Dividend Discount Model: Disadvantages

The dividend discount model also has its fair share of criticism. While some have hailed it as being indisputable and being not subjective, recent academicians and practitioners have come up with arguments that make you believe the exact opposite.

Recent studies have unearthed some glaring flaws in what was considered to be a perfect valuation model.

This article is focused on understanding these shortcomings. This knowledge will help us understand when not to apply the dividend discount model.

1. Limited Use: The model is only applicable to mature, stable companies who have a proven track record of paying out dividends consistently. While, prima facie, it may seem like a good thing, there is a big trade-off. Investors who only invest in mature stable companies tend to miss out high growth ones.

   High growth companies, by definition face lots of opportunities in the future. They may want to develop new products or explore new markets. To do so, they may need more cash than they have on hand. Hence such companies have to raise more equity or debt. Obviously they cannot afford the luxury of having the cash to pay out dividends. These companies are therefore missed by investors who are focused too much on the dividends.

   For instance, investors following the dividend discount model would never have invested in companies like Google or Facebook. Even, a global behemoth like Microsoft did not have any track record of paying dividends until very recently. Hence, according to dividend discount model, these companies cannot be valued at all!

   Many investors prefer an alternate approach. They try to forecast the time when the growing company will actually evolve into a mature stable business and will start paying out dividends. However, this is extremely difficult.

   The projections become more and more risky as we try to project farther and farther into the future. Thus, we can conclude that the dividend discount models have limited applicability.

2. May not be Related to Earnings: 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.

   There have been instances where companies have been simultaneously borrowing cash while maintaining a dividend payout. In this case, this is a clear incorrect utilization of resources and paying dividends is eroding value. Hence, assuming that dividends are directly related to value creation is a faulty assumption until it is backed by relevant data.

3. Too Many Assumptions: The dividend discount model is full of too many assumptions. There are assumptions regarding dividends which we discussed above. Then there are also assumptions regarding growth rate, interest rates and tax rates. Most of these factors are beyond the control of the investors. This factor too reduces the validity of the model.

4. Tax Efficiency: In many countries, it may not be efficient to pay dividends. The tax structures are created in such a way that capital gains may be taxed lower than dividends. Also, many tax structures may encourage repurchase of shares instead of paying out dividends.

   In these countries most of the companies will not pay out dividends because it leads to dilution of value. Any investor who only strictly believes in dividend discount model will have no option but to ignore all the shares pertaining to that particular country! This is one more reason why dividend discount model fails to guide investors.

5. Control: Lastly, the dividend discount model is not applicable to large shareholders. Since they buy a big stake in the corporation, they have some degree of control and can influence the dividend policy if they want to. Thus, for them, at least, dividends are an irrelevant metric.

Therefore, dividend discount model is not very useful for investors who want to invest in high risk return companies. Also, it may not be in alignment with the tax structures being followed by certain countries.