on a Schweser practice test (maybe book two, exam 2?) there was a question involving a company which DID pay dividends at a regular and steadily increasing level and had stable cash flows, and we were asked to determine the best valuation technique for a minority shareholder. One answer which was “DDM or cash flow” was incorrect, and the answer was DDM only was correct, with the explanation given that it was a minority shareholder with dividends, therefore DDM was superior. Why? What’s inferior about FCFE (or FCFF, subtracting out the mkt. value of debt for that matter) in this case?
DDM is way easier to compute and there aren’t accounting issues with dividends.
The question tells you that you are looking at the problem from the point of view of a MINORITY sharefholder, in that case you will always prefer DDM. FCFE is used when you are valuing a controlling stake. THe reasoning behind this is that as a minority shareholder you are not in a position to influence dividend payments, hence you just take the given dividends as a given. FCF assumes that you are able to excercise some amount of controll.
Maybe it’s not the right hour to be asking a “real world” sort of question, and just be satisfied with the “minority shareholder perspective + dividend stream = DDM” approach. I guess that’s reasonable, since financials can be manipulated every which way, and the dividend payment is more of “the truth”… but… in the real world, there is significant pressure on dividend paying companies to keep paying dividends (actually, that’s also somewhere in the curriculum, too, maybe level 1?). So, aren’t there tons of times where a company (entering the decline part of the lifecycle) pays a regular dividend, but looking at the financial statements, it doesn’t look to be sustainable? Couldn’t/wouldn’t the “truth” show up in the FCFE before the dividend is lowered or dropped, as the company tries to hold the dividend up as long as possible? In that case, I would definitely think the free cash valuation metrics would be helpful alongside the DDM, and it would be hard to say why one is more appropriate to use than the other.
You are right about the dividend pressure… the CFA reading does specify that you should first verify that the dividends are consistent as they relate to EPS first before using. If they’re not, then you should use another valuation method.
Important thing is that DDM is really for minority/noncontrol investors. If you’re a controlling investor, you dont have to have dividends for it to be your $$.