sustainabilityofthebank’scurrenthighreturnonequity.If
competitionarrivessoonerthanexpected,thevalueofequity
willdrop drastically. Forinstance, thevalue of equityper
sharedropsto Rs 317 ifthereturnonequitydropsto 15%
next year (instead of remaining at 23.22%).
Applicability of the Dividend Discount Model
Although many analysts have abandoned the dividend
discountmodel,arguingthatitsfocusondividendsaloneis
toonarrow,themodeldoeshaveitsproponents.Infact,many
intheBenjaminGrahamschoolofvalueinvestingswearby
the dividend discount model and its soundness. In this
section, we begin by considering the advantages of the
dividenddiscountmodelandthenfollowupbylookingatits
limitations.Weendthesectionbylookingatscenarioswhere
the dividend discount model is most applicable.
Strengths of the Model
The dividend discount model’s primary attraction is its
simplicityanditsintuitivelogic.Afterall,dividendsrepresent
theonlycashflowfromthefirmthatistangibletoinvestors.
Estimatesoffreecashflowstoequityandtothefirmremain
estimates, and conservativeinvestors can reasonably argue
that they cannot lay claim on these cash flows. Thus,
Microsoftmayhavelargefreecashflowstoequity,butan
investorinMicrosoftcannotdemandashareofMicrosoft’s
cash balance.
Thesecondadvantageofusingthedividenddiscountmodelis
thatweneedfewerassumptionstogettoforecasteddividends
thantoforecastedfreecashflowstoeitherequityordebt.To