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Dividend discount models are amongst the oldest category of valuation models that have been used by the market. However, there are some peculiar characteristics of this model that should be considered before deciding whether or not to use this model. These characteristics have been mentioned in this article.
Dividend discount models are only meant for investors who want to invest long term in the growth of a company. The model is not known for beating the market every year. This is not the investing strategy that you would want to use if your intent is to flip stocks quickly. In fact, most stocks recommended by dividend discount models are known to remain low priced for a few years before the market corrects itself and shares return to their fair value.
Studies have shown that if the return of shares selected using dividend discount models is compared to the general market over a short time period, these shares almost never outperform the market. However, if the time horizon is changed from months to years, these shares do the exact opposite and almost always outperform the market. Hence dividend discount models are for what Warren Buffet likes to call “decades investors” or people who have no intention of pulling out their money for a decade or so.
Hence, it is recommended only to seasoned investors who have a lot of patience, are not in the habit of checking their stock price daily and ascertaining the change in value and have the cash flow ability to bear what is “perceived loss” till they make abnormal gains. If investors using dividend discount models face monetary pressures, they may have to liquidate their holding at an unfavorable time which obviously is not a desirable outcome.
Secondly, dividend discount models are heavily biased towards only one kind of stocks. This flaw is basically built into the model. The model divides the infinite life of the company into two parts. One is the horizon period and the second is the perpetuity. Horizon periods are estimated to have a higher growth rate. Thus the model pays more attention to the earnings and dividends that will be paid in the near future. Dividend discount models are notorious because they always recommend the same kind of stock i.e. the one with low price to earnings ratio and high dividend yields.
Analysts have conducted studies wherein they found out that the stocks recommended after conducting an elaborate dividend discount model analysis were the exact same if only two parameters were used i.e. low price to earnings ratios and high dividend yields.
The disadvantage of picking these types of shares is that investors may miss out on multi-bagger stocks which do not have these characteristics but give handsome payoffs to investors who are willing to take the risks.
Lastly, stocks following dividend discount models have a strong disadvantage in many countries. In many countries, dividends are taxed at two levels. Also, in many countries the rate at which corporations are taxed for paying dividends is higher than if the use other methods like share repurchase.
However, this tax disadvantage built into the dividend discount models is offset by the security that a stable stream of predictable cash flows provides. So ultimately, it becomes a matter of perspective. Some investors prefer tax efficient companies whereas others prefer consistent payouts and are willing to pay a price for the same.
The dividend discount models are believed by many investors to be the gold standard in investing. As we can see that is not the case. Dividend discount models are the gold standard for a certain type of investors. Hence before applying the principles, one must be aware of the probable outcome that they can expect.
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