Abstract
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.
Highlights
In this document, we give support to the idea that potential dividends that are not distributed should be neglected in firm valuation, because only distributed cash flows add value to shareholders
It should be noted that a definition of cash flow to equity is meant to be valid for all possible cases, and should not depend on a particular assumption about investment in liquid assets, otherwise the consequent definition of firm value would depend on a particular assumption about investment in liquid assets
Benninga and Sarig (1997) share Damodaran’s view: Free Cash Flow (FCF) [is] a concept that defines the amount of cash that the firm can [italics added] distribute to security holders (...) Cash and marketable securities are the best example of working capital items that we exclude from our definition of [change in net working capital], as they are the firm’s stock of excess liquidity adjustment. (p. 36)
Summary
We give support to the idea that potential dividends that are not distributed (and are invested in liquid assets) should be neglected in firm valuation, because only distributed cash flows add value to shareholders. To include undistributed potential dividends in valuation is admissible only if they are expected to be invested at the cost of equity capital, ke, i.e. the net present value (NPV) of those investments is zero from the point of view of current shareholders If the latter assumption held, changes in liquid assets could be included in the Cash Flow to Equity, because they would be value-neutral (DeAngelo and DeAngelo, 2006; Magni, 2007). Benninga and Sarig (1997) share Damodaran’s view: Free Cash Flow (FCF) [is] a concept that defines the amount of cash that the firm can [italics added] distribute to security holders (...) Cash and marketable securities are the best example of working capital items that we exclude from our definition of [change in net working capital], as they are the firm’s stock of excess liquidity adjustment. Usually in real life, as empirical evidence suggests, keeping cash holdings destroys value: the NPV of those invested funds is not zero (below zero)
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