Updated for the 2026-2027 CFA® Level I curriculum.
Present value models value a share of common equity as the present value of the cash flows an investor expects to receive from owning it. This reading gives you two versions of that idea: the dividend discount model and the free cash flow to equity model.
After this note, you should be able to explain why present value models work, describe the structure of each model, and know when analysts switch from dividends to FCFE.
Quick Answer
Present value models value equity as the present value of expected future cash flows to equity holders, discounted at the required return on equity.
The dividend discount model (DDM) discounts expected dividends.
The FCFE model discounts cash available after operating costs, taxes, and reinvestment, plus net borrowing.
Analysts use FCFE when dividends do not reflect a company's cash-generating capacity for shareholders.
Key Takeaways About Present Value Models: Dividend Discount and FCFE Models
Present value models value equity as the present value of expected future cash flows to shareholders, discounted at the required return on equity.
The dividend discount model treats expected future dividends as the relevant cash flow.
The FCFE model treats free cash flow to equity as the relevant cash flow, whether or not it is paid out.
FCFE is cash flow available after operating expenses, taxes, and reinvestment, plus net borrowing; a net debt repayment reduces FCFE.
Analysts prefer FCFE when a company pays no dividends, pays dividends unrelated to its cash-generating capacity, or is being valued from a control perspective.
DDM and FCFE share the same present value logic. They differ only in the cash flow definition used.
Choosing between the two models is a data and perspective decision, not a change in valuation theory.
What You Need to Know for CFA Level I
Explain why present value is used to value common equity.
Identify the cash flow discounted under the dividend discount model.
Identify the cash flow discounted under the FCFE model.
Recognize when FCFE is more appropriate than dividends as the cash flow measure.
Distinguish a minority shareholder perspective (dividends) from a control perspective (FCFE).
Rationale for Present Value Valuation
Intrinsic value is what an asset is worth based on its expected future cash flows. For common equity, those cash flows go to shareholders, so present value models discount expected shareholder cash flows at the required return on equity.
Equity has no maturity date. Analysts discount cash flows over a long or indefinite horizon, using the cost of equity as the discount rate. This approach differs from the other two main equity valuation approaches tested at Level I: multiplier models, which compare price to a fundamental like earnings, and asset-based models, which value equity from net asset value. Present value models tie value directly to what the investor expects to receive, not to comparable prices or balance sheet figures.
Dividend Discount Model Structure
The dividend discount model defines the relevant cash flow as dividends. In general form:
Where:
= intrinsic value of a share today
= expected dividend in period t
= required return on equity
DDM works well when a company's dividend policy is stable and tied to its earnings and cash flow capacity. Dividends are the cash flow a minority shareholder actually receives, so DDM ties value directly to that experience.
Free Cash Flow to Equity Model Structure
The FCFE model defines the relevant cash flow as free cash flow to equity: cash available after operating expenses, taxes, and the investment needed to sustain and grow operations, plus net borrowing (new debt raised minus debt repaid). FCFE represents cash available to shareholders whether or not it is distributed.
Where:
= expected free cash flow to equity in period t
= required return on equity
The FCFE model values equity based on cash-generating capacity, not on the company's payout decision.
When the Two Models Differ in the Cash Flow Discounted
DDM and FCFE use the same present value mechanics. The difference is entirely in which cash flow gets discounted.
Feature | Dividend Discount Model | FCFE Model |
|---|---|---|
Cash flow discounted | Expected dividends | Expected FCFE |
Who receives it | Actual dividend recipients | Equity holders, distributed or retained |
Best used when | Dividend policy tracks earnings and cash flow capacity | Company pays little or no dividends, or valuation reflects a control perspective |
Discount rate | Required return on equity | Required return on equity |
Result if payout equals FCFE |
Three situations commonly call for FCFE instead of dividends:
The company pays no dividends or pays less than its cash-generating capacity would allow.
Dividends are unrelated to earnings or cash flow trends, making them a poor forecasting base.
The analyst is valuing the company from a control perspective, where an acquirer could change the payout policy and access the full FCFE.
Worked Example
An analyst compares two companies with identical risk and a 10% required return on equity.
Company Alpha pays out 100% of net income as dividends. Current dividend is $3.00 per share, expected to grow at 5% per year indefinitely.
Company Beta pays no dividends. It reinvests all cash flow into projects but generates FCFE of $3.00 per share currently, also expected to grow at 5% per year indefinitely.
Step 1: Value Alpha using DDM
Step 2: Try to value Beta using DDM
Beta pays no dividends, so . A direct DDM calculation would suggest , which does not capture the company's available cash flow.
Step 3: Value Beta using FCFE instead
Beta's equity value does not disappear because it pays no dividends. The FCFE model captures the cash flow available to shareholders even though management reinvests it rather than distributing it. Applying DDM directly to a non-dividend-paying company would understate its value.
The FCFE model gives Beta the same value as Alpha because both companies generate identical cash flow available to shareholders, just with different payout choices.
Common Exam Traps
Assuming a non-dividend-paying company has no equity value. Applying DDM directly when ignores cash flow available to shareholders; use FCFE when appropriate.
Confusing FCFE with the dividend actually paid. FCFE is the cash flow potentially available to equity holders, not the amount the board decides to distribute.
Treating DDM and FCFE as different valuation theories. Both discount expected cash flow at the required return on equity. They differ only in which cash flow is discounted.
Using DDM for a control-perspective valuation. An acquirer can change payout policy, so FCFE better reflects value available to a controlling shareholder.
Giving a model choice without the reason. Stating "use FCFE" without explaining why (no dividends, unstable payout, or control perspective) misses the analytical point being tested.
Practice Question
An analyst is valuing two companies with identical risk and identical required returns on equity. Company Y pays out 100% of net income as dividends. Company Z pays no dividends and reinvests all its free cash flow into positive net present value projects, though its FCFE grows at the same rate as Company Y's dividend.
Which model is most appropriate for valuing Company Z's equity, and why?
The dividend discount model, because dividends represent the only cash flow shareholders can rely on.
The FCFE model, because it captures the cash flow available to shareholders regardless of whether it is distributed.
Either model produces the same value, because both discount cash flow at the same required return.
Correct Answer: B
Company Z pays no dividends, so a direct DDM would use and miss its cash-generating capacity. FCFE captures cash flow available to shareholders even when retained.
Option A: Incorrect. Dividends are a poor cash flow proxy when a company retains its cash flow instead of distributing it. DDM would understate or misstate Z's value.
Option C: Incorrect. The two models produce equal values only when dividends equal FCFE, typically under full payout. Since Z pays no dividends, applying DDM directly does not match the FCFE result.
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FAQs About Present Value Models: Dividend Discount and FCFE Models
What is the difference between the dividend discount model and the FCFE model?
Both discount expected future cash flow at the required return on equity. DDM discounts expected dividends. The FCFE model discounts free cash flow to equity, which includes cash a company retains instead of paying out.
Why would an analyst use FCFE instead of dividends?
Analysts use FCFE when a company pays no dividends, when dividends do not track earnings or cash flow capacity, or when valuing equity from a control perspective where payout policy could change.
Can the dividend discount model value a company that pays no dividends?
Not directly. If expected dividends are zero, DDM produces a value near zero even though the company may generate substantial cash flow. The FCFE model is the appropriate alternative in that case.