DCF for companies with dividends
How do you value dividends' impact on equity value in a DCF? The company I'm modeling has a programmatic dividends payout plan. In the projection period, the cash on B/S decreases by the amount paid out each year. I understand that DCF is built on UFCF, and enterprise value doesn't change whether or not a company pays dividends. However, the equity value is lowered by the amount of cash paid out, so the ending equity value with dividends is lower than the equity value without dividends. That doesn't make sense to me. Shouldn't dividends add to equity value for shareholders? How do you add the value of dividends to equity value build? Thanks!
You don't generally account for dividends in a regular DCF. The purpose of a DCF is to determine the intrinsic value of a business based on cash flows. What the company ultimately does with its excess cash flows is irrelevant.
Free cash flow can go to a number of places: (1) re-invested in the business to drive growth (but this is already captured in your OPEX projections in your DCF), (2) pay down debt, (3) return to shareholders through buybacks or dividends.
In more mechanical terms, when you do a DCF, you end up with an "enterprise value", which is the value of the business itself. From there you deduct the claims that the equityholders don't get (e.g., debt) to calculate equity value, which is the value that the equity holder receives.
Dividends are paid to equity holders. Therefore, if a company has a DCF-calculated enterprise value of $100 with $20 debt, $10 cash, the equity value is $90. If you pay out a $1 dividend, cash is now $9, but the equityholder receives an extra $1, so the equity value doesn't change. Similarly, if you pay down $20 debt, it's neutral because cash goes down and debt goes down as well.
Also, remember you are discounting cash flows to the present. Therefore, how the cash and debt balances change in future periods doesn't matter because you are evaluating everything from a present day basis.
If cash is used to pay down debt, then net debt doesn’t change (=10). But when cash is used for dividends, net debt goes up (=11 in your example) and EV is lowered by 1. To get to the correct equity value, is it right to add the PV of interim dividends and terminal value of dividends, on top of the regular equity value?
Not quite. When cash is used for dividends, EV doesn't change.
Enterprise value means the present value of future free cash flows that the enterprise generates. That means it does NOT include the cash sitting in the bank at the present moment.
The reason it's called "free" is because the "non-free" cash flows have already been spent to fund the business (cogs, opex, capex, etc.) The free cash flow is what is left over.
Let's say this is your company, and the PV of future free cash flows is $100. You had previously borrowed $20 to fund the creation of the enterprise. The rest of the setup costs were funded by you personally.
Therefore, regardless of how much your enterprise is worth, you only owe $20. Everything else goes to YOU, the equityholder, i.e., "equity value"
Let's also say you have $10 in the corporate bank account at the present moment. So you have an enterprise worth $100 in addition to $10 in the bank account. However, you also owe $20, so what do you, the equityholder, get if you sell the business right now?
You receive $100 for the business, pay back the $20, and put the remaining $80 of proceeds into the corporate bank account, which had $10 prior to the deal.
You, the equityholder, now have a corporate bank account with $100 - $20 + $10 = $90...and that's it. The business itself is gone and your debt has been paid off. Only the account remains.
You can keep it in the corporate bank account OR you can transfer it to your own personal bank account....in other words, pay yourself a dividend. Either way, you have $90 of equity value.
Similarly, if you expect to take a portion of future free cash flows into perpetuity every year and place it in your bank account, then instead of receiving $100 of proceeds, you'll receive $100 minus the present value of those future dividends in proceeds...which accrues in your personal bank account.
Let's say the PV of those future dividends is $15. Then in the scenario above, at deal close, instead of having $90 in the corporate bank account and $0 in your personal account, you would have $75 in the corporate bank account, $0 in your personal account, and the expectation of a perpetual stream of dividends flowing into your personal account, the present value of which is $15.
So $75 + $15 is still = $90.
The only difference between this and a DCF of a regular company is that instead of the non-borrowed setup costs being funded by only you, you recruited a bunch of other friends to fund it with you. You can split that pie however you want among yourselves, but that pie is still only $90 in total.
That's why dividends don't matter here. It's out one pocket and into the other pocket from the perspective of the equityholders. That's different than operating expenses for example, because that money is leaving the accounts of both the business and the equityholders.
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