic value of the equity for Google, which does not currently pay any dividends. You are going to use an income approach and are trying to choose between the free cash flow to equity (FCFE) approach and the dividend discount model (DDM) approach. Which would be more appropriate in this instance?why? What concerns would you have in applying either of these valuation approaches to a company such as this?

Answer 1

Dividend discount model can only be used with those companies who are paying with constant dividend and if the company is not paying out dividend even if it is making profit then we cannot apply dividend discount model.

In this case,it can be seen that the Google is not paying any kind of dividend currently and I will be trying to use free cash flow to equity model because it is considering the free cash flows rather than the dividend payments so free cash flows method will be selected in order to value Google.

Free cash flows to equity will be a perfect model which will be estimating the overall return which are generated for the equity shareholders and it will not just include Dividend so it is better than dividend discounting model.

Concerns related to dividend discount model is that there will be no growth in dividend constantly and many company do not have dividend, whereas free cash flows to equity method will be trying to estimate the overall free cash flows to equity but it will also not consider the cash flows differently from operations and Investments, so it is not a segregating method between various parts of income for the shareholders