Business Valuation : A study of the accuracy of the free cash flow to equity approach and the dividend discount model

Abstract: Background: In an inefficient market, the intrinsic value of an asset may not be equal to its true market value. Therefore, before engaging in a stock transaction, both the seller and the buyer would want to know the intrinsic value of the stock as neither would want to lose money during the process. An effective valuation model enabling investors to efficiently determine firm values is therefore considered to be a crucial factor. Purpose: The purpose of this thesis is to analyze the free cash flow to equity (FCFE) approach and the dividend discount model (DDM) on 30 Swedish companies. This to conclude if they are considered to be accurate valuation models and to determine if one of the methods gives a more accurate estimation of the companies’ share prices than the other. Additionally, the report will examine if one model is preferred for a specific sector and if a payout ratio exists where the DDM generates a particularly realistic valuation. Method: A database will be produced to estimate share prices for each company using both the FCFE approach and the DDM over five consecutive years. The accuracy of the models will be evaluated by dividing the projected share prices with their corresponding actual stock prices to calculate the percentage deviations. The smaller the percentage deviation, the more accurate is the estimated share price considered to be. Conclusion: It is evident from the findings of this thesis that the FCFE approach and the DDM produce accurate valuations for Swedish companies. It is difficult to determine that one is preferred over the other altogether, instead the FCFE approach is preferred in some cases and the DDM in others. This depends on the companies’ actual stock prices, which industry the companies operate in and the amount the companies are assumed to pay out as dividends.