This lesson concludes the module by examining the application of TVM and the cost of capital to equity valuation. It covers the Dividend Discount Model (DDM) and Free Cash Flow models.

  • Equity Valuation Principles: The intrinsic value of a common stock is the present value of its expected future cash flows. The CFA Institute identifies dividends, free cash flow, and residual income as alternative cash flow definitions for discounted cash flow models. The choice of model depends on the company’s characteristics.

  • The Dividend Discount Model (DDM): This model values a stock as the present value of all expected future dividends. As the CFA Institute explains, the DDM is most suitable for dividend-paying stocks where the company has a discernible dividend policy linked to profitability and the investor has a minority ownership perspective.

  • The Gordon Growth Model (Constant Growth DDM): Assumes dividends grow at a constant rate forever. The formula is:

    • V0 = D1 / (r – g) where g is the constant dividend growth rate and r is the required rate of return. The model is highly sensitive to the growth and required return assumptions.

  • Multistage Dividend Discount Models: For companies with varying growth rates (high growth in early years, stable growth later), multistage models are used. The two-stage DDM, the H-model, and the three-stage DDM provide different approaches to modeling this growth pattern.

  • Free Cash Flow Models (FCFF and FCFE): The CFA Institute notes that free cash flow models are particularly useful when the company does not pay dividends, dividends differ significantly from the company’s capacity to pay dividends, free cash flows align with profitability, or the investor takes a control perspective.

    • FCFF (Free Cash Flow to the Firm): Cash flow available to all investors (debt and equity holders). The firm value is the present value of FCFF discounted at WACC.

    • FCFE (Free Cash Flow to Equity): Cash flow available to common stockholders. The equity value is the present value of FCFE discounted at the cost of equity.

  • Selecting the Right Valuation Model: The choice between DDM and free cash flow models depends on the company’s dividend policy, growth characteristics, and the analyst’s perspective (control vs. minority ownership). The CFA Institute provides a decision framework based on these factors

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