Criticism of dividend discount model (DDM)

There are two common arguments against dividend discount model (DDM):

1. DMM undervalues companies as DMM does not account for company assets, cash flow, or earnings.

2. Valuations based on DMM are useless as predicting future dividends is not possible and the model is sensitive to the dividend growth rate assumptions.

On the surface, the first argument looks to have merit: Surely, a company that has cash on their account and no debt is worth at least the cash balance. And an international brand name (for example, Coca Cola) has to be worth something. Unfortunately, an individual investor cannot access the company cash account nor can she/he sell company assets (factories, brand names, warehouses). The only way the individual investor can benefit from the company assets is through the dividends. Now if you are Buffet or have about $1B or so, you can buy entire companies at which point you have access to company assets. But for an individual investor, this is not an option and dividends are the only benefit for owning a common stock.

Moreover, the assets are needed to support the dividends and they do not come on top of the dividends. Taking Coca Cola as on example, the earnings and hence dividends of Coca Cola would pretty much disappear if it ever decided to sell its brand name. So the DMM indirectly but correctly values the company assets and how they will benefit the shareholder.

The second argument concerning the prediction of future dividends clearly has some merit but this problem can be mitigated by focusing on large companies that pay stable or slowly growing dividend. For analyzing faster growth companies, the investors should be conservative and only invest if even pessimistic growth assumptions justify the price. The best argument for DDM, however, is that there is no simpler alternative for valuing stocks that somehow does not require predicting future.

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