Question

Explain the advantages of using a two-stage dividend discount model (DDM) to value a share rather than a constant-growth dividend model. Using a simple numerical example, describe one weakness in all DDMs

Answer 1

Two-stage DDM is a useful technique because in some cases, scenarios exist where company may experience a supernormal growth rate for a few years, after which it would fall back to a more normal or sustainable growth rate. An example could be a start up. When it comes in to existence, for a few years in early growth stages, it may experience a high growth rate, as it expands its' business. However, once the business becomes mature, growth rate declines from the earlier level to lower rate, which is more constant and normal.

Another example could be when a new technology is introduced in market, company may see phenomenol increase in its growth rate. However, once the technology becomes common in market, the growth rate subdues to a normal rate.

In constant growth-dividend model, company is assumed to be growing at a normal stage for life. However, this may only stay true for mature companies, where market is saturated and there exists no or little avenues of growth and expansion.

The greatest weakness of all DDMs is that it is inappliable to shares that do not pay dividends. In intent, it assumes that the only return earned from share investment is through or related to dividends and ignores capital appreciation. Moreoevr, it is very sensitive to the assumptions of dividend payments as well as growth and discount rates.

For example,

if we assumed that starting next year, company would be paying $2 dividend, growing 5% each year and required rate of return was 10%, then stock price = $40 (= $2/(.10 - .05)). However, next year company announces an acquisition, which will consolidate and add to company's position as well as business risk profile. However, in order to have funds for acquisition (and maintain lower borrowings), company announces to skip dividend for next 5 years.

Zero dividend may mean zero (or lower share price) for company - but effectively, by business, company is increasing the value for shareholders by acquisition. Hence, a disconnect. This shows how DDM relies overly on dividend payments, without any consideration to business.