Question

Please describe the differences and similarities of 3 valuation approaches: NPV, Free Cash Flow, and Dividend models.

Answer 1

The similarities are :

• All 3 approaches calculate the value as the present value of a series of future cash flows
• All 3 approaches require a discount rate
• All 3 approaches can be used for multi-stage growth possibilities

The differences are :

• NPV and cash flow approaches use free cash flows, whereas dividend approach uses dividends
• In dividend growth model and cash flow models, the growth rate cannot be higher the discount rate because the terminal value becomes indeterminable. However this is not the case with NPV model because there is no terminal value required
• NPV and cash flow models use net income as a base figure and calculate the cash flows whereas the dividend model usually takes dividends directly without requiring net income as a base figure