Equity intrinsic value comes from discounting expected cash flows. Different models discount different flows: dividends, free cash flow to equity, free cash flow to the firm, or residual income. Each demands different inputs and fits different firms.
Equity intrinsic value equals the present value of expected future cash flows discounted at a required return. To calculate and then interpret that intrinsic value, four steps apply to every model:
- Forecast the relevant cash flow (dividends, free cash flow to equity (FCFE), FCFF, or residual income)
- Estimate growth rates and forecast horizon
- Select the appropriate discount rate
- Discount all cash flows back to today
KEY: DDM, FCFE, and residual income discount equity flows at the cost of equity to get equity value directly. FCFF discounts firm flows at WACC to get firm value, then subtracts debt to get equity value.
FCFE. Cash available to shareholders after operating expenses, taxes, reinvestment, and debt servicing. FCFE = Net Income + Depreciation − CapEx − ΔWorking Capital + Net Borrowing.
Common mistakes
- Using r ≤ g in the Gordon model. The formula requires r > g. If asked for value with g = 6% and r = 5%, the answer is "model is inapplicable," not a negative number. Trap: computing $2 / (0.05 − 0.06) = −$200.
- Discounting terminal value by n+1 instead of n. Terminal value sits AT time n and captures dividends from n+1 forward. Discount it n periods, not n+1. Trap: dividing $65.23 by 1.09^4 instead of 1.09^3.
- Using D0 instead of D1 in Gordon Growth. The numerator is NEXT year's dividend, D1 = D0(1+g). Trap: plugging $2.40 (D0) when the question gives D0 and constant growth of 4%. The correct D1 is $2.496.
Bottom line
- Equity intrinsic value = present value of expected cash flows. Match the flow to the rate: equity flows discount at cost of equity, firm flows at WACC
- Gordon Growth: V0 = D1 / (r − g). Requires r > g and stable g forever; the numerator is next year's dividend, D1 = D0(1+g)
- DDM uses dividends, FCFE uses free cash flow to equity (cost of equity), FCFF uses free cash flow to firm (WACC), residual income uses book value plus excess earnings
- Preferred stock value = D / r (perpetuity formula)
Exam shortcut
For Gordon Growth, always verify r > g BEFORE computing. If the question pairs constant g > r, the model is inapplicable. That is the answer. For multistage, lay out a timeline: explicit dividends D1 through Dn, then terminal value AT time n discounted n periods. For preferred stock contingencies, memorize one rule: "Holder option raises value, issuer option lowers value." That single rule answers every contingency question.
The full lesson (about 2,191 words, 15 min read) adds 2 worked examples, all 6 common mistakes, a self-check, free in the app.
Learning objectives
- DCF and growth models
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