Dividend Discount Model Basics

A Dividend Discount Model forecasts and discounts dividends to estimate the value of shares for sale in the marketplace. While Discounted Cash Flow valuations use Free Cash Flow, which could be safely removed from the business for investors, dividends actually are removed for investor profits. Recognizing this, dividend discount models rely on future dividend projections discounted to the present to estimate current value. This process is not problem free.

Problem 1: No Dividend Firms

The most obvious problem is that all firms do not pay dividends. Any firm which does not pay dividends, roughly a third of all public companies, cannot be valued with the dividend discount model. A firm which discontinues its dividends also cannot be measured with Dividend Discount Models. You can only measure firms which pay dividends.

Problem 2: Non-Dividend Value

The use of dividends brings another problem: There are several potential sources of cash flow which are not recognized by using dividends. While dividend based valuations do not ignore all non-dividend sources of cash flow to investors, it does not include all sources. Any benefits arising from share classes may not be recognized. In Dividend Discount Model Valuations, shares are worth primarily what they create in dividend value.

Problem 3: Assumptions

Another Issue is the amount of assumptions that must be made to execute the model. With a Dividend Discount Model, you must estimate both growth rates and dividend policy, which adds another potential layer of inaccuracy. Inaccuracy increases as faulty assumptions rise.

Multiple Model Options

The way estimations of growth and dividend policy are used by dividend discount models also gives rise to problems. There are two specific dividend discount models: Constant Growth, and Multiple Stage. Constant Growth assumes one set rate and dividend policy in the future and is severely limited in its application. Growth rates and dividend policies change and Constant Rates do not accurately reflect reality. Multiple Growth Dividend Discount Models, on the other hand, add more assumptions that must be made. They gain the benefit of being far more customizable for differing scenarios, and being useful for wider firm valuations. However, since you can make more assumptions, you can also make more mistakes.

Both models are not particularly great at handling high growth rates. If the growth rate exceeds capitalization rates in the constant growth model, the result may gain the huge flaw of being negative after computation. Shares obviously do not have negative value.