When we value an asset, we should try to use the simplest possible model.
As Aswath Damodaran says – If we can value an asset with three inputs, we should not be using five. If we can value a company with three years of cash flow forecasts, forecasting 10 years of cash flow is asking for trouble.
I will prefer to use the dividend discount model than the discounted cash flow model for valuation.
Because it’s simple and dividends are the true tangible cash, the shareholders receive from the company.
Moreover, fewer assumptions are required to forecast dividends than to forecast free cash flow. Dividend forecast can be obtained by applying growth rate estimate to dividend paid last year.
However, free cash flow forecast requires assumptions about net operating profit after tax, capital expenditure, deprecation and working capital.
So, a valuation based on dividends tends to be more predictable and stable than a valuation based on cash flow.