P / E Ratio and Dividend Discount Model Essay

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Issues in using the Dividend Discount Model
The dividend discount model's primary attraction is its simplicity and its intuitive logic. There are many analysts, however, who view its results with suspicion because of limitations that they perceive it to possess. The model, they claim, is not really useful in valuation, except for a limited number of stable, high-dividend paying stocks. This section examines some of the areas where the dividend discount model is perceived to fall short.
(a) Valuing non-dividend paying or low dividend paying stocks
The conventional wisdom is that the dividend discount model cannot be used to value a stock that pays low or no dividends. It is wrong. If the dividend payout ratio is adjusted to reflect changes in the expected growth rate, a reasonable value can be obtained even for non-dividend paying firms. Thus, a high-growth firm, paying no dividends currently, can still be valued based upon dividends that it is expected to pay out when the growth rate declines. If the payout ratio is not adjusted to reflect changes in the growth rate, however, the dividend discount model will underestimate the value of non-dividend paying or low-dividend paying stocks.
(b) Is the model too conservative in estimating value?
A standard critique of the dividend discount model is that it provides too conservative an estimate of value. This criticism is predicated on the notion that the value is determined by more than the present value of expected dividends. For instance, it is argued that the dividend discount model does not reflect the value of 'unutilized assets'.

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