While many analysts have abandoned the dividend discount model, arguing that its focus on dividends alone is too narrow, the model does have its proponents. In fact, many in the Ben Graham school of value investing swear by the dividend discount model and its soundness. In this section, we will begin by considering the advantages of the dividend discount model and then follow up by looking at its limitations. We will end the section by looking at scenarios where the dividend discount model is most applicable.
The dividend discount model's primary attraction is its simplicity and its intuitive logic. After all, dividends represent the only cash flow from the firm that is tangible to investors. Estimates of free cash flows to equity and the firm remain estimates and conservative investors can reasonably argue that they cannot lay claim on these cash flows. Thus, Microsoft may have large free cash flows to equity but an investor in Microsoft cannot demand a share of Microsoft's cash balance.
The second advantage of using the dividend discount model is that we need fewer assumptions to get to forecasted dividends than to forecasted free cashflows to either equity or debt. To get to the latter, we have to make assumptions about capital expenditures, depreciation and working capital. To get to the former, we can begin with dividends paid last year and estimate a growth rate in these dividends.
Finally, it can be argued that managers set their dividends at levels that they can sustain even with volatile earnings. Unlike cash flows that ebb and flow with a company's earnings and reinvestments, dividends remain stable for most firms. Thus, valuations based upon dividends will be less volatile over time than cash flow based valuations.
The dividend discount model's strict adherence to dividends as cash flows does expose it to a serious problem. As we noted in the last chapter, many firms choose to hold back cash that they can pay out to stockholders. As a consequence, the free cash flows to equity at these firms exceed dividends and large cash balances build up. While stockholders may not have a direct claim on the cash balances, they do own a share of these cash balances and their equity values should reflect them. In the dividend discount model, we essentially abandon equity claims on cash balances and under value companies with large and increasing cash balances.
At the other end of the spectrum, there are also firms that pay far more in dividends than they have available in cash flows, often funding the difference with new debt or equity issues. With these firms, using the dividend discount model can generate too optimistic an estimate of value because we are assuming that firms can continue to draw on external funding to meet the dividend deficit in perpetuity.
Notwithstanding its limitations, the dividend discount model can be useful in three scenarios.
• It establishes a baseline or floor value for firms that have cash flows to equity that exceed dividends. For these firms, the dividend discount model will yield a conservative estimate of value, on the assumption that the cash not paid out by managers will be wasted n poor investments or acquisitions.
• It yields realistic estimates of value per share for firms that do pay out their free cash flow to equity as dividends, at least on average over time. There are firms, especially in mature businesses, with stable earnings, that try to calibrate their dividends to available cashflows. At least until very recently, regulated utility companies in the United States, such as phone and power, were good examples of such firms.
• In sectors where cash flow estimation is difficult or impossible, dividends are the only cash flows that can be estimated with any degree of precision. There are two reasons why all of the companies that we have valued using the dividend discount model in this chapter are financial service companies. The first is that estimating capital expenditures and working capital for a bank, an investment bank or an insurance company is difficult to do.6 The second is that retained earnings and book equity have real consequences for financial service companies since their regulatory capital ratios are computed on the basis of book value of equity.
In summary, then, the dividend discount model has far more applicability than its critics concede. Even the conventional wisdom that the dividend discount model cannot be used to value a stock that pays low or no dividends is wrong. If the dividend payout ratio is adjusted to reflect changes in the expected growth rate, a reasonable value can be obtained even for non-dividend paying firms. Thus, a high-growth firm, paying no
6 This is true for any firm whose primary asset is human capital. Accounting conventions have generally treated expenditure on human capital (training, recruiting etc.) as operating expenditures. Working capital is meaningless for a bank, at least in its conventional form since current assets and liabilities comprise much of what is on the balance sheet.
dividends currently, can still be valued based upon dividends that it is expected to pay out when the growth rate declines.
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