Wednesday, February 22, 2017

Equity Management #3 : The Dividend Discount model is overrated

One of the fundamental building blocks taught in the CFA is the dividend discount model or DDM. In Chapter 4 of the Equity Management book, empirical studies would succeed at demolishing the explanatory power of DMM when it comes to stock returns.

For the novices, the dividend discount model is basically the  idea that a stock price should be the net present value of all future dividend payments.

V = D1/(1+r) + D2/(1+R)^2 + D3/(1+r)^3 +....

If dividends grow at a constant rate, the equation collapses to  V = D1 / (r - g)

V = Price of the Stock
Dx = Dividend in year x.
r = risk free interest rate
g = rate of dividend growth

If you read a brokerage report which employs the dividend discount model, you can now objectively take those results with a pinch of salt. There are simply too many variables which require a future prediction for your value calculation have a chance of being accurate at all. First you have predict future dividends. Second, you have to know future interest rates. Even if you are able to plug everything into your spreadsheet, in essence, you are getting an estimate derived from other estimated values. No wonder many analysts cover their tracks and recommend a buy only when the current market price is discounted from this calculated value estimate.

This authors performed a series of regression exercises and concluded that the DDM does not adequately explain what drives investment returns.

An investor is better off relying on a low P/E ratio and a low price/sales ratio to make investment decisions.

The chapter ends with a valuable quote from Paul Samuelson which I am still trying to channel when it comes to my own investment portfolio. The quote goes like this," I prefer paradigms that combine plausible Newtonian theories with observed Baconian facts. But never would I refuse to houseroom to a sturdy fact just because it is a bastard without a name and a parental model. "

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