It says this in the vignette: The free cash flow valuation approach is superior to the discounted dividend valuation approach because the company’s dividends have been substantially different from its FCFE. The answer says this statement is correct. Two reasons why I thought this was wrong: 1) A company can have a stable dividend policy that is related directly to earnings, but also have a very volatile capital structure. Thus, it’s FCFE could be all over the place (due to changes in leverage cause that will impact FCFE through net borrowing) yet still have a stable dividend policy that is linked to earnings. So DDM could very well be used. 2) “Company’s dividends have been substantially different from its FCFE” - maybe my english is bad, but to me that is saying the amount of dividends has been different from the amount of FCFE. Of course, Dividends will ALWAYS be substantially different in amount from FCFE, so that is no reason to not use DDM. Maybe if they said dividend growth, or they said dividend policy, it would have been more clear? Maybe I over thought this question (or am I wrong)? I feel kinda pissed cause I understand the concept well, but I feel like that is the reason why I answered it ‘incorrectly’ Thots?
I think the idea might be that dividends are a way to pay out FCFE. If FCFE deviates substantially from the dividend, it’s risky to assume that company can continue paying out a dividend. The other thing that I’d say is that dividends are paid out based on a decision by management, whereas FCFE is a business-grounded metric. A FCFF approach would be best and most conservative way to value the company.
And just to talk to your first point, a company can pay a steady dividend payment until it goes all the way into the ground. As much as the CFA leads us to believe with these insane calculations, the net borrowing portion of the equation is probably unlikely to be very volatile unless the company is REALLY bad.