POTENTIAL DIVIDENDS AND ACTUAL CASH FLOWS IN EQUITY VALUATION. A CRITICAL ANALYSIS
DOI:
https://doi.org/10.1016/S0123-5923(09)70092-0Keywords:
Cash flow to equity, potential dividends, equity valueAbstract
Practitioners and most academics in valuation include changes in liquid assets (potential dividends) in the cash flows. This widespread and wrong practice is inconsistent with basic finance theory. We present economic, theoretical, and empirical arguments to support the thesis. Economic arguments underline that only flows of cash should be considered for valuation; theoretical arguments show how potential dividends lead to contradiction and to arbitrage losses. Empirical arguments, from recent studies, suggest that investors discount potential dividends with high discount rates, which means that changes in liquid assets are not value drivers. Hence, when valuing cash flows, we should consider only actual payments.
Downloads
References
Benninga, S.Z. and Sarig, O.H. (1997). Corporate Finance. A Valuation Approach. New York, NY: McGraw-Hill.
Brealey, R. and Myers, S.C. (2003). Principles of Corporate Finance (7th ed.). New York, NY: McGraw- Hill-Irwin.
Cash Management Fundamentals Professional Development Program. (2007). Northwestern University Website. Retrieved in November 21, 2007, from: http://www.scs.northwestern.edu/pdp/npdp/cmf/
Copeland, T.E., Koller, T. and Murrin, J. (1990). Valuation: Measuring and Managing the Value of Companies. New York, NY: John Wiley & Sons.
Copeland, T.E., Koller, T. and Murrin, J. (1994). Valuation: Measuring and Managing the Value of Companies (2nd ed.). New York, NY: John Wiley & Sons.
Copeland, T.E., Koller, T. and Murrin, J. (2000). Valuation: Measuring and Managing the Value of Companies (3rd ed.). New York NY: John Wiley & Sons.
Damodaran, A. (1999). Applied Corporate Finance. A Users Manual. New York, NY: John Wiley & Sons.
Damodaran, A. (2006a). Damodaran on Valuation (2nd ed.). Hoboken, NJ: John Wiley & Sons.
Damodaran, A. (2006b). Valuation approaches and metrics: a survey of the theory and evidence. Available at SSRN: http://www.stern.nyu.edu/~adamodar/pdfiles/papers/valuesurvey.pdf (November). Originally published in Found ati ons and Trends® in Finance, 1(8), 693-784, 2005.
Damodaran, A. (2008). Equity instruments: Part I. Discounted cash flow valuation. Recuperado el 16 de febrero de 2008, de: www.stern.nyu.edu/~adamodar/pdfiles/eqnotes/packet1.pdf, (updated January 14, 2008).
DeAngelo, H. and DeAngelo, L. (2006). The Irrelevance of the MM dividend irrelevance theorem. Journal of Financial Economics, 79, 293–315.
DeAngelo, H. and DeAngelo, L. (2007). Payout policy pedagogy: what matters and why. European Financial Management, 13(1), 11- 27.
Faulkender, M.W. and Wang, R. (2004). Corporate financial policy and the value of cash (working paper). Available at SSRN: http://ssrn.com/abstract=563595
Fernández, P. (2002). Valuation Methods and Shareholder Value Creation. San Diego, CA: Academic Press.
Fernández, P. (2007). Company valuation methods. The most common errors in valuation (working paper). Available at SSRN: http://ssrn.com/abstract=274973
Harford, J. (1999). Corporate cash reserves and acquisitions. Journal of Finance, 54(6), 1969-1997. Available at SSRN: http://ssrn.com/abstract=2109 or DOI: 10.2139/ ssrn.2109.
Jensen, M.C. (1986) Agency cost of free cash flow, corporate finance, and takeovers. American Economic Review, 76(2), 323-329. Available at SSRN: http://ssrn.com/abstract=99580 or DOI: 10.2139/ssrn.99580.
Lorie, J.H. and Savage, L.J. (1955). Three problems in rationing capital. Journal of Business, 28, 229–239. Reprinted in E. Solomon (Ed.), 1959, The Management of Corporate Capital. Glencoe, IL: The Free Press.
Magni, C.A. (2007). Relevance or irrelevance of retention for dividend policy irrelevance (working paper). Available at SSRN: http://ssrn.com/abstract=1027401
Mikkelson, W.H. and Partch, M. (2003). Do Persistent Large Cash Reserves Lead to Poor Performance? (working paper). Available at SSRN: http://ssrn.com/abstract=186950 or DOI: 10.2139/ssrn.186950. A final versio n of this pa per was published as: Do Persistent Large Cash Reserves Hinder Performance? in Journal of Financial and Quantitative Analysis, 38(2), 275-294.
