Question

1. What are the limitations of the dividend discount model?
2. A stock currently pays a dividend of $4 for the year. Expected dividend growth is 20% for the next three years and then growth is expected to revert to 4% thereafter for an indefinite amount of time. The appropriate required rate of return is 10%. What is this stock’s intrinsic value?
3. What is the rate of return on an investment that costs $500 and is sold after 1 year for $560?

Answer 1

1)

the limitations of the dividend discount model are as below:

a. It is difficult to estimate dividend as management has the discretion to change the payout ratio despite earnings level

b. It doesn't factor other cash flows such as buybacks and also does not account free cash flows

c. This model only useful for those companies which pays dividends.

d. like other discount cash flows model, the value based on this model is highly sensitive to any changes in the growth/discount rate.

2)

What is this stock’s intrinsic value

=(4*(1+20%)^1)/(1+10%)^1+(4*(1+20%)^2)/(1+10%)^2+(4*(1+20%)^3)/(1+10%)^3+((4*(1+20%)^3*(1+4%))/(10%-4%))/(1+10%)^3

=104.33

3)

he rate of return on an investment that costs $500

=560/500-1

=12%