The value of an asset is related to the returns we expect to receive from holding it, and the discount rate we use to account for the time value of money.

The three most widely used definitions of cash flows are dividends, free cash flow, and residual income.

Dividend Discount Model

The model defines cash flows as dividends.

Advantages:

• An Investor who buys and holds a share of stock generally receives cash returns only in the form of dividends.
• DDM accounts for reinvested earnings when it takes all future dividends into account.
• Dividends are less volatile than other return concepts such as earnings and DDM values are often viewed as reflecting long-run intrinsic value.

Disadvantages:

• It cannot be applied to valuation of companies that do not have established dividend policy and do not pay dividends.
• It is not applicable for valuation of control ownership.

The model is most suitable when:

• The company is dividend-paying (i.e., the analyst has a dividend record to analyze).
• The board of directors has established a dividend policy that ties to the company's performance.
• The investor takes a non-control perspective.

Free Cash Flow Model

The concept of free cash flow responds to the reality that, for a going concern, some of the cash flow from operations is not "free" but rather needs to be committed to reinvestment and new investment in assets.

• Free cash flow to the firm (FCFF) equals operating cash flow less capital expenditures.
• Free cash flow to equity (FCFE) equals operating cash flow less capital expenditures and net debt payments.
• Capital expenditures refer to reinvestment in new assets, including working capital.

Advantages:

• In contrast to dividends, a record of free cash flows is observable for any company.
• Free cash flow always reflects the capital that can potentially be paid out to shareholders, notwithstanding the dividend policy.
• Since FCF model is based on the capital exceeding operational needs, it is useful for valuation of control ownership that allows investors to redeploy this capital.

Disadvantages:

• Many companies have negative free cash flow for years due to large capital demands. Since prediction of free cash flow far in the future would be imprecise, FCF model cannot be used for growth companies.

The model is most suitable when:

• The company is not dividend-paying.
• Dividends deviate significantly from FCFE.
• Control equity interest is being valued.
• Free cash flows are expected to be positive and reflect company profitability in the near future.

Residual Income Model

Residual income for a given period is the earnings for that period excess of the investors' required rate of return on beginning-of-period investment (common stockholders' equity). That is, it equals accounting earnings minus opportunity costs of invested capital. It attempts to match profits to the time period in which they are earned but not necessarily realized as cash.

Example

Suppose shareholders' initial investment is $100 million. The required rate of return on the stock is 10%. The company earns $12 million in the course of a year. How much value has the company added for shareholders?

A return of 0.1 x $100 million = $10 million just meets the amount investors could have earned in an equivalent-risk investment. Only the residual excess amount of $12 million - $10 million = $2 represents value added, or an economic gain, to shareholders. So, $2 million is the company's residual income for the period.

Advantages:

• It reflects economic value earned on shareholders' investments.
• It can be applied even when the company is not paying dividends and has negative free cash flows.
• A significant part of a company's value is its book value, which makes the model less dependent on forecast of distant cash flows.

Disadvantages:

• The model is based on accrual accounting. Consequently, it bears the risk of earnings distortion and requires significant adjustments of accounting data to be used as inputs in the model.

The model is most suitable when:

• The company is not dividend-paying.
• Expected free cash flows are negative for extended period of time in the future.