Why Is Free Cash Flow Approach Better Than Dividend Discount Models?

The dividend discount models assume that the investors have no control over the payout policy of the firm whatsoever. This is true for the case of the minority shareholder. Hence, it is said that as far as the minority shareholder is concerned, dividend discount models may be the best tools for valuing a firm.

This may not be the case when potentially bigger shareholders come into picture. Bigger shareholders find the free cash flow approach much more suitable for their needs. Thus free cash flow approach is said to have the perspective of a big ticket acquirer.

In this article, we will compare the dividend discount model and the free cash flow model.

Dividends do Not Mean Good Performance

The dividend discount models use dividends as a proxy for the firm’s operating performance. The underlying logic is that a firm can continue to pay dividends in the long run only if its underlying business is stable and prosperous.

Multiple cases in the stock market have shown that this need not necessarily be the case. Firm’s can borrow money and keep on paying dividends and mask the fact that the underlying business is rapidly deteriorating. Alternatively, firms could have robust business models and may need cash to invest in them and hence may feel that paying out dividends is sub-optimal utilization of cash.

The correlation between dividends and underlying performance is just that, a correlation! Dividends are neither the cause nor the effect of good performance.

It just happens to be the case that a lot of good businesses tend to pay dividends too! Dividends are just used to distribute the wealth. They are in no way, signals that wealth has been created by the company.

Free Cash Flow Means Value Creation

Free cash flow, on the other hand, is an almost certain signal that the firm is in good financial health. A firm cannot free cash flow by borrowing more money or by creating fictitious accounting entries. For free cash flow to be present the operations have to be efficient and the firm has to be creating value.

The presence of free cash flow therefore is a huge positive signal. The absence may not be considered to be a sure shot negative thing. When companies are in their growth phase, they need cash. Hence, in such scenarios the present day free cash flow may be negative. However, it is expected to be much better in the future.

Thus, free cash flow as a metric, provides a much deeper insight into the workings of a firm.

Control Perspective

Also, dividend discount models have the perspective of a minority shareholder who has no control over the proceedings. They have no option but to agree to the diktat of the board of directors. On the other hand, larger shareholders may be able to purchase a significant holding which might put them in a position to control or at least influence the decisions of the board of directors. They may therefore be able to get a payout policy passed which may be as per their convenience.

For larger shareholders, dividends are completely irrelevant. Neither do they signal a firm’s underlying performance, nor are they the only way that they as investors can plow back their cash.

Difficult to Predict

All being said, the free cash flow models also have a major disadvantage. This disadvantage is that free cash flow is very difficult to predict.

While dividends are completely in the hands of the management and can be accurately estimated based on empirical evidence, free cash flow is influenced by numerous factors and predicting it is a challenge to say the least. However, the challenge is worthwhile since a more accurate valuation is derived using this model.

Lastly, in some cases there may be a huge difference in the valuation derived from dividend discount models and from free cash flow models. Smaller differences can simply be ignored. However, when differences are large, they may be because of the control premium that some large investors are willing to pay.