DISCOUNTED CASHFLOW MODELS: WHAT THEY ARE AND HOW TO CHOOSE THE
RIGHT ONE..
THE FUNDAMENTAL CHOICES FOR DCF VALUATION
 Cashflows to Discount
 Dividends
 Free Cash Flows to Equity
 Free Cash Flows to Firm
 Expected Growth
 Stable Growth
 Two Stages of Growth: High Growth > Stable Growth
 Three Stages of Growth: High Growth > Transition Period > Stable
Growth
 Discount Rate
 Cost of Equity
 Cost of Capital
 Base Year Numbers
 Current Earnings / Cash Flows
 Normalized Earnings / Cash Flows
WHICH CASH FLOW TO DISCOUNT...
 The Discount Rate should be consistent with the cash flow being
discounted
 Cash Flow to Equity > Cost of Equity
 Cash Flow to Firm > Cost of Capital
 Should you discount Cash Flow to Equity or Cash Flow to Firm?
 Use Equity Valuation
 (a) for firms which have stable leverage, whether high or not,
and
 (b) if equity (stock) is being valued
 Use Firm Valuation
 (a) for firms which have high leverage, and expect to lower the
leverage over time, because
 debt payments do not have to be factored in
 the discount rate (cost of capital) does not change dramatically
over time.
 (b) for firms for which you have partial information on leverage
(eg: interest expenses are missing..)
 (c) in all other cases, where you are more interested in valuing
the firm than the equity. (Value Consulting?)
 Given that you discount cash flow to equity, should you discount
dividends or Free Cash Flow to Equity?
 Use the Dividend Discount Model
 (a) For firms which pay dividends (and repurchase stock) which
are close to the Free Cash Flow to Equity (over a extended period)
 (b)For firms where FCFE are difficult to estimate (Example: Banks
and Financial Service companies)
 Use the FCFE Model
 (a) For firms which pay dividends which are significantly higher
or lower than the Free Cash Flow to Equity. (What is significant?
... As a rule of thumb, if dividends are less than 75% of FCFE
or dividends are greater than FCFE)
 (b) For firms where dividends are not available (Example: Private
Companies, IPOs)
WHAT IS THE RIGHT GROWTH PATTERN...
THE PRESENT VALUE FORMULAE
 For Stable Firm:
 For two stage growth:
 For three stage growth:
Definitions of Terms
V_{0}= Value of Equity (if cash flows to equity are discounted) or
Firm (if cash flows to firm are discounted)
CF_{t} = Cash Flow in period t; Dividends or FCFE if valuing equity or FCFF if valuing firm.
r = Cost of Equity (if discounting Dividends or FCFE) or Cost
of Capital (if discounting FCFF)
g = Expected growth rate in Cash Flow being discounted
g_{a}= Expected growth in Cash Flow being discounted in first stage
of three stage growth model
g_{n}= Expected growth in Cash Flow being discounted in stable period
n = Length of the high growth period in twostage model
n1 = Length of the first high growth period in threestage model
n2  n1 = Transition period in threestage model
WHICH MODEL SHOULD I USE?
 Use the growth model only if cash flows are positive
 Use the stable growth model, if
 the firm is growing at a rate which is below or close (within
12% ) to the growth rate of the economy
 Use the twostage growth model if
 the firm is growing at a moderate rate (... within 8% of the stable
growth rate)
 Use the threestage growth model if
 the firm is growing at a high rate (... more than 8% higher than
the stable growth rate)
SUMMARIZING THE MODEL CHOICES

Dividend Discount Model

FCFE Model

FCFF Model

Stable Growth Model 
 Growth rate in firmís earnings is stable. (g of firm_{economy}+1%)
 Dividends are close to FCFE (or) FCFE is difficult to compute.
 Leverage is stable

 Growth rate in firmís earnings is stable. (g_{firmeconomy}+1%)
 Dividends are very different from FCFE (or) Dividends not available
(Private firm)
 Leverage is stable

 Growth rate in firmís earnings is stable. (g_{firmeconomy}+1%)
 Leverage is high and expected to change over time (unstable).

TwoStage Model 
 Growth rate in firmís earnings is moderate.
 Dividends are close to FCFE (or) FCFE is difficult to compute.
 Leverage is stable

 Growth rate in firmís earnings is moderate.
 Dividends are very different from FCFE (or) Dividends not available
(Private firm)
 Leverage is stable

 Growth rate in firmís earnings is moderate.
 Leverage is high and expected to change over time (unstable).

ThreeStage Model 
 Growth rate in firmís earnings is high.
 Dividends are close to FCFE (or) FCFE is difficult to compute.
 Leverage is stable

 Growth rate in firmís earnings is high.
 Dividends are very different from FCFE (or) Dividends not available
(Private firm)
 Leverage is stable

 Growth rate in firmís earnings is high.
 Leverage is high and expected to change over time (unstable).

GROWTH AND FIRM CHARACTERISTICS

Dividend Discount Model 
FCFE Discount Model 
FCFF Discount Model 
High growth firms generally 
 Pay no or low dividends
 Earn high returns on projects (ROA)
 Have low leverage (D/E)
 Have high risk (high betas)

 Have high capital expenditures relative to depreciation.
 Earn high returns on projects
 Have low leverage
 Have high risk

 Have high capital expenditures relative to depreciation.
 Earn high returns on projects
 Have low leverage
 Have high risk

Stable growth firms generally 
 Pay large dividends relative to earnings (high payout)
 Earn moderate returns on projects (ROA is closer to market or
industry average)
 Have higher leverage
 Have average risk (betas are closer to one.)

 narrow the difference between cap ex and depreciation. (Sometimes
they offset each other)
 Earn moderate returns on projects (ROA is closer to market or
industry average)
 Have higher leverage
 Have average risk (betas are closer to one.)

 narrow the difference between cap ex and depreciation. (Sometimes
they offset each other)
 Earn moderate returns on projects (ROA is closer to market or
industry average)
 Have higher leverage
 Have average risk (betas are closer to one.)

SHOULD I NORMALIZE EARNINGS?
 Why normalize earnings?
 The firm may have had an exceptionally good or bad year (which
is not expected to be sustainable)
 The firm is in financial trouble, and its current earnings are
below normal or negative.
 What types of firms can I normalize earnings for?
 The firms used to be financially healthy, and the current problems
are viewed as temporary.
 The firm is a small upstart firm in an established industry, where
the average firm is profitable.
HOW DO I NORMALIZE EARNINGS?
 If the firm is in trouble because of a recession, and its size
has not changed significantly over time,
 Use average earnings over an extended time period for the firm
Normalized Earnings = Average Earnings from past period (5 or
10 years)
 If the firm is in trouble because of a recession, and its size
has changed significantly over time,
 Use average Return on Equity over an extended time period for
the firm
Normalized Earnings = Current Book Value of Equity * Average Return
on Equity (Firm)
 If the firm is in trouble because of firmspecific factors, and
the rest of the industry is healthy,
 Use average Return on Equity for comparable firms
Normalized Earnings = Current Book Value of Equity * Average Return
on Equity (Comparables)