an approach brings even more assumptions into the model–although it doesn’t assume that a dividend will grow at a constant rate, it must guess when and by how much a dividend will change over time.
What Should Be “Expected“?
Another sticking point with the DDM is that no one really knows for certain the appropriate expected rate of return to use. It’s not always wise simply to use the long-term interest rate because the appropriateness of this can change.
The High-Growth Problem
No fancy DDM model is able to solve the problem of high-growth stocks. If the company’s dividend growth rate exceeds the expected return rate, you cannot calculate a value–because you get a negative denominator in the formula. Stocks don’t have a negative value. Consider a company with a dividend growing at 20% while the expected return rate is only 5%: in the denominator (r-g) you would have -15% (5%-20%)!
In fact, even if the growth rate does not exceed the expected return rate, Growth stocks, which don’t pay dividends, are even tougher to value using this model. If you hope to value a growth stock with the dividend discount model, your valuation will be based on nothing more than guesses about the company’s future profits and dividend policy decisions. Most growth stocks don’t pay out dividends. Rather, they re-invest earnings into the company with the hopes of providing shareholders with returns by means of a higher share price.
Consider Microsoft, which didn’t pay a dividend for decades. Given this fact, the model might suggest the company was worthless at that time–which is completely absurd. Remember, only about a third of all public companies bother to pay dividends. Furthermore, even companies that do offer payouts are allocating less and less of their earnings to shareholders.
The dividend discount model is by no means the be-all and end-all for valuation. That being said, learning about the dividend discount model does encourage thinking. It forces investors to evaluate different assumptions about growth and future prospects. If nothing else, the DDM demonstrates the underlying principle that a company is worth the sum of its discounted future cash flows. (Whether or not dividends are the correct measure of cash flow is another question.) The challenge is to make the model as applicable to reality as possible, which means using the most reliable assumptions possible.