Contrast dividends, residual income and free cash flow as DCF inputs and say in which investment settings each one fits
The idea
Three cash flow measures can drive a present value model. Dividends are what a minority shareholder actually receives, and suit mature companies whose dividend policy is linked to profitability. Free cash flow suits companies that pay no dividend or pay far less than they could, and suits valuations from a controlling shareholder's viewpoint, since a controller can direct how cash is used. Residual income, profit above a charge for equity capital, suits companies with negative free cash flow for the foreseeable future or no dividends, provided the accounting is of good quality. The trap is using dividends for a firm whose payout bears little relation to its earnings, or free cash flow for a firm investing so heavily that its flows stay negative for years.
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