Discounted Cash Flow and Dividend Discount Models
Discounted Cash Flow and Dividend Discount Models tests the mechanics and assumptions of present-value valuation. Candidates must build clean forecasts, choose a discount rate consistent with the cash flow, and defend terminal value.
Core rules
- FCFF is cash available to all capital providers and is discounted at WACC. FCFE is cash available to equity and is discounted at the cost of equity.
- FCFF = EBIT × (1 − tax rate) + depreciation − capex − increase in net working capital, before interest.
- Terminal value commonly uses the Gordon growth model: TV = FCFF_(n+1) ÷ (WACC − g), or an exit multiple. Discount TV back from the terminal date.
- The Gordon DDM values equity as D1 ÷ (r − g). D1 is next year’s dividend, not the last paid dividend.
- Sustainable growth is approximately ROE × retention ratio. A growth rate above the long-run nominal economy growth is hard to sustain.
Worked example
A stock just paid a $2.00 dividend. Dividends are expected to grow 4%, and the required return is 9%. D1 = $2.00 × 1.04 = $2.08. Value = $2.08 ÷ (0.09 − 0.04) = $41.60. At a market price of $44, the implied return is $2.08 ÷ $44 + 4% = 8.73%, below the 9% required return, so the stock appears overvalued.
Traps
Do not use D0 in the numerator. Do not discount a year-5 terminal value by five years if it is based on year-6 cash flow and already represents value at the end of year 5; be consistent with timing. Never let g exceed the discount rate. Do not use WACC to discount FCFE.