Question

Discuss the pros and cons of using the discounted dividend model as opposed to the corporate valuation method for evaluating stocks and/or private companies. Use the spreadsheet on page 322 of the textbook to receive full credit.

Answer 1

The dividend discount model calculates the "true" value of a firm based on the dividends the company pays its shareholders. The justification for using dividends to value a company is that dividends represent the actual cash flows going to the shareholder, so valuing the present value of these cash flows should give you a value for how much the shares should be worth. This is a pro over corporate valuation method as it involves real cash flows instead of accrual.

Another advantage is, there is no ambiguity regarding the definition of dividends. Whereas there is subjectivity as to what constitutes earnings and what constitutes free cash flow. Therefore, even if different analysts are asked to come up with a valuation for a company using a discounted dividend model, it is likely that they will come up with more or less the same valuation. This lack of subjectivity makes the model more reliable and hence more preferred.

The regular payment of dividends is the sign that a company has matured in its business. Its business is stable and there is not much expectation of turbulence in the future unless something drastic happens. This information is valuable to many investors who prefer stability over possibility of quick gains. Thus, from a valuation point of view, it is far easier to arrive at a discount rate. Since consistency eliminates risk, dividends are generally discounted at a lower rate as compared to other metrics that can be used in valuation.

Con is that we need dividend cash flow to be stable and predictable but we can be sure of such things only for Blue Chip companies and they aren't in abundance in market. We can't do this for junk bond corporates.

Another con being, if a firm pays no dividends at all, this model cannot be applied to the firm regardless of how profitable or cash flow efficient its operations are.

Another major disadvantage is the fact that the dividend discount model implicitly assumes that the dividends paid out are correlated to earnings. This means that higher earnings will translate into higher dividends and vice versa. But, in practice, this is almost never the case. Companies strive to maintain stable dividend payouts, even if they are facing extreme variations in their earnings.