The dividend discount model is used for the purpose of equity valuation. There are different types of dividend discount model and all these models are very useful. The usefulness of the DDM (dividend discount model) depends on the application of the same.
A sensitivity analysis of the dividend discount model is very necessary because the model itself is highly sensitive towards the presumptions regarding the growth and discount rates.The investor can be benefited by the sensitivity analysis because this particular analysis can provide an idea about how various presumptions can create different values.
The dividend discount model compels the investor to think about different situations regarding the market price of the stock. The dividend discount model is used by huge number of professionals because the model is able to illustrate the difference between reality and theories through different examples. But at the same time it should also be remembered that there are some important factors like the realistic transition phases and some others, which are missing from the DDM.
The DDM needs various data to bring out the value of an equity.
DPS(1), which represents the amount of expected dividend, is very important for DDM. The growth rate in dividend is also an important factor in the use of dividend discount model. Another important data is ‘Ks’. ‘Ks’ represents the expected rate of return and this can be estimated through the following formula:
Risk-free rate + (market risk premium)* Beta
There are several types of dividend discount model.
Following are the two most preferred types of DDM:
Stable Model: According to this model, value of stock is equal to DPS(1) / Ks – g. This model is appropriate for the firms with long term steady growth. These types of firms pretend to grow simultaneously with the long term nominal development rate of the economy.
Two-Stage Model: This particular model tries to bring out the difference between the theory and the reality. It simply pretends that the company would go through several good and bad periods. According to this model, the company that is going through a high-growth period is bound to face a decline in the growth rate. After that downfall the company is expected to experience a stable growth phase.