The dividend discount model is based on the premise that the only cash flows received by stockholders are dividends. Even if we use the modified version of the model and treat stock buybacks as dividends, we may misvalue firms that consistently fail to return what they can afford to their stockholders.
This chapter uses a more expansive definition of cash flows to equity as the cash flows left over after meeting all financial obligations, including debt payments, and after covering capital expenditure and working capital needs. It discusses the reasons for differences between dividends and free cash flows to equity (FCFE), and presents the discounted free cash flow to equity model for valuation.
Given what firms are returning to their stockholders in the form of dividends or stock buybacks, how do we decide whether they are returning too much or too little? We propose a simple measure how much cash is available to be paid out to stockholders after meeting reinvestment needs and compare this amount to the amount actually returned to stockholders.
To estimate how much cash a firm can afford to return to its stockholders, we begin with the net income—the accounting measure of the stockholders' earnings during the period—and convert it to a cash flow by subtracting out a firm's reinvestment needs. First, any capital expenditures, defined broadly to include ...