The dividend valuation model is a formula that is used to determine the overall value of a stock. Once that value is determined, it can be compared to the current market price that the stock is trading at. That allows investors to know if shares are being traded at a price that is greater than or less than its actual value.
The dividend valuation model is often referred to as the dividend discount model.
To determine the value of a stock, this valuation model uses future dividends to create a prediction on share values. It is based on the sole idea that investors are purchasing that stock to receive dividends.
Here are the advantages and disadvantages to examine when using the dividend valuation model to assign values to specific stocks.
List of the Advantages of the Dividend Valuation Model
1. It is a very conservative model of valuation.
Unlike other models that are sometimes used for stocks, the dividend valuation model does not require growth assumptions to create a value. The dividend growth rate for stocks being evaluated cannot be higher than the rate of return, otherwise the formula is unable to work. That means you’re using this model to predict what future dividends will be, based on what the current dividend happens to be.
2. It is very easy to understand.
Once you know how to do the math within the dividend valuation model, you can use it for any stock that offers a dividend. That gives you more control over your investment options because you’ll be able to see the actual value in the trading price of the share. It saves you time when trying to weed out stocks that are overpriced without forcing you into a process that is overly complicated.
3. It gives you options to grow the value of your portfolio.
Stocks which pay dividends generally outperform stocks that do not. By using this valuation model, it becomes easier to find a place to invest because you’ll be able to maintain the value of the investment. At the same time, you’ll earn income through the dividends being earned, which allows you to grow the overall value of your portfolio, especially if you’ve invested in several dividend stocks from a variety of industries.
4. It operates within a margin of safety.
No valuation model is perfect. The individualized nature of today’s business world means there isn’t one definitive model to use for stock valuation either. One of the advantages that comes with the dividend valuation method is that a margin of safety is already built into it. You’ll be able to determine where the value stands, then assign a place of investment which works for your budget. That means you stay in control of when and how you invest.
5. It eliminates subjectivity from the equation.
Although the dividend valuation model is reliant on assumptions to create results, there is less subjectivity involved with this model compared to other methods of valuation. The definition of a dividend is not ambiguous. That means there is less subjectivity involved when using this model to determine value, making it more likely that every investor will come up with a similar result using this model.
6. It does not require control to be valuable.
Minority shareholders do not have the ability to influence payout policies. That is because they have no control over the company. The only facts that they have available to them are the dividend payout policies. When these policies are examined over the course of months or years, then the patterns which emerge can be used to predict future dividends. There is no requirement to be an institutional investor when using this valuation model.
7. It rates the stability of a mature business.
The dividend valuation model was never designed to work with small businesses and startups. It is designed to be a measurement of the health of a mature business. Regular dividend payments are a sign that a company has entered the third stage of business development, which promotes profitability for investors. That makes it easier, compared to other valuation methods, to determine what the discount rate should be.
List of the Disadvantages of the Dividend Valuation Model
1. It is overly simplistic.
The reality of the investment world is that the dividends at a company are not going to grow at a specific rate until the end of time. Some companies increase their dividends over time. Others may reduce their dividends. Some have even chosen to eliminate them altogether. These actions are not part of the calculation process of the valuation model. That means this model is best used on the few companies which consistently provide a dividend growth rate each year.
2. It only works on stocks which pay dividends.
When comparing small-cap stocks to large-cap stocks, it is the smaller businesses which have performed better over long-term time periods. Most small businesses are not in a position to pay a dividend, which means this valuation model cannot be used to determine their value. It can only be used on stocks that do pay a dividend. If investors focused only on this specific model, then they would potentially miss a number of opportunities to add value to their portfolio.
3. It does not include non-dividend factors.
There are many factors which can influence the valuation of a stock over time. Customer retention, brand loyalty, and even intangible asset ownership all have the potential to increase the value of the company. If the dividend growth rate is stable and known, these non-dividend factors can actually change the valuation of the company in question. That means the valuation method, even when calculated correctly, may not produce desired results.
4. It only values dividend payments as a return on investment.
The idea that the only way to create profits from the actions of an investment is through dividends is a thought process which is fundamentally flawed. There are numerous ways to increase portfolio wealth by working with stocks, bonds, mutual funds, ETFs, and other financial products. Only looking at dividend stocks means a portfolio may not have the diversity required to make it through a period of economic recession.
5. It ignores the effects of a stock buyback.
The action of a stock buyback can have a dramatic effect on stock value to shareholders when they receive the return. This is another example of the ultra-conservative nature of this valuation model. There are many actions which may affect the final value of a stock. The dividend valuation model forces investors to make the assumption that none of these other effects will every take place over the entire history of the business.
6. It is highly sensitive to the quality of information involved.
The success or failure of the dividend valuation model is based on the inputs provided to it. If the information is inaccurate, then the valuations received from the model will also be inaccurate. Investors will find that this model only works well when the assumptions they are forced to make turn out to be mostly accurate. It is always better to be too safe than too reckless when making an investment, but with this option, it is almost too conservative for many stocks to have it be an effective tool.
7. It is subject to personal bias.
Investors tend to value stocks based on their personal observations and experiences. That means this valuation model is prone to bias. If an investor has a positive outlook for a specific stock, even though the information may say otherwise, the valuation will still come out high. If this model is being used to determine the viability of an investment, it may be a good idea to have a third party involved to look over the data with you.
8. It assumes dividends are tied to earnings.
Businesses which have offered a stable rate of return through dividends for shareholders have made this a top priority. Even when there are large variations in their earnings, the maintenance of a stable dividend payout occurs. Some companies have even borrowed money to ensure that they were able to maintain their status as a regular dividend provider. If a business does not have their earnings directly tied to their income, then this valuation method becomes worthless.
9. It does not take into account taxation rules.
In most countries, paying dividends is not advantageous from a taxation perspective. For that reason, it may be more profitable to have a stock repurchase instead. Some may choose to invest their profits back into the business. This model does not take this consideration into account either.
These dividend valuation model advantages and disadvantages show that this formula can be helpful when looking at specific stocks with a reputation of dividend payments. Although any stock paying a dividend can be examined with this method, any other stock cannot. That means investors are only focusing on one segment of the market, which over time may limit the amount of growth that is achievable.
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