Question

Authors such as Fama and French use the dividend discount model in order to study the equity premium puzzle. While it surely has its drawbacks, the attractiveness of the dividend discount model stems from its solid consideration of (answer)

Answer 1

The dividend discount model is a way of valuing a company based on the theory that a stock is worth the discounted sum of all of its future dividend payments.

The value of a stock is worth all of the future cash flows expected to be generated by the firm, discounted by an appropriate risk-adjusted rate. According to the model, dividends are the cash flows that are returned to the shareholder.

Current Stock Price = D / (k_e - g)

D=Dividend is the current year

k_e=Rate of return

g=g is the expected growth rate

Fama-French model is proposed as an alternative to the CAPM model to explain the equity premium found in stock market. The equity premium – the difference between the expected return on the market portfolio of common stocks and the risk free interest is important in portfolio allocation decisions, estimates of the cost of capital.

Attractiveness

Justification: The primary advantage of the dividend discount model is that it is grounded in theory. The justifications are rock solid and indisputable. When an investor buys a share of the business, they are basically paying a price today which entitles them to enjoy the benefits of all the dividends that the corporation will pay throughout its lifetime. Hence, the value of the firm is basically the value of a perpetual never ending stream of dividends that the buyer intends to receive later with the passage of time.

Consistency: A second advantage of the dividend discount model is the fact that dividends tend to stay consistent over long periods of time. Companies experience a lot of volatility in measures like earnings and free cash flow. However, companies usually ensure that dividends are only paid out from cash which is expected to be present with the company every year.

No Subjectivity: There is no ambiguity regarding the definition of dividends. Whereas there is subjectivity as to what constitutes earnings and what constitutes free cash flow.

No Requirement of Control: Dividends are the only measure of valuation available to the minority shareholder. While institutional investors can acquire big stakes and actually influence the dividend payout policies, minority shareholders have no control over the company. Thus, the only thing that they can be sure about is that fact that they will receive dividend year on year because they have been receiving it consistently in the past.

Mature Businesses: The regular payment of dividends is the sign that a company has matured in its business. Its business is stable and there is not much expectation of turbulence in the future unless something drastic happens. This information is valuable to many investors who prefer stability over possibility of quick gains.

Drawbacks

Limited Use: The model is only applicable to mature, stable companies who have a proven track record of paying out dividends consistently. While, prima facie, it may seem like a good thing, there is a big trade-off. Investors who only invest in mature stable companies tend to miss out high growth ones.

High growth companies, by definition face lots of opportunities in the future. They may want to develop new products or explore new markets. To do so, they may need more cash than they have on hand. Hence such companies have to raise more equity or debt. Obviously they cannot afford the luxury of having the cash to pay out dividends. These companies are therefore missed by investors who are focused too much on the dividends.

May Not Be Related To Earnings: Another major disadvantage is the fact that the dividend discount model implicitly assumes that the dividends paid out are correlated to earnings. This means that higher earnings will translate into higher dividends and vice versa. But, in practice, this is almost never the case. Companies strive to maintain stable dividend payouts, even if they are facing extreme variations in their earnings. There have been instances where companies have been simultaneously borrowing cash while maintaining a dividend payout. In this case, this is a clear incorrect utilization of resources and paying dividends is eroding value.

Too Many Assumptions: The dividend discount model is full of too many assumptions. Then there are also assumptions regarding growth rate, interest rates and tax rates. Most of these factors are beyond the control of the investors.

Tax Efficiency: It may not be efficient to pay dividends. The tax structures are created in such a way that capital gains may be taxed lower than dividends. Also, many tax structures may encourage repurchase of shares instead of paying out dividends. Therefore most of the companies will not pay out dividends because it leads to dilution of value.

Control: the dividend discount model is not applicable to large shareholders. Since they buy a big stake in the corporation, they have some degree of control and can influence the dividend policy .