Question

Provide the issues or disadvantages of a dividend discount model (Gordon Growth Model) for equity and give a detailed quantitative example and interpretation. Use the following to calculate, D0=$2.20, g=5%, Beta 1.2, Rf=3%

Answer 1

The disadvantages of the DDM is:

• Since, the Gordon growth model assumes that the growth rate is constant, this model can only be applied to the mature and stable companies. This model cannot be used in the case of young companies and start up companies which exhibit a multiple growth pattern.
• There are two many assumptions made in this model, which might not be practical in the real world. There are assumptions about the growth rate, tax rate and interest rates.
• The DDM model cannot be used in the case of companies where the shareholders are a majority since they have a majority stake in the company.  As, they will be controlling and influencing the dividends that is to be paid, hence the dividends are a irrelevant metric.
• Dividends any not be related to earnings, As per the DDM, the dividends paid increase as the earnings increase but sometimes firms maintain a stable dividends e policy and does not increase dividends with increase in the earnings. So, dividend is not directly related to creating value of a share. Hence, this model stands faulty.

For example,

Suppose a firm pays a dividend of $3.5. The growth rate is expected to be 6% till perpetuity. The required rate of return is 10%

So, the share price will be:

Po = D1 / Re - g

= 3.5*1.06/ 0.10 - 0.06

= $92.75

So, the current stock price is $92.75. According to the DDM the current stock price is $92.75.

We can caluclate the require dreturn as :

Re = Rf + beta (Rm - Rf),

= 3 + 1.2 ( Rm - 3)

As per the data given, the required return on market is not mentioned . Let us assume the required rate of return to be 10%

So, the stock price is :

Po = D1/ Re - G

= 2.2*1.05/ 0.1 - 0.05

=$46.2

SO, the current stock price is $46.2.