Over-Valuation: Avoid Double Counting when Retaining Dividends in the FCFE Valuation

Joao Marques Silva and Jose Azevedo Pereira

International Journal of Financial Research, 2017, vol. 8, issue 4, 107-114

Abstract: Valuation based on DCF (Discounted Cash Flow) has been the dominant valuation procedure during the last decades. In spite of this dominance, enterprise valuation using the discounted FCF (Free Cash Flow) model has some practical drawbacks, since there is often some confusion on how to effectively use it. Commonly, the valuation procedures start by estimating future FCF figures from historical data, such as mean FCF, growth and retention ratio, alongside many other variables. These FCF forecasts are discounted at the cost of equity (FCFE ¨C FCF to Equity) or the Weighted Average Cost of Capital WACC (FCFF ¨C FCF to Firm). Implicit in the above mentioned valuation procedures is the expectation that the company puts the retained free cash that is generating to good use, yielding a value capable of rewarding appropriately the level of risk inherent in the way it used. Some poorly performed valuation studies however tend to double count (Damodaran, 2006a) the retained cash¡¯s interest in subsequent values of FCF, or include the accumulated cash build-up in the Terminal Value. This paper discusses how these two common double-counting mistakes are made and evaluates their weight in the final valuation figure for the particular case of retained FCFE (the case for the FCFF is analogous, but we focus on FCFE for simplicity) using projected figures.

Keywords: valuation; free cash flow; discounted cash flow; reinvestment performance (search for similar items in EconPapers)
Date: 2017
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Persistent link: https://EconPapers.repec.org/RePEc:jfr:ijfr11:v:8:y:2017:i:4:p:107-114

DOI: 10.5430/ijfr.v8n4p107

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