May 2019 Q5 b.
The dividend growth 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.
Required:
Identify and explain THREE (3) weaknesses of the dividend growth model as a way of valuing a company with shares. (6 marks)
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- The future dividend growth rate
The DGM is based on the assumption that the future dividend growth rate is constant, but experience shows that a constant dividend growth rate is, in reality, very rare. This may be seen as less of a problem if the future dividend growth rate is regarded as an average growth rate. Estimating the future dividend growth rate is very difficult in practice and the DGM is very sensitive to small changes in this key variable. It is common practice to estimate the future dividend growth rate by calculating the historical dividend growth, but the assumption that the future will reflect the past is an easy one to challenge. - The cost of equity
The DGM assumes that the future cost of equity is constant, when in reality it changes quite frequently. The cost of equity can be calculated using the capital asset pricing model, but this model usually employs historical information, which may not reflect accurately expectations about the future. - Zero dividends
It is sometimes claimed that the DGM cannot be used when no dividends are paid, but this depends on whether dividends are expected in the future. If dividends are forecast to be paid from a future date, the dividend growth model can be applied at that point to calculate a share price, which can then be discounted to give the current ex dividend share price. Only in the case where no dividends are paid and no dividends are expected to be paid will the DGM have no application.