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Types of CF valuation models (RI model (Residual income ((economic gain to…
Types of CF valuation models
RI model
Residual income
economic gain to shareholders
earned in excess of opportunity costs
common shareholders
:pencil2: = Net Income – (cost of equity ×
Beginning BV of common equity)
Problems
Understanding of accrual accounting
Poor quality of accounting
BVPS
= BVPS at t = 0 + PV of expected future
residual earnings
:no_entry: Valid only when
Clean Surplus
Accounting
BV t = BVt-1 + NIt – Dividendst
RI model when
pays
no dividend
negative FCF
Use DDM
when
Company pays dividends
Dividends relate on earnings
Earnings rise => Dividends rise
Valuing minority share
Assume no control over
timing and amount of dividends
Use FCF
when
No history of dividends
Dividends are not related to earnings/profitability
of the company
Use FCFF instead of
FCFE when
Company has volatile capital structure
Company is highly leveraged
Company has negative FCFE
Investor has a controlling share
:warning: growing companies
have negative FCF