Two analysts model the same utility. One uses a constant 5% growth rate, the other assumes 15% for four years first. The gap between their value estimates is larger than the entire dividend stream they agree on.
Every discounted cash flow (DCF) model says the same thing: value is the present value of expected future cash flows. What differs is the definition of "cash flow." Three definitions dominate.
- Dividends: the only cash a non-controlling shareholder actually receives. Reinvested earnings are not ignored; they show up as higher future dividends.
- Free cash flow: free cash flow to the firm (FCFF) is operating cash flow minus capital expenditures; free cash flow to equity (FCFE) nets out debt payments.
- Residual income: period earnings in excess of the required return on beginning book value. Value equals book value per share plus the present value of future residual income.
DECISION: Use a dividend discount model (DDM) when the company pays dividends, dividend policy bears an understandable and consistent relation to profitability, and you take a non-control perspective.
Common mistakes
- Putting in the numerator. Example 1 becomes $2.00 / 0.05 = $40.00 instead of $41.60. The Gordon growth numerator is always next year's dividend.
- Over-discounting the terminal value. is built from but already sits at t = 4, so it is discounted four periods, not five. Dividing $45.91 by yields $27.25 and a value of $33.81.
- Misreading H. H is half the decline period. An eight-year fade gives H = 4, not 8; using 8 doubles the growth premium to $1.20 and inflates the H-model value to $46.25.
Bottom line
- Model choice: DDM for dividend payers with consistent policy and a non-control view; FCFE/FCFF for non-payers, dividend/FCFE mismatches, or a control view; residual income for non-payers with negative free cash flow
- General DDM: value = present value of dividends over n years plus present value of terminal price; over an infinite horizon, all dividends
- Gordon growth: V0 = D0(1+g)/(r−g) = D1/(r−g), valid only when r > g and g is near or below nominal GDP growth
- Perpetual preferred: V0 = D/r, the zero-growth special case
Exam shortcut
Read the stem for the model trigger before touching the calculator. "Stable, regulated, mature, payout in a narrow band" means Gordon growth. "Patent expires in five years" means two-stage. "Growth declines gradually as competitors enter" means H-model, and H is half the stated fade period. "No dividend and heavy capital spending" means the answer is not a DDM at all.
The full lesson (about 3,714 words, 25 min read) adds 2 worked examples, all 6 common mistakes, a self-check, free in the app.
Learning objectives
- discounted dividend valuation
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