Question

In the dividend discount model (DDM) we assume that the required rate of return is higher than the long-term growth rate, in the discounted cash flow (DCF) model we assume that the weighted average cost of capital (WACC) is greater than the long-term growth rate. In the DDM model we assume that at some point dividends grow at a constant rate forever, in the DCF model we assume that at some point free cash flows grow at a constant rate forever. Which model do you think is a better model?

Answer 1

Answer-

The Discounted cash flow (DCF) model is a better model than Dividend discounted model (DDM) model as

1) Many firms pay no or low cash dividends which is the sole basis of DDM.
2) Dividends are paid based on discretion of the board of directors and it is poorly aligned to the profitability of the company.
3) In case of acquisition the free cash flow which is the basis of DCF model is appropriate measure as the owners have control perspective.
4) The free cash flows are related to long run profitability of firm in case of DCF model comparison to the dividends as they are based on discretion of management in DDM.
5) The valuations are very sensitive to estimate of growth rates and required rate of return which are difficult to estimate.
6) The growth patterns used in DDM cannot be predicted properly for some firms which make the model difficult and valuations become unreliable.
7) The WACC is a better measure of discount rate used in DCF rather than the required rate of return in case of DDM.
8) Dividends are not paid cosistently by companies and att times they are stable or constant and there mifght be change in dividend policy of a company which will not be consistent with previous years valuations of the company when using DDM.