The downsides of using the dividend discount model (DDM) include the difficulty of accurate projections, the fact that it does not factor in buybacks, and its fundamental assumption of income only from dividends.

Key Takeaways

  • There are a few key downsides to the dividend discount model (DDM), including its lack of accuracy. 
  • A key limiting factor of the DDM is that it can only be used with companies that pay dividends at a rising rate. 
  • The DDM is also considered too conservative by not taking into account stock buybacks. 

The DDM assigns a value to a stock by essentially using a type of discounted cash flow (DCF) analysis to determine the current value of future projected dividends. If the value determined is higher than the stock's current share price, then the stock is considered undervalued and worth buying.

While the DDM can be helpful in evaluating potential dividend income from a stock, it has several inherent drawbacks. 

Drawback No. 1: Must Pay Dividends

The first drawback of the DDM is that it cannot be used to evaluate stocks that don't pay dividends, regardless of the capital gains that could be realized from investing in the stock. The DDM is built on the flawed assumption that the only value of a stock is the return on investment (ROI) it provides through dividends.

Beyond that, it only works when the dividends are expected to rise at a constant rate in the future. This makes the DDM useless when it comes to analyzing a number of companies. Only stable, relatively mature companies with a track record of dividend payments can be used with the DDM. 

This means that investors who only utilize the DDM would miss out on the likes of high-growth companies, such as Google (GOOG). 

Drawback No. 2: Many Assumptions Required 

Another shortcoming of the DDM is the fact that the value calculation it uses requires a number of assumptions regarding things such as growth rate, the required rate of return, and tax rate. This includes the fact that the DDM model assumes dividends and earnings are correlated. 

One example is the fact that dividend yields change substantially over time. If any of the projections or assumptions made in the calculation are even slightly in error, this can result in an analyst determining a value for a stock that is significantly off in terms of being overvalued or undervalued. 

There are a number of variations of the DDM that attempt to overcome this problem. However, most of them involve making additional projections and calculations that are also subject to errors that are magnified over time.

Drawback No. 3: Ignores Buybacks

Additional criticism of the DDM is that it ignores the effects of stock buybacks, effects that can make a vast difference in regard to stock value being returned to shareholders. Ignoring stock buybacks illustrates the problem with the DDM of being, overall, too conservative in its estimation of stock value. Meanwhile, tax structures in other countries make it more advantageous to do share buybacks versus dividends.