Question

What are the pros and cons of net realizable value and dividend discount model?

Answer 1

Advantages of Dividend Discount Model:

1. The regular payment of dividends is the sign that company 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 the possibility of quick gains. Thus, from a valuation point of view, it is far easier to arrive at a discount rate.

2.  There is no ambiguity regarding the definition of dividends. Whereas there is subjectivity as to what constitutes earnings and what constitutes free cash flow. Hence valuation comes reliable

3. Dividends tend to stay consistent over long periods of time hence more dependent

4. Easier to understand

Disadvantages of Net Realizable Value:

1. The model is only applicable to mature, stable companies that have a proven track record of paying out dividends consistently.

2.  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.

3. 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 if they want to. Thus, for them, at least, dividends are an irrelevant metric.

4. Too many assumptions which might not show an accurate picture of the situation.

Advantages of Net Realizable Value (NRV):

1. easier to calculate

2. Low number of assumptions

3. All variables are know

Disadvantages of Net Realizable Value:

1. NRV is important for resources that are relied upon to be sold later and for which a secondary/resale market exists. It is hard to identify items for which have limited second-hand use

2. There is an inconsistency between the acknowledgment guideline and the setup supposition that the organization is a going concern

3. An exit based system does not take into account changes in the general price level.

4. The sale price has little relevance for assets that the company expects to utilize. hence the sale value has no relevance for profitability.