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Debunking the Dividend Discount Model

From Theory To Practice

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The dividend discount model is one of the prized possessions in the field of finance. It was developed by Myron Gordon in 1959, and simplifies the infinitely long discounted cash flow stream of a dividend paying company down to a tangible model that is designed to calculate a stock’s value today. In this simplification, the model assumes the dividends will grow at a constant rate indefinitely, the stock price will also grow at this same rate, and the required return in the stock exceeds this constant growth rate.

These assumptions are loosely tied to reality, and what is even more problematic is when an investor attempts to apply this model to a real investment. The inputs required to complete the model involve several layers of subjectivity, and the model becomes extremely difficult to use for a non-dividend paying company. Lastly, the stock price that outputs from the model is highly sensitive to small changes to any of the inputs. This alone renders its applicability to make an investment almost obsolete.

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