Cash paid for common stock dividends should be shown on the statement of cash flows under
2022 Curriculum CFA Program Level II Equity Investments Show IntroductionDiscounted cash flow (DCF) valuation views the intrinsic value of a security as the present value of its expected future cash flows. When applied to dividends, the DCF model is the discounted dividend approach or dividend discount model (DDM). Our coverage extends DCF analysis to value a company and its equity securities by valuing free cash flow to the firm (FCFF) and free cash flow to equity (FCFE). Whereas dividends are the cash flows actually paid to stockholders, free cash flows are the cash flows available for distribution to shareholders. Unlike dividends, FCFF and FCFE are not readily available data. Analysts need to compute these quantities from available financial information, which requires a clear understanding of free cash flows and the ability to interpret and use the information correctly. Forecasting future free cash flows is a rich and demanding exercise. The analyst’s understanding of a company’s financial statements, its operations, its financing, and its industry can pay real “dividends” as he or she addresses that task. Many analysts consider free cash flow models to be more useful than DDMs in practice. Free cash flows provide an economically sound basis for valuation. A study of professional analysts substantiates the importance of free cash flow valuation (Pinto, Robinson, Stowe 2019). When valuing individual equities, 92.8% of analysts use market multiples and 78.8% use a discounted cash flow approach. When using discounted cash flow analysis, 20.5% of analysts use a residual income approach, 35.1% use a dividend discount model, and 86.9% use a discounted free cash flow model. Of those using discounted free cash flow models, FCFF models are used roughly twice as frequently as FCFE models. Analysts often use more than one method to value equities, and it is clear that free cash flow analysis is in near universal use. Analysts like to use free cash flow as the return (either FCFF or FCFE) whenever one or more of the following conditions is present:
Common equity can be valued directly by finding the present value of FCFE or indirectly by first using an FCFF model to estimate the value of the firm and then subtracting the value of non-common-stock capital (usually debt) to arrive at an estimate of the value of equity. The purpose of the coverage in the subsequent sections is to develop the background required to use the FCFF or FCFE approaches to value a company’s equity. In the next section, we define the concepts of free cash flow to the firm and free cash flow to equity and then present the two valuation models based on discounting of FCFF and FCFE. We also explore the constant-growth models for valuing FCFF and FCFE, which are special cases of the general models. The subsequent sections turn to the vital task of calculating and forecasting FCFF and FCFE. They also explain multistage free cash flow valuation models and present some of the issues associated with their application. Analysts usually value operating assets and non-operating assets separately and then combine them to find the total value of the firm, an approach described in the last section on this topic. Learning OutcomesThe member should be able to:
SummaryDiscounted cash flow models are widely used by analysts to value companies.
Is cash paid for dividends an operating activity?Paragraph 33 of IAS 7 states that interest paid and interest and dividends received are normally classified as operating cash flows by a financial institution.
How are dividends treated in cash flow statement?Dividends and Cash Flow
Dividend payments are recorded on the cash flow statement in the financing section, because they involve owners and affect cash flow. This is the sole impact that dividend issuance has on the cash flow statement.
What is dividend received in cash flow statement?If the company receives dividends from an investment, that is considered dividend income. Any dividend income should be recorded in the operation section as a cash inflow.
Do stock dividends affect cash flow statement?A stock dividend is an award to shareholders of additional shares rather than cash. Similarly, stock dividends do not represent a cash flow transaction and are not considered an expense. Companies distribute stock dividends to their shareholders in a certain proportion to its common shares outstanding.
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