Question

What are the strengths and weaknesses of the dividend discount model as a method of valuing a firm?

Answer 1

The dividend discount model is widely used to inderstand the intrinsic value of shares. Following are it's strength-

• Easy to compute - the DDM has a simple formula that can be used to compute the value of the stock.
• Not subjective - As we are using dividend to measure the value, there is no subjectivity involded. In case of free cash flow and net income there can be ambiguity.
• Minority control - Is is useful to compute the value of a share in case you are a minoity shareholder. Dividends are not determined by the decisions of the minority shareholder and hence DDM takes a perspective of a minority shareholder.

Following are the disadvantages of the DDM-

• Limited usage - This model is only applicable to firm that are mature and have a consistent dividend and growth for a lifetime.
• Not related to earnings - The DDM consider the dividend paid by a company and not the earnings of the company while computing the value. It expects that the dividend will increase the earnings of a company increased but this does not happen always.
• Applicability- the DDM is not applicable to the shareholders who have a control over the company's decisions. Dividend is not a relevant factor for them as they can control it.

Do let me know in the comment section in case of any doubt.