The ownership perspective in the free cash flow approach is that of an acquirer who can change the firm’s dividend policy, which is a control perspective, or for minority shareholders of a company that is in-play. The ownership perspective implicit in the dividend discount approach is that of a minority owner who has no direct control over the firm’s dividend policy.
Analysts often prefer to use free cash flow rather than dividend-based valuation for the following reasons:
- Many firms pay no, or low, cash dividends.
- Dividends are paid at the discretion of the board of directors.
- If a company is viewed as an acquisition target, free cash flow is a more appropriate measure because the new owners will have discretion over its distribution (control perspective).
- Free cash flows may be more related to long-run profitability of the firm as compared to dividends.