Question

Discuss the limitations of Dividend Growth Model and the challenges you may find when you apply this model to real world stock valuation.

Answer 1

DDM:
Whereas DDM more specific in its approach to calculating a value per share.
DDM is based on the dividends the company pays its shareholders.

It's the present value of all the future dividends.

It's the most basic of absolute valuation models.

It's a closed form of valuation.

As per Gordon Growth Model of Stock Valuation:

P=Do(1+g)/(Re-g)

P= price of share.
Do= most recent dividend
g= Growth rate
Re= required rate of return.

Disadvantages:

1. It is based on the assumption that companies dividend is constant and known. (In real life it's not).
2. It is not useful in case of valuation of growth companies, which generally does not pay a dividend.
3. Does not take into consideration the on dividend factors like Goodwill.

In real life, it's difficult to calculate a stable and constant dividend growth rate.

Many mid-cap and small-cap companies don't pay a dividend. So it's not useful in case of estimation of the value of such companies.