Reading 60: Equity Valuation: Concepts and Basic Tools-LOS c cas

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Session 14: Equity Analysis and Valuation
Reading 60: Equity Valuation: Concepts and Basic Tools

LOS c: Explain the rationale for using present-value of cash flow models to value equity and describe the dividend discount and free-cash-flow-to-equity models.

 

 

A valuation model based on the cash flows that a firm will have available to pay dividends in the future is best characterized as a(n):

A) free cash flow to the firm model.

B) infinite period dividend discount model.

C) free cash flow to equity model.

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Free cash flow to equity represents a firm’s capacity to pay future dividends. A free cash flow to equity model estimates the firm’s FCFE for future periods and values the stock as the present value of the firm’s future FCFE per share.

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Witronix is a rapidly growing U.S. company that has increased free cash flow to equity and dividends at an average rate of 25% per year for the last four years. The present value model that is most appropriate for estimating the value of this company is a:

A) multistage dividend discount model.

B) Gordon growth model.

C) single stage free cash flow to equity model.

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A multistage model is the most appropriate model because the company is growing dividends at a higher rate than can be sustained in the long run. Though the company may be able to grow dividends at a higher-than-sustainable 25% annual rate for a finite period, at some point dividend growth will have to slow to a lower, more sustainable rate. The Gordon growth model is appropriate to use for mature companies that have a history of increasing their dividend at a steady and sustainable rate. A single stage free cash flow to equity model is similar to the Gordon growth model, but values future free cash flow to equity rather than dividends.