5.3. FCFE VERSUS DIVIDEND DISCOUNT MODEL VALUATION
The FCFE model can be viewed as an alternative to the dividend discount model. Since the two approaches sometimes provide different estimates of value for equity, it is worth examining when they provide similar estimates of value, when they provide different estimates of value, and what the difference tells us about the firm.
5.3.1. When They Are Similar
There are two conditions under which the value from using the FCFE in discounted cash flow valuation will be the same as the value obtained from using the dividend discount model. The first is the obvious one, where the dividends are equal to the FCFE. There are firms that maintain a policy of paying out excess cash as dividends either because they have precommitted to doing so or because they have investors who expect this policy of them.
The second condition is more subtle, where the FCFE is greater than dividends, but the excess cash (FCFE minus dividends) is invested in fairly priced assets (i.e., assets that earn a fair rate of return and thus have zero net present value). For instance, investing in financial assets that are fairly priced should yield a net present value of zero. To get equivalent values from the two approaches, though, we have to keep track of accumulating cash in the dividend discount model and add it to the value of equity (as shown in Illustration 5.10 at the end of this section).
5.3.2. When They Are Different
There are several cases where the two ...
