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The E-Model: A Three-Stage FCFE Model
Source: Aswath Damodaran (p. 366)
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The E-Model: A Three-Stage FCFE Model
Source: Aswath Damodaran (p. 368)
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Three-Stage FCFE Model
The following example of a three-stage FCFE model is a little different than the last two examples because we are given
growth in total FCFE in each of three stages, rather than the growth rates in the components.
Growth in the first and third stage is constant, while growth in the second stage is declining.
There is one tricky feature to this problem - the required return in each of the three growth stages is different.
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Example: Three-stage FCFE model
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Example: Three-stage FCFE model
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Example: Three-stage FCFE model
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Example: Three-stage FCFE model
Source: Aswath Damodaran (p. 372) 7
DDM Valuation and FCFE Valuation
When the Values from DDM and FCFE Models Are Similar?
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.
The second condition is more subtle, where the FCFE is greater than dividends, but the excess cash (FCFE minus
dividends) is invested in projects with net present value of zero.
(For instance, investing in financial assets that are fairly priced should yield a net present value of zero.)
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DDM Valuation and FCFE Valuation
Source: Aswath Damodaran (pp. 372-373)
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 projects; V(FCFE) > V(DDM)
When the payment of smaller dividends than can be afforded to be paid out by a firm may lead to a lower debt ratio and a
higher cost of capital, causing a loss in value; V(FCFE) > V(DDM) When the Values from DDM and FCFE Models Are Different?
Continued on next slide
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DDM Valuation and FCFE Valuation
When DDM valuation and FCFE valuation are different?
When, in the cases where dividends are greater than FCFE, the firm has to issue either new stock or new debt to pay these
dividends leading to negative consequences for value:
substantial issuance costs, overlevered and exposed to
distress/default and leading to a loss in value, paying too much in dividends leading to capital rationing constraints where good projects are rejected.
When firms pay out much less in dividends than they have
available in FCFE, the expected growth rate and terminal value will be higher in the DDM, but the year-to-year cash flows will be higher in the FCFE model.
Source: Aswath Damodaran (pp. 372-373)
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Differeces between DDM and FCFE Models
Source: Aswath Damodaran (p. 373)
Valuing Coca-Cola with a Three-Stage FCFE Model
Source: Aswath Damodaran (pp. 374-376)
Valuing Coca-Cola with a Three-Stage FCFE Model
Valuing Coca-Cola with a Three-Stage FCFE Model
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Valuing Coca-Cola with a Three-Stage FCFE Model
Valuing Coca-Cola with a Three-Stage FCFE Model
Conclusion
(tip) Equity Valuation versus Firm Valuation
Assets Liabilities
Assets in Place Debt
Equity
Fixed Claim on cash flows Little or No role in management Fixed Maturity
Tax Deductible
Residual Claim on cash flows Significant Role in management Perpetual Lives
Growth Assets Existing Investments
Generate cashflows today Includes long lived (fixed) and
short-lived(working capital) assets
Expected Value that will be created by future investments
Equity valuation: Value just the equity claim in the business
Firm Valuation: Value the entire business
Source: Aswath Damodaran 17
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