Takeovers and the Dividend Discount Model
10 Pages Posted: 27 Jan 2020
Date Written: January 13, 2020
The standard dividend discount model assumes an infinite stream of dividends, but many stocks disappear through merger at a premium at some point in their corporate life, with a current takeover probability of about 0.5% to 2% per year for publicly-traded firms in the U.S. Ignoring takeover probabilities (1) predicts stock prices that are too low; and (2) underestimates the implied cost of capital. This may help explain the poor predictive performance of implied cost of capital methods and the low returns found for most stocks over their lives, since firms that are not acquired are unlikely to earn their true cost of equity.
Keywords: dividend discount model, implied cost of capital, takeovers, cost of equity
Suggested Citation: Suggested Citation