Advantages and disadvantages of Dividend discounted model and Residual income model PDF

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This summary contains the tables which indicate the advantages and disadvantages of Dividend discounted model and Residual income model...

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Advantages & disadvantages of each valuation model: 1. Dividends Discounted Model (DDM) Disadvantages: 1. Dividends reflect the distribution of value and not the creation of value • Distribution of value tends to be arbitrary and not reflective of performance, e.g. some firms pay the same dividend every year or pay a fixed percentage of earnings (but their earnings change every year) 2. What if the firm has a policy of not pay dividends? • E.g. Warren Buffett’s company Berkshire Hathaway has never paid a dividend, but its market value is >US$460bn 3. Companies can return cash to shareholders in other ways, e.g. by buying-back shares (this is common in the US) The solution is to transform the dividend discount model, so we can value the firm based on its earnings rather than dividends 2. Residual Income Model Advantages 1. Focus on value drivers: 2. Incorporates the financial statements:

focuses on profitability of investment and growth in investment that drive value; directs strategic thinking to these drivers incorporates the value already recognized in the balance sheet (the book value)

3. Uses accrual accounting:

uses the properties of accrual accounting that recognize value added ahead of cash flows, matches value added to value given up and treats investment as an asset rather than a loss of value analysts forecast earnings (from which forecasted residual earnings can be calculated)

4. Aligned with what people forecast:

Disadvantages 1. Accounting complexity: 2. Suspect accounting:

requires an understanding of how accrual accounting works relies on accounting numbers that can be suspect...