Valuation with dividend restriction: FCF or DDM?
Hi everyone,
I need to value a holding and have a question related to the valuation method.
Specifically, as the holding fully consolidates all its subsidiaries and we consider to purchase 100% of the holding, when we use the FCF method we include all the cash flows as they appear on the financial statements. For the utilities project I am working on (100% Equity, no debt), it means nice and steady FCFF (=FCFE) over 20 years (A).
However, in my country and probably everywhere else, you cannot distribute dividend if your retained earnings are negative. For capital intensive projects and digressive depreciation, it means that the cash piles up until the end of your project, which can be 20 years later, with the liquidation of the project. In terms of dividend, it means a sad dividend for 19 years and then a huge quasi-lump sum (B).
If the time value of money was not taken into account, those two streams of cash flows will give the same result (that is, the total cash generated by the project). However, if you discount (A) you find a much better value than (B), that is, if you use the Free Cash Flow to Firm method you have better result than if you use the Dividend Discount Model.
Because cash is king, (B) is closer to the cash reality of the holding than (A), but I doubt that the seller will effectively consider a bid at (B). However, by the time the cash generated by the granddaughter will come in the pocket of the grandmother, the latter will probably be dead.
I would be glad to hear your opinion on this matter.
Thanks
Cheers
ps: some people told me that the trick is to use shareholders loans, equity reduction or "management contracts" to allow the cash to leave the company quicker. That is already a good point.
Sad to see this question never picked up, I had a similar question I just posted as well. I agree with you, @Shimmy2. After all these years, have you any other contributions to make?
Glad you asked! Yes, I think I've got the answer now :).
Equivalency between DDM and DCF comes from the discount rate.
Cheers,
Romain
Thanks Romain!
- What do you mean the lump sum is "derisked"?
Let's assume the scenario of two equal (Holdco or not) projects, 100% equity. One calculation of DCF from FCFE and one based on Dividends. They should then both give an equity value with the only difference that the DDM is lower due to the cash flows being moved backwards. Correct? (In practice we wouldn't change our required return so rate of discounting is the same for both.)
Best,
Christiaan
Hey Christian,
what I mean is that the lump sum at the end of the project (in 20y) will have a lower risk compared to the yearly FCF. By adjusting the discount rate, you'll reach the same equity value.
Imagine you have an asset producing 100 of FCF next year, and the right discount rate is 10% (to go from year 0 to year 1). Using a DCF approach you'll get an equity value of 100/1.1~ 90.
Now assume that you cannot withdraw the fund before Year 2 because of some local accounting rules. The risk of "going" from year 1 to year 2 is much lower than the risk of going from year 0 to year 1, because the funds have already been produced by the asset.
Investing the cash (100) at the risk free rate in the vehicle, and assuming that the vehicle is risk free between year 1 and year 2, you'll get : 100*(1+RF) / (1+10%) *(1+RF) = 1/(1+10%) ~ 90 again.
Hope this helps.
Best,
Romain
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