Question

Discuss the Flaws of the dividend discount model.

Answer 1

The dividend discount model is dependent on two estimates:

*The expected stream of dividends, and

*The required return appropriate to the stock.

As for the expected stream of dividends, it is plain knowledge that what a coporate would pay as dividends in the distant future would be anybody's guess.

The usual predictions about dividend would be any one of the following:

*Constant dividend. Here the dividend is a constant dollar amount per share into perpetuity. It is the simplest assumption possible and the most flawed.

*Constant growth rate in dividends. Here the dividend is expected to grow at a constant rate every year over the previous year's dividend. The flaw is that one cannot say for sure whether the dividends will grow into the future at the same rate.

*Mixed growth rates. May be initial few years with super normal growth, followed by constant normal growth. The super normal growth can have more than one stage.

The other factor 'required rate of return', is again an estimate based on historical data, which may again be per CAPM or the DDM. The CAPM is a single factor model and depends on the period chosen for determining the parameters like beta, etc. The DDM again requires the growth rate estimation.