Question

Why does the DDM focus only on dividends?

Answer 1

Dividend discounting model only focuses on cash flows hence the dividend received in cash is key component of this model. The whatever cash share holders receive will decide the addition to cost of equity for firm.

Cost of equity = Dividend Yield + Growth rate

Breaking it; Cost of equity = Expected dividend / Price of share + Growth rate of dividend

Dividend discount model is purely based on cash flow of the equity viz. dividend. Dividend is estimated based on expectations of the financial manager. As equity is perpetual for a firm i.e. it will last forever and based on this analogy the dividend or cash flow is not discounted for a fixed period Therefore, formula of present value of perpetuity is applied.

As this model captures the return of the stock considering dividend growth. The dividend growth is deducted from the overall expected return of the stock. Suppose the expected return on a stock was 10% and 6% comes from dividend growth then we will see stock value appreciating with 4% only (10%-6%). The model is represented by formula:

Stock value = Dividend per share / (Expected return – Dividend growth rate)

The model has limitation when firm do not give dividend to its equity shareholders. Most of the firm in real life scenarios firms may like to go for the expansion and hence don’t pay high dividends hence here dividend discount model takes a rest and other robust valuation techniques are applied.