Critically discuss the Discounted Dividend Model (DDM) and the Gordon

Growth Model and their limitations.

ANSWER

1)

DISCOUNTED DIVIDEND MODEL

The dividend discount model (DDM) is a quantitative method used for predicting the price of a company's stock based on the theory that its present-day price is worth the sum of all of its future dividend payments when discounted back to their present value. It attempts to calculate the fair value of a stock irrespective of the prevailing market conditions and takes into consideration the dividend payout factors and the market expected returns. If the value obtained from the DDM is higher than the current trading price of shares, then the stock is undervalued and qualifies for a buy, and vice versa.

Drawback No. 1: Must Pay Dividends

The first drawback of the DDM is that it cannot be used to evaluate stocks that don't pay dividends, regardless of the capital gains that could be realized from investing in the stock. The DDM is built on the flawed assumption that the only value of a stock is the return on investment (ROI) it provides through dividends.

Drawback No. 2: Many Assumptions Required

Another shortcoming of the DDM is the fact that the value calculation it uses requires a number of assumptions regarding things such as growth rate, the required rate of return, and tax rate. This includes the fact that the DDM model assumes dividends and earnings are correlated.

Drawback No. 3: Ignores Buybacks

Additional criticism of the DDM is that it ignores the effects of stock buybacks, effects that can make a vast difference in regard to stock value being returned to shareholders. Ignoring stock buybacks illustrates the problem with the DDM of being, overall, too conservative in its estimation of stock value. Meanwhile, tax structures in other countries make it more advantageous to do share buybacks versus dividends.

2)

The Gordon Growth Model (GGM) is used to determine the intrinsic value of a stock based on a future series of dividends that grow at a constant rate. It is a popular and straightforward variant of the dividend discount model (DDM). The GGM assumes the dividend grows at a constant rate in perpetuity and solves for the present value of the infinite series of future dividends. Because the model assumes a constant growth rate, it is generally only used for companies with stable growth rates in dividends per share.

LIMITATIONS

1.The main limitation of the Gordon growth model lies in its assumption of constant growth in dividends per share. It is very rare for companies to show constant growth in their dividends due to business cycles and unexpected financial difficulties or successes. The model is thus limited to firms showing stable growth rates.

2.The second issue occurs with the relationship between the discount factor and the growth rate used in the model. If the required rate of return is less than the growth rate of dividends per share, the result is a negative value, rendering the model worthless. Also, if the required rate of return is the same as the growth rate, the value per share approaches infinity.