The Gordon growth model is a simple and convenient way of valuing stocks but it is extremely sensitive to the inputs for the growth rate. Used incorrectly, it can yield misleading or even absurd results, since, as the growth rate converges on the discount rate, the value goes to infinity. As the growth rate approaches the cost of equity, the value per share approaches infinity. If the growth rate exceeds the cost of equity, the value per share becomes negative.
In summary, the Gordon growth model is best suited for firms growing at a rate comparable to or lower than the nominal growth in the economy and which have well established dividend payout policies that they intend to continue into the future. The dividend payout of the firm has to be consistent with the assumption of stability, since stable firms generally pay substantial dividends1. In particular, this model will under estimate the value of the stock in firms that consistently pay out less than they can afford and accumulate cash in the process.
The dividend discount model's primary attraction is its simplicity and its intuitive logic. After all, dividends represent the only cash flow from the firm that is tangible to investors. Estimates of free cash flows to equity and the firm remain estimates and conservative investors can reasonably argue that they cannot lay claim on these cash flows. Thus, finally, it can be argued that managers set their dividends at levels that they can sustain even with volatile earnings. Unlike cash flows that ebb and flow with a company's earnings and reinvestments, dividends remain stable for most firms. Thus, valuations based upon dividends will be less volatile over time than cash flow based valuations.
The FCFE model is a more general version of the dividend discount model and allows analysts more freedom in estimating cash flows. In a sense, it substitutes potential dividends for actual dividends paid and should yield more realistic estimates of value for firms where the two numbers deviate. While free cash flows to equity models relax the constraints on measuring cash flows to equity placed by dividend discount models, there is a cost. Analysts have to estimate net capital expenditures and non-cash working capital needs each year to get to cash flows. While this may be straight forward, analysts also have to estimate how much cash the firm will raise from new debt issues and how much they will use to repay old debt. This exercise is fairly straight forward when firms maintain stable debt ratios but becomes increasingly complicated as debt ratios are expected to change over time.
Clearly, free cash flows to equity models cannot be used when the inputs needed to compute free cash flows to equity (capital expenditures, depreciation, working capital and net debt cash flows) are difficult or impossible to estimate. As noted earlier in the discussion of dividend discount models, this is often the case with financial service companies and can sometimes be an issue when there is incomplete or unreliable financial information available on the company. If this occurs, falling back on the dividend discount model will yield more reliable estimates of value.
The FCFE model can be viewed as an alternative to the dividend discount model. Since the two approaches sometimes provide different estimates of value for equity, it is worth examining when they provide similar estimates of value, when they provide different estimates of value and what the difference tells us about the firm.
There are two conditions under which the value from using the FCFE in discounted cash flow valuation will be the same as the value obtained from using the dividend discount model. The first is the obvious one, where the dividends are equal to the FCFE. There are firms that maintain a policy of paying out excess cash as dividends either because they have pre-committed to doing so or because they have investors who expect this policy of them.
The second condition is more subtle, where the FCFE is greater than dividends, but the excess cash (FCFE - Dividends) is invested in fairly priced assets (i.e. assets that earn a fair rate of return and thus have zero net present value). There are several cases where the two models will provide different estimates of value. First, when the FCFE is greater than the dividend and the excess cash either earns below-market interest rates or is invested in negative net present value assets, the value from the FCFE model will be greater than the value from the dividend discount model. There is reason to believe that this is not as unusual as it would seem at the outset. There are numerous case studies of firms, which having accumulated large cash balances by paying out low dividends relative to FCFE, have chosen to use this cash to finance unwise takeovers (where the price paid is greater than the value received from the takeover).
Second, the payment of dividends less than FCFE lowers debt-equity ratios and may lead the firm to become under levered, causing a loss in value. In the cases where dividends are greater than FCFE, the firm will have to issue either new stock or debt to pay these dividends or cut back on its investments, leading to at least one of three negative consequences for value. If the firm issues new equity to fund dividends, it will face substantial issuance costs that decrease value.
