Common mistake 1 with Equity valuation (DDM, FCF, residual income)

Using a terminal growth rate above long-run nominal GDP growth. No firm outgrows the economy forever.

Common mistake 2 with Equity valuation (DDM, FCF, residual income)

Discounting FCFF at the cost of equity, or FCFE at WACC.

Common mistake 3 with Equity valuation (DDM, FCF, residual income)

Forgetting that the Gordon model needs next year's dividend, D1 = D0(1 + g), not today's.

Common mistake 4 with Equity valuation (DDM, FCF, residual income)

Treating the result as precise. It is only as good as r and g, which are the two most uncertain inputs.

EconStatsCraft › Equity valuation (DDM, FCF, residual income)

Equity valuation (DDM, FCF, residual income)

Intrinsic value per share three ways - discounted dividends, discounted free cash flow, or book value plus residual income - with a high-growth stage, a terminal value and a grid showing how much the answer moves with a point on r or g.

The intuition

A share is a claim on future cash, so it is worth the present value of that cash. The models differ only in which cash they count: dividends actually paid, free cash flow the business could pay, or the profit earned above what shareholders require on the capital they have put in. With consistent assumptions all three give the same answer.

When to use it

Valuing a share for an equity research note, a CFA equity question, or a sanity check on a market price. Dividend models suit mature payers, free cash flow models suit firms that pay little or nothing, and residual income suits banks and firms with negative free cash flow but positive earnings.

Where the estimator comes from

With dividends growing at a constant g<r, V_0=\sum_{t\ge1}D_0(1+g)^t(1+r)^{-t}=\frac{D_1}{r-g}, a geometric series. A two-stage model sums the first n dividends explicitly and adds the Gordon value of the rest, \frac{D_{n+1}}{r-g_2}, discounted n years. Residual income rewrites the same value using clean-surplus accounting, B_t=B_{t-1}+E_t-D_t: substituting D_t and telescoping gives V_0=B_0+\sum_t\frac{E_t-rB_{t-1}}{(1+r)^t}, so value is book value plus the present value of profit above the cost of equity.

The model

V_0 = \sum_{t=1}^{n}\frac{D_0(1+g_1)^t}{(1+r)^t} + \frac{D_{n+1}}{(r-g_2)(1+r)^n},\qquad V_0 = B_0 + \sum_{t\ge1}\frac{(\text{ROE}-r)\,B_{t-1}}{(1+r)^t}

What it assumes

Growth settles to a constant rate g below the required return r forever. If g is close to r the terminal value explodes.
The required return is constant over time, usually from CAPM.
FCFF must be discounted at WACC and gives firm value, from which net debt is subtracted; FCFE is discounted at the cost of equity and gives equity value directly.
Residual income relies on clean-surplus accounting: book value changes only by earnings minus dividends.

Statistical properties

Value rises with g and falls with r, and is extremely sensitive to both when r − g is small.
Justified price-to-book equals one exactly when ROE equals the cost of equity.
FCFF valued at WACC minus net debt equals FCFE valued at the cost of equity when capital structure is held constant.
Residual income recognises value earlier than dividends, so less of it sits in the terminal value.

How to read the output

Most of the value usually sits in the terminal value. If it is above 70% of the total, the answer is mostly a statement about g and r.
The sensitivity grid is the honest output. A one-point change in r or g often moves value by 15% or more.
Value above the market price means the share looks undervalued on these assumptions, not that it is undervalued.
In residual income, a firm earning exactly its cost of equity is worth its book value. ROE above r is what creates a premium to book.

A worked reading

A share paying 2.00 today, with dividends growing 8% a year for five years and 4% after that, discounted at 10%. The five high-growth dividends are worth 9.47 today. The dividend in year six is 3.06, so the terminal value at year five is 3.06 / (10% − 4%) = 50.94, worth 31.63 today. Intrinsic value is 41.10, against a market price of 40, so the share looks about 3% undervalued. But 77% of the value is the terminal value, and the grid shows that at r = 11% the same share is worth only 35.13. The honest conclusion is "fairly priced, within the uncertainty of r".

Symptom → diagnosis → what to do

If you see this	It means	Do this
Value is enormous or negative	Terminal growth at or above the required return	Lower g below r
Value far from the market price	Inputs, not the market, are off	Check r against CAPM and g against nominal GDP
Terminal value above 90% of total	High-growth stage too short	Model the transition with more years
FCFF value per share looks too high	Net debt not subtracted	Enter net debt and shares outstanding
Residual income negative every year	ROE below the cost of equity	Correct: the firm destroys value and is worth less than book

Common mistakes

Using a terminal growth rate above long-run nominal GDP growth. No firm outgrows the economy forever.
Discounting FCFF at the cost of equity, or FCFE at WACC.
Forgetting that the Gordon model needs next year's dividend, D1 = D0(1 + g), not today's.
Treating the result as precise. It is only as good as r and g, which are the two most uncertain inputs.

Where to read this properly

CFA Institute, Equity Valuation readings on discounted dividend, free cash flow and residual income models (Level II).
Gordon (1962), The Investment, Financing and Valuation of the Corporation.
Damodaran, Investment Valuation (2012), ch. 13–15.

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Equity valuation (DDM, FCF, residual income)

The intuition

When to use it

Where the estimator comes from

The model

What it assumes

Statistical properties

How to read the output

A worked reading

Symptom → diagnosis → what to do

Common mistakes

Where to read this properly

See also

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