Features and Faults of the Dividend Discount Model

The dividend discount model is a method that investors use to attempt to value a stock based on the value of the dividends that it pays. This method has both some merit and some drawbacks. The basic idea behind the dividend discount model is that you can determine the value of a stock by looking at the dividends that it pays. If someone is getting a certain amount of money from the dividends, investors would be willing to pay a specific amount. This tells you how much you should be willing to pay for the stock and whether the price for it is currently undervalued, or overvalued. As with all valuation formulas, there are some inherent problems with the model. However, you can potentially get some useful information out of using this model.

Basic Formula

The basic formula for the dividend discount model is very simple. You will take the price of the dividend that was paid and divide that by an expected rate of return. For example, let's say that you had a company that paid a $10 dividend. Let's also say that you had an expected rate of return of 5 percent. In this case you would take the price of $10 and divide it by .05. This gives you a number of $200. This would mean that the value of the stock should be $200 per share at that particular time. 

Advantages

The biggest advantage of this method is that it provides you with a way to value stocks based on the dividends that they pay. Many investors do not know what dividends mean and this can be a useful tool to help you figure it out. Another advantage of this method is that it is very simple. You do not have to engage in a lot of technical calculations. You have one formula to calculate and then you can continue with your investment.

Disadvantages

Even though this method can be beneficial, it also has a few flaws. The biggest problem is that it cannot provide a value for a company unless it pays dividends. In today's market, the vast majority of companies do not pay a regular dividend. Many companies instead choose to focus on growth and invest their profits back into the company. According to this model, the stocks of those companies would not be worth anything. However, we know that a lot of these companies are very valuable and profitable. 

Another problem with this model is that you have to make many assumptions in order for the formula to work. You are going to have to predict whether a company will continue to pay the same dividend, or whether it will continue paying dividends at all. If you do not guess right, the formula becomes worthless. 

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