Limitations of The Dividend Discount Model

As we discussed in the last article, the dividend discount model could be used to come up with a valuation for a firm based on the number of dividends that we expect that the firm is going to issue over time. So we can value the firm by taking their future dividend payments and we will discount back to their present value. But there are a couple of issues with this and one is that it's difficult to forecast dividends correctly but also there are several things that are under managerial discretion that will actually affect the dividend discount model.

Let's jump into an example and we'll take a look at this. Let's say that you're trying to come up with a valuation of ABC Motors. ABC Motors has come up with a flying car. They're really excited about their product. They're ready to launch this new flying car and you're saying "How do I value this firm?" They're going public and you're trying to come up with a valuation.

So one thing you can do is you can just use the dividend discount model. So we'll say that the share price is going to be equal to the annual dividend over the cost of equity which is (Re) here minus the growth rate (g). So we've got all this information here I'm not going to go over the model again check out our article if you haven't read it. Our dividend payout is going to be 50 cents a share. Now we've got our cost of equity capital that is 14% or, 0.14 minus 0.11 which is 11% of our forecasted growth.

So now we've got 0.5 over 0.03 which is going to give us a share price of $16.67. So this is going to be our share price for ABC Motors based on the dividend discount model.

Why dividend discount model is bad?

The first one is let's say that this growth rate was 8% instead of 11%. Well, then we gonna end up with a valuation of $8.33. So now we've basically lost 50% of the value, all we have was a 3% difference in the forecasted dividend growth. This is actually this is the least of our problems in the sense with the dividend discount model. We've also got several issues regarding our dividend forecast other than just making a mistake. 

Dividend forecast depends on:

1. Earnings: What if the firm decides you know what we're gonna go out and get a bunch of leverage we're gonna borrow a lot that affects interest expense which in turn affects earnings and that's going to affect our growth rate.

2. Dividend payment rate: When we talk about share repurchases we're talking about the firm buying back its own stock. So if the firm has a certain dividend and then it actually goes in and repurchases a lot of its stock that's going to actually increase the dividend payout assuming the dividend remains constant.

3. Share Outstanding: Also share repurchases are just going to affect the number of shares outstanding.

So all three what these have in common is that they are subject to discretion and it's the part of the managers, we don't know what the managers are gonna do. So what people have done, they actually come up with some alternative models. They kind of avoid these issues by just focusing on dividends and dividend growth and we can actually look at, for example:

1. The total payout model: What they mean by this alternative model is, they're saying we're gonna look at dividends and share repurchases. We're not factoring in share repurchases above when we're looking at the dividend discount model where we're not even taking a consideration off share repurchases, which affect both the number of shares outstanding and the dividend payout rate. And then there's also 

2. The discounted cash flow model: With this model, we're going to do a discounted cash flow model and look at cash flow to both debt and equity holders. What does that do? You might say "Well what is the advantage of that?" The answer is now we can ignore the effect of the firm's financing decision.

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