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

Fully agree that in dividend discount modeil(whether constant or non constant ie 2 stage divinded discoutn model), the actual comlications are not the formulae but the value of inputs which is very difficult to estimate with 100% correction and precision .

As the question demands, let us discuss the complexity involved in the inputs of the formula of constant growth dividend discount modeil whereP=D/r-g whereP is the share price for the next period, D = Dividend pay out ratio, k= required rate of return(derived from Capital asset privcing model), g=expected growth rate.

The greatest weakness of this model is that it values only the companies that pay dividend.

Also this model assumes a constant dividend growth rate in perpetuity.SO for the new companies whoses rates do fluctuate in intial years, this model doesnot hold good.

Secondly, the outputs are too sensitive ie highly reactive to inputs under this model.