Actual and Potential Dividends: Reconciling Theory and Practice

Abstract

The concept of potential dividends (PD) and its application in valuation models have been subject to an active debate. The opponents of the inclusion of PD into free cash flow to equity point out the logical inconsistencies and theoretical flaws of the concept, while advocates argue that ignoring the PD in value estimation may cause the results to be biased. I argue that while under rigorous assumptions of the Modigliani-Miller theory the PD concept may appear to be disputable, it represents an important part of the valuation model as soon as those assumptions are relaxed to allow for deviations commonly observed in practice. The aim of the paper is to present guidance to the application of PD and actual dividends (AD) concepts in valuation models. I maintain that each of the two methodologies can be used only in the specifically predefined contexts, which are described in the paper. Ultimately, the paper attempts to make practical recommendations regarding the application of the PD and AD concepts in valuation.