Making the Dividend Discount Model Relevant for Financial Analysts

24 Pages Posted: 25 Jan 2018

Date Written: October 26, 1998

Abstract

The traditional dividend discount model is irrelevant for financial analysts. It requires them to forecast an infinite stream of dividends. Most of the present value is due to the forecast dividends far in the future. This part of the forecast is highly uncertain; hence nobody takes the forecast seriously or believes the resulting present value. Fairfield [1994] restates the model in terms of abnormal earnings, which reflect a firm’s abnormal ROE. A reasonable abnormal ROE forecast will fall to zero before long. This and the discounting process assure that the early years account for most of the present value. Thus, the forecast required by this variant of the model is believable.

This paper reviews Fairfield’s model and provides additional insight into the price/book value and price/earnings ratios. It also presents her model as a spreadsheet that financial analysts can use. Hypothetical growth and val-ue companies are analyzed to illustrate the ideas. A hypothetical cyclical company is analyzed to show that Fairfield’s characterization of the price/earnings ratio’s behavior is too simple. An innovative and practical approach to forecasting abnormal ROEs is developed. The model also is used to illustrate the advantage of financing growth by selling stock at a high price/book value ratio.

Keywords: dividend discount, stock valuation, asset pricing, financial analysis, investment analysis, portfolio choice, investment decisions

JEL Classification: G00, G10, G11, G12

Suggested Citation

Ferguson, Robert, Making the Dividend Discount Model Relevant for Financial Analysts (October 26, 1998). Available at SSRN: https://ssrn.com/abstract=3104851 or http://dx.doi.org/10.2139/ssrn.3104851

Robert Ferguson (Contact Author)

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