Calculating Free Cash Flow to the Firm: Method #2: Cash Flow From Operations
February 12, 2025
A lot of developing countries do not have the finances required to build large scale infrastructure projects. However, these countries do have large parcels of lands in urban areas. There is a dire need for infrastructure projects in the developing world. Cities like Beijing, Mumbai, Karachi and Bangkok are bursting at their seams due to […]
Financial modeling is not a perfect science. In fact, it would be fair to say that financial modeling is part art and part science. This is because the specific steps required to create a financial model cannot be chalked out. However, there is a broad framework which needs to be followed in order to create […]
The American energy sector has really taken off in the past few years. The discovery of “fracking” or hydraulic fracturing has completely changed the dynamics of the oil and gas industry. The end result has been a historic boom in the oil and gas industry. For the first time in many decades, America has become […]
In the past few articles, we have studied about the various models that are available to help us predict the value of a firm based on the dividends that it provides. However, all these models had one flaw. They expected that the dividends of the firm will follow some set pattern. For instance, the assumptions […]
Commercial banking is fundamentally different from retail banking in several ways. One of the main differences between the two types of banking is the relationship management approach. The commercial banking system relies heavily on relationship management. Each and every corporate customer of a commercial bank has a dedicated relationship manager. This is possible because of […]
The dividend discount model also has its fair share of criticism. While some have hailed it as being indisputable and being not subjective, recent academicians and practitioners have come up with arguments that make you believe the exact opposite.
Recent studies have unearthed some glaring flaws in what was considered to be a perfect valuation model.
This article is focused on understanding these shortcomings. This knowledge will help us understand when not to apply the dividend discount model.
High growth companies, by definition face lots of opportunities in the future. They may want to develop new products or explore new markets. To do so, they may need more cash than they have on hand. Hence such companies have to raise more equity or debt. Obviously they cannot afford the luxury of having the cash to pay out dividends. These companies are therefore missed by investors who are focused too much on the dividends.
For instance, investors following the dividend discount model would never have invested in companies like Google or Facebook. Even, a global behemoth like Microsoft did not have any track record of paying dividends until very recently. Hence, according to dividend discount model, these companies cannot be valued at all!
Many investors prefer an alternate approach. They try to forecast the time when the growing company will actually evolve into a mature stable business and will start paying out dividends. However, this is extremely difficult.
The projections become more and more risky as we try to project farther and farther into the future. Thus, we can conclude that the dividend discount models have limited applicability.
There have been instances where companies have been simultaneously borrowing cash while maintaining a dividend payout. In this case, this is a clear incorrect utilization of resources and paying dividends is eroding value. Hence, assuming that dividends are directly related to value creation is a faulty assumption until it is backed by relevant data.
In these countries most of the companies will not pay out dividends because it leads to dilution of value. Any investor who only strictly believes in dividend discount model will have no option but to ignore all the shares pertaining to that particular country! This is one more reason why dividend discount model fails to guide investors.
Therefore, dividend discount model is not very useful for investors who want to invest in high risk return companies. Also, it may not be in alignment with the tax structures being followed by certain countries.
Your email address will not be published. Required fields are marked *