The free cash flow to equity (FCFE) model does not represent a radical departure from the traditional dividend discount model. In fact, one way to describe a free cash flow to equity model is that it represents a model where we discount potential dividends rather than actual dividends. Consequently, the three versions of the FCFE valuation model presented in this section are simple variants on the dividend discount model, with one significant change—free cash flows to equity replace dividends in the models.

5.2.1. Underlying Principle

When we replace the dividends with FCFE to value equity, we are doing more than substituting one cash flow for another. We are implicitly assuming that the FCFE will be paid out to stockholders. There are two consequences.

  1. There will be no future cash buildup in the firm, since the cash that is available after debt payments and reinvestment needs is paid out to stockholders each period.

  2. The expected growth in FCFE will include growth in income from operating assets and not growth in income from increases in marketable securities. This follows directly from the preceding point.

How does discounting free cash flows to equity compare with the modified dividend discount model, where stock buybacks are added back to dividends and discounted? You can consider stock buybacks to be the return of excess cash accumulated largely as a consequence of not paying out FCFE as dividends. Thus, FCFE represents a smoothed-out ...

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