Mr. Amit is happy with the investment in a company as it is paying good dividend for the last few years. Last year it paid a dividend of 2 per…

No. of Shares = 1,300 crores /40 = 32.50 Crores EPS = PAT / No.of shares = 290 crores / 32.5 crores = 8.92 Calculation of value per share using Free Cash Flow to Equity as basis: FCFE = Net income – [(1-b) (capex – dep) + (1-b) (AWC)] FCFE = 8.92 – [(1-0.27) (47-39) + (1-0.27) (3.45)] = 8.92 - [5.84 + 2.52] = 0.564 Cost of Equity (K e )= R f + β (R m – R f ) = 8.7 + 0.1 (10.3 – 8.7) = 8.86% P 0 = FCFE(1+g) / (K e -g) = 0.56(1.08) / (0.0886-0.08) = 0.6048 / 0.0086 = 70.33 Calculation of value per share using dividend discount model: P 0 = D 0 (1+g) / (K e -g) = 2(1.08) / (0.0886-.08) = 2.16 / 0.0086 = 251.16 From the above we can see that value per share on the basis of dividend discount model is more than the value per share on the basis of free cash flow to equity model. In the dividend discount model, the analyst considers the stream of expected dividends to value the company's stock. It is assumed that the company follows a consistent dividend payout ratio which can be less than the actual cash available with the firm. A stock's intrinsic value based on the dividend discount model may not represent the fair value for the shareholders because dividends are distributed in the form of cash from profits. In case the company is maintaining healthy cash in its balance sheet then it means that dividend pay-out is low which could result in undervaluation of the stock. In the case of free cash flow to equity model a stock is valued on the cash flow available for distribution after all the reinvestment needs of capex and incremental working capital are met. Thus, using the free cash flow to equity model provides a better measure for valuations in comparison to the dividend discount model. Thus, the view of Mr. Amit that dividend discount model represents the fair value is incorrect. The share is not under-valued rather it is overvalued if we take "free cash flow to equity model" into consideration.