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What is the limitation of each approach? The constant dividend growth model The multi-stage dividend model...

What is the limitation of each approach?

  1. The constant dividend growth model

  1. The multi-stage dividend model

3. The multiples approach (e.g. price/earnings)

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Expert Solution

The models represented her are used to value the equity of any company. the first two are part of the dividend discount model while the last one is the example of relative or comparable company analysis model. Now each of them has some limitations associated with them those limitations are listed below:

1. Constant Dividend growth model: Assumes that the dividend distributed by the firm would be constant throughout the life of the firm which is an unrealistic approach.

It also assumes that the would even distribute a dividend to its equity investor. which is again unrealistic approach.

2. multi stage dividend model: Now this is bit modified than constant dividend model but still it is prone to limitations. such as the assumption of the dividend distribution in the future and predicting the amount, which is based on the certain story unsupported by the realistic approach.

3. Multiples approach: the assumption that the market has valued the business correctly. If both Visa and MasterCard are trading at nosebleed levels, it may not matter that one has a lower P/E or better return on equity.

Also, all valuation metrics are based on past performance. Future performance drives stock prices and relative valuation does not account for growth.

There are many cases where there is no 'real' comparable for the company in question. The denominator used in the relative valuation methodology inconsistent across companies.

jeff jeffy answered 2 years ago
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