Question

With respect to the dividend discount model (constant and nonconstant forms), net present value model, FCF enterprise value model, etc., it has been suggested that the complexity is not the actual formula but the inputs. Use the constant growth dividend discount model (P = D / r – g) to explain why—and what about—the complexity of the inputs is key to the analysis.

Answer 1

The constant growth dividend discount model says that P = D / r – g)

where P = Price of the share

D = Next expected dividend

r = required return

g = growth rate in dividends

The formula gives the PV of a growing perpetuity. It is mathematically correct and hence gives accurate value if, the values of inputs are correct. But, the problem here, lies in estimating the values the variables 'r' and 'g'.

The required return (r) is the rate of return that the market would expect of a similar security. For determining this, one has to resort to the CAPM, which states that the required return on a security is a function of the risk free rate, beta of the security and the expected market return. Each of these variables required for CAPM are based on historical data, which, need not hold good in future.

Similarly, the growth rate worked out on the basis of past dividend experience need not hold good in future.

Hence, the problem lies not in the formula but on the values of the variables in the formula (inputs) which are at best reasonable estimates.