If the firm borrows the money to pay the dividends, the firm may become over levered (relative to the optimal) leading to a loss in value. Finally, if paying too much in dividends leads to capital rationing constraints where good projects are rejected, there will be a loss of value (captured by the net present value of the rejected projects).
There is a third possibility and it reflects different assumptions about reinvestment and growth in the two models. If the same growth rate used in the dividend discount and FCFE models, the FCFE model will give a higher value than the dividend discount model
whenever FCFE are higher than dividends and a lower value when dividends exceed FCFE. In reality, the growth rate in FCFE should be different from the growth rate in dividends, because the free cash flow to equity is assumed to be paid out to stockholders.
This will affect the equity reinvestment rate of the firm. In addition, the return on equity used in the FCFE model should reflect the return on equity on non-cash investments, whereas the return on equity used in the dividend discount model should be the overall return on equity.
What we can state in this project is that due to the effective and considerable factors and items in each models and their tolerance during the years in Technology Sector companies listed in Bursa Malaysia, and not existing a constant or even rational growth rate among them, it is so difficult to predict and forecast their values in this market and it is also risky with low accuracy.
These two models applied in this project (DDM and FCFE) for valuing the companies' equity, generally are standard and easiest models with high accuracy among the other valuation models. Using valuation models which need more data and items in their valuation procedure will be more risky with higher false possibility. According to the comparison of the two models in our study, FCFE model requires more data and information about the company and its operation. Therefore unexpected and non preventable changes in the company will cause more difference between the estimated intrinsic value and the actual value observed at the end of the year. However using DDM which needs few data of the company is functioning more accurate and reliable in forecasting the value of equity of the company.
On the whole, to summarize the project, it is realized that this project could successfully consider these two models by using the actual data and information of the companies and the outcome of this project is reasonable and applicable by other researchers or investors. This project shows that applying DDM for valuation of companies in Technology Sector is more suitable and reliable in compare with FCFE model.
One of the purposes of this project is presenting a comprehensive and accurate concept of valuation of companies and several introduced models in this way. Since valuation of companies is almost a new concept and there are limited researches and surveys done for this concept, perfect information are collected about the whole existing valuation models in this study and comparing them with each other.
The other purpose of this project is concentrating more in detail on the two models of Discounted Dividend Model and Free Cash Flow to Equity Model while applied them in real situation among the listed companies of technology sector in Malaysia in order to compare and evaluate these two models and verifying them in term of their applicability in forecasting the future values of companies.
This project is fulfilled by selecting the listed companies of technology sector in Malaysia and applying DDM and FCFE models for estimating the intrinsic values of their equity and finally introducing DDM as the most relevant valuation model can be applied in current market situation in Malaysia in compare with FCFE.
As a part of conclusion, It should be stateted that according to the logic and pre-assumptions of these two models, they are more applicable and reliable in those markets which are more stable and the companies are growing in a constant growth rates. However, enough knowledge and competency of the managers and expertise in each company, especially those people who are in level of decision making, and using the real information and analyzing them will lead the company towards development and success by making accurate decision while investing.
By using the latest information and data of the twenty eight selected companies in Malaysia and relying to their real data and information, this project could evaluate and compare the two models of DDM and FCFE in Malaysian Technology Sector and presenting perfect and useful information about the valuation models especially these two models, and analyzing these models and interpreting and expressing the models and considering the suitable situations while using them, verifying the impacts and effects of these two models in valuation process and studying the suitable times and conditions to use these two models and finally comparing the two models together.
According to the findings in this project, the valuation models of Stable Growth DDM and FCFE, since they are considering many different items and factors of the companies, are more usable in stable markets in which the companies are growing constantly and they are paying dividends equal to their Free Cash Flow. Since the Malaysian economy is a growing economy with high growth rate, and the companies are also growing rapidly, therefore the accuracy of these two models are affected, especially when the Stable Growth models are using. In fact, in such market those models which are dealing with high growth rates or multi growth rate can be applied to forecast the values more accurate and reliable.
However in this project, since the Stable Growth models of DDM and FCFE are considered, the result shows more accuracy of DDM and higher relevant relation between the intrinsic values obtained and actual values observed.
