Do dividends affect stock valuation?

If a company pays a dividend, it certainly sweetens the investment deal. That said, I don’t value a company in a different way if it issues dividends. If you’re starting with revenue and working your way down to a free cash flow estimate, that all happens before dividends are taken out.

I value large businesses as if they were a small business I could buy outright. So I look at the free cash flow I expect the business to earn and look at that as the money I end up with as the business owner.

What the company owner ends up doing with the free cash flow is another matter. Maybe the owner buys back stock, maybe he pays himself a dividend, maybe he just lets it pile up on the company balance sheet. As a business owner, the priority is generating free cash flow. The second order of business if finding out what to do with that cash.

What you do end up doing with it depends on your priorities as a business owner. When you’re investing in businesses that are run and managed by others, your mission is to invest in companies run by management whose goals for the free cash are somewhat aligned with yours.

So I would value a dividend-paying company the same way I would value a company that didn’t pay dividends. What’s important is whether you agree with what the company is doing with its free cash flow.

If current income is important to you or if you don’t feel the company has great reinvestment prospects, you’d value a dividend payout more highly. If you thought the business could do better by eventually reinvesting that cash in its business, you might not mind the cash building up in the balance sheet.

Either way, free cash flow is before the dividend payout, so you don’t need to do something separate when valuing a dividend-paying company when your model is based on a free cash flow estimate.

— Answer provided by Motley Fool member Mike Sandrik

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