Dividend Discount Model

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The dividend discount model is based on the concept that the future value of the all cash flows (dividends) of a particular stock is discounted to the present value by a certain percentage (risk rate).

This model requires speculation to estimate the future value of the dividends over a period of time. Assumptions need to be made regarding the company’s future long term growth. The major assumption that dividend discount model makes is that the dividends grow at a steady constant rate over a period of time but in reality it is not easy to predict what the value of dividend will be next year.

There is another model known as multi stage model which says that dividends are expected to grow over time at differing rates. The challenge here is to forecast how much variations will there be in the upcoming years.  One con of dividend discount model is that no one can is certain about the uncertainty of the expected rate of return to use. If the dividend growth rate exceeds the expected rate of return the value cannot be calculated because of the negative denominator and the value of the stock cannot be negative.

Further to this growth stocks are even more difficult to value using dividend discount model because then the valuation would be solely based on company’s future profits and dividend policy decisions which is very uncertain. In fact most growth stocks don’t even pay dividends.
To make the most out of the dividend discount model reliable assumptions need to be used because it encourages investors to evaluate different assumptions about company’s future and growth.