Why use dividends only when they reflect true ability to pay?
Because dividends are just what the company chooses to pay, not what it can afford to pay.
Example:
Imagine two companies:
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Company A earns 2 in dividends.
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Company B earns 8 in dividends.
→ Which one is more valuable?
You can’t tell just from dividends. Why?
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Maybe Company A is reinvesting the rest wisely.
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Maybe Company B is overpaying by taking on debt or selling assets.
So if you blindly use dividends, you might:
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Undervalue a company that is reinvesting efficiently.
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Overvalue a company that’s paying out unsustainable dividends.
Why use Free Cash Flow to Equity (FCFE) instead?
Because FCFE shows the true cash available to shareholders, after:
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Paying operating costs and taxes,
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Covering capital expenditures (to maintain and grow the business),
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Servicing debt (interest and principal),
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Considering any new debt raised.
FCFE = True owner cash available
It answers the key question:
“How much cash could this business send to its owners if it wanted to, without hurting its operations or borrowing recklessly?”
Summary: Think like a business owner
| Measure | What it shows | When to use |
|---|---|---|
| Dividends | What the company chooses to pay | Only if it’s a consistent, sustainable policy that reflects capacity |
| FCFE | What the company can afford to pay | Use when dividends are not aligned with cash-generating ability |
Equity is a residual claim
- Equity holders get whatever is left over after all expenses, reinvestment, and debt payments.