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.
A share is worth the cash it will hand its owner, measured in today's dollars. You calculate intrinsic value by discounting those expected cash flows at the return an investor requires. Every present value model follows the same four steps:
- Forecast the relevant cash flow (dividends, free cash flow to equity (FCFE), free cash flow to the firm (FCFF), or residual income)
- Estimate growth rates and forecast horizon
- Select the appropriate discount rate
- Discount all cash flows back to today
The four models differ in which cash flow they count and which rate discounts it. Use the table to contrast the inputs of the dividend discount, FCFE, FCFF and residual income models.
KEY: DDM, FCFE, and residual income discount equity flows at the cost of equity to get equity value directly.
Common mistakes
- Using r ≤ g in the Gordon model. The formula requires r > g, and in a multistage model the same test applies to the terminal stage (the high-growth stage can exceed r temporarily).
- 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 the current flow instead of next year's. The numerator is NEXT year's dividend, D1 = D0(1+g), and the same holds for FCFE and FCFF. 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)
- FCFE = NI + Dep − Capex − ΔWC + Net borrowing, discounted at the cost of equity to give equity value directly
- FCFF = NI + Dep + Int(1 − t) − Capex − ΔWC, discounted at WACC to give firm value; subtract debt to reach equity value
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. Next, check whether the given flow is this year's or next year's, and grow it once if needed. For FCFF, the answer choices usually include firm value per share and the cost-of-equity value, so subtract debt and use WACC.
The full lesson (about 4,064 words, 27 min read) adds 10 worked examples, all 6 common mistakes, a self-check, free in the app.
Learning objectives
- DCF and growth models
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