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Lesson 1 of 9 · 13 min

Present value models: DDM and FCFE

A share is worth the present value of the cash it will deliver: either the dividends expected (DDM) or the cash the company could pay out (FCFE), discounted at the required return on equity.

In short

  • Present value models rest on a basic idea: people invest for future benefits, so value = PV of those benefits.
  • Dividend discount model (DDM): V0=∑Dt/(1+r)tV_0 = \sum D_t/(1+r)^t over all future years.
  • For an n-year holding period: PV of n dividends + PV of the expected sale price PnP_n (the terminal value). The value does not depend on the holding period.
  • FCFE = CFO − fixed capital investment + net borrowing. It measures dividend-paying capacity and works for non-dividend payers.
  • The required return r often comes from the CAPM: r=Rf+β×r = R_f + \beta \times equity risk premium. There is no single correct r.

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Present value models: DDM and FCFE · Discounted Cash Flow (DCF) and Growth Models