Question

You want to use the dividend discount model with a constant growth rate to value security. What is the most difficult input to estimate correctly? Why? Does getting this input wrong give significant consequences? Explain.

Answer 1

We know that the formula to calculate the current share price by dividend discount model

Stock Price P = D1 / (k – g)

Where:

P = the current stock price

D1 = dividend for next year

k = required rate of return or cost of equity

g = constant growth rate of dividends

The variable inputs are the dividend, required rate of return and constant growth rate of dividends. In this model it is assumed that the average growth rate of dividend is constant for infinite time, therefore it is most difficult input to estimate correctly for such a long duration. Getting this input wrong give significant consequences because if constant growth rate of dividends is higher, it will calculate the higher value of stock price and if constant growth rate of dividends becomes equal to required rate of return then the value Stock Price will become infinite.