101 Concepts for the Level I Exam

Concept 76: Dividend Discount and Free-Cash-Flow-to-Equity Models

Dividend discount model: Value is estimated as the present value of expected future dividends plus the present value of a terminal value.

$V_0\ =\ \sum^n_{t=1}{{{D^t}\over {{\left(1+r\right)}^t}}+{{P^n}\over {{\left(1+r\right)}^n}}}$

A stock paid a $10 dividend last year. The next year’s dividend will be 8% higher and the stock will sell at $150 at year-end. Calculate the value of this stock if the required rate of return is 12%.

Solution:

D₁ = D₀ x (1 + dividend growth rate) = $10 x 1.08 = $10.8

$V_0\ =\ {{\$10.8}\over {1.12}}+{{\$150}\over {1.12}}=\$143.57$

Free cash flow to equity model: Value is estimated as the present value of expected future free cash flow to equity. FCFE is the cash available to the firm’s equity holders after a firm meets all its other obligations.