Miller, M.H. and Modigliani, F. (1961). Dividend policy, growth and the valuation of shares. The Journal of Business, 34(4), 411- 433.
Modigliani, F. and Miller, M.H. (1958). The cost of capital, corporation taxes and the theory of investment. American Economic Review, 47, 261-297.
Modigliani, F. and Miller, M.H. (1963). Corporate income taxes and the cost of capital: a correction. American Economic Review, 53, 433-443.
Nau, R.F. and McCardle, K.F. (1991). Arbitrage, rationality, and equilibrium. Theory and Decision, 31(2-3), 199-240.
Opler, T.C., Pinkowitz, L., Stulz, R.M. and Williamson, R. (1999). The determinants and implications of corporate cash holdings. Journal of Financial Economics, 52(1), 3- 46. Available at SSRN: http://ssrn.com/ abst ract= 225 992
Penman, S. (1992). Return to fundamentals. Journal of Accounting, Auditing and Finance, 7, 465-483. Reprinted in R. Brief and K.V. Peasnell (Eds.), Clean Surplus: A Link Between Accounting and Finance. New York and Lond on: Garland Publishing.
Penman, S. (2007). Financial Statement Analysis and Security Valuation (3rd ed.). New York, NY: McGraw-Hill.
Penman, S. and Sougiannis, T. (1998). A comparison of dividends, cash flow, and earnings approaches to equity valuation. Contemporary Accounting Research, 15(3), 343- 383.
Pinkowitz, L., Stulz, R.M. and Williamson, R. (2003). Do firms in countries with poor protection of investor rights hold more cash? (Dice Center Working Paper No. 2003-2029). Available at SSRN: http://ssrn.com/ abst ract= 476 442or DOI: 10.2139/ssrn.476442.
Pinkowitz, L. and Williamson, R. (2002). What is a dollar worth? The market value of cash holdings (working paper). Available at SSRN: http://ssrn.com/abstract=355840 or DOI: 10.2139/ssrn.355840.
Pinkowitz, L., Williamson, R. and Stulz, R.M. (2007). Cash holdings, dividend policy, and corporate governance: a cross-country analysis. Journal of Applied Corporate Finance, 19(1), 81-87.
Ruback, R. S. (2002). Capital cash flows: a simple approach to valuing cash flows. Financial Management, 31(2), 85-103.
Schwetzler, B. and Carsten, R. (2003). Valuation effects of corporate cash holdings: Evidence from Germany (HHL working paper). Available at SSRN: http://ssrn.com/abstract=490262
Shrieves, R.E. and Wachowicz, J.M. (2001). Free Cash Flow (FCF), Economic Value Added (EVA), and Net Present Value (NPV): A Reconciliation of Variations of Discounted-Cash-Flow (DCF) Valuation. The Engineering Econ omist , 4 6(1), 33-52.
Smith, J.E. and Nau, R. (1995). Valuing risky projects: option pricing theory and decision analysis. Management Science, 41(5), 795- 816.
Tham, J. and Vélez-Pareja, I. (2004). Principles of Cash Flow Valuation. Boston, MA: Academic Press.
Varian, H.R. (1987). The arbitrage principle in financial economics. The Journal of Economic Perspectives, 1(2), 55-72.
Vélez-Pareja, I. (1999a). Construction of free cash flows: a pedagogical note. Part I (December) (working paper). Available at SSRN: http://ssrn.com/abstract=196588
Vélez-Pareja, I. (1999b). Construction of free cash flows: a pedagogical note. Part II (December) (working paper). Available at SSRN: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=199752
Vélez-Pareja, I. (2004). The correct definition for the cash flows to value a firm (free cash flow and cash flow to equity) (September 30) (working paper). Available at SSRN: http://ssrn.com/abstract=597681
Vélez-Pareja, I. (2005a). Once more, the correct definition for the cash flows to value a firm (free cash flow and cash flow to equity) (working paper). Available at SSRN: http://ssrn.com/abstract=642763
Vélez-Pareja, I. (2005b). Construction of cash flows revisited (working paper). Available at SSRN: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=784486
Published
Issue
Section
License
Articles are the sole responsibility of their authors, and will not compromise Icesi’s University principles or policies nor those of the Editorial Board of the journal Estudios Gerenciales. Authors authorize and accept the transfer of all rights to the journal, both for its print and electronic publication. After an article is published, it may be reproduced without previous permission of the author or the journal but the author(s), year, title, volume, number and range of pages of the publication must be mentioned. In addition, Estudios Gerenciales must be mentioned as the source (please, refrain from using Revista Estudios Gerenciales).
How to Cite
