Drawbacks 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.

The DDM assigns 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. The first 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 it provides through dividends.

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 and required rate of return. 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.

An 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.

  1. How does the dividend discount method (DDM) work?

    Learn about the dividend discount model and when it can most appropriately be used to measure the value of a stock by fundamental ... Read Answer >>
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