Question

Two of the dividend valuation models used in equity valuation are the zero growth model and the constant growth model. If you were trying to decide which model is best suited to use in valuing a particular company's common stock, what deciding factors would you take into account when trying to choose between the zero growth model and the constant growth model? When comparing the use of these two models, how would each impact the price you would be willing to pay today for that particular common stock issue?

Answer 1

Introduction to the Dividend Discount Model

The Dividend Discount Model (DDM) is used to estimate the price of a company’s stocks. The model is based on the theory that the present value of the stock is equal to the present value of all future dividend payments when discounted back to the present.

The Dividend Discount Model (DDM)

Companies generally provide services or produce goods, to make profits. The business usually uses these profits to distribute dividends to the shareholders.

The Discount Dividend Model stipulates that the value of the company is the present value of all dividends it will ever pay to the shareholders. The method uses the principle of the time value of money.

FV=PV*(1+r)

Where:

• FV is the future value of the cash flow;
• PV is the present value of the cash flow;
• r is the rate of return we can achieve on investment.

Rearranging the formula, we can calculate the present value from the future value:

PV = FV/(1+r)

Advantages of the DDM

Even though the model has some limitations, it has advantages as well:

• The method has a strong theoretical background and a sound mathematical model;
• The Dividend Discount Model eliminates potential subjectivity;
• Dividends can influence the stock price. Therefore companies tend to keep them in line with the fundamental metrics of the company, meaning our inputs are less susceptible to being tampered with;
• Analysts believe that the Dividend Discount Model is most applicable to companies that pay dividends; however, we can still apply it to firms that do not distribute profits to their shareholders by making assumptions about what dividend these companies can pay

Conclusion

All variants of the Dividend Discount Model allow us to value shares outside of the current market conditions. This allows us to compare even companies from very different industries.

We should remember that the model is only one of a vast plethora of valuation tools that are available to us. It can indicate undervalued stocks and an underlying investment opportunity, but we should always use it in corroboration with other techniques and information. Other methods that we can combine with DDM include Return on Equity (ROE), Price-to-earnings ratio, Dividend payout ratio, and others.

The DDM is developed under the assumption that the intrinsic value of a stock reflects the present value of all future cash flows. It makes it easy to calculate a fair stock price, at least from a mathematical point of view, requiring minimum input variables. However, it relies on assumptions that are hard to forecast.

Generally, an analyst needs to forecast future dividend payments, cost of equity capital, and future dividend growth rate. Doing so in real life is close to impossible, and we need to be fully aware that the theoretical stock price from applying the method can be far from reality.