Which of the following is least likely a potential problem associated with the three-stage dividend discount model (DDM)? The: A) stable period payout ratio may be too high resulting in an extremely low value. B) beta in the stable period is too high, resulting in an extremely low stock value. C) growth rate in the stable growth period is too high, resulting in extremely high stock value. D) high-growth and transitional periods are too long, resulting in an extremely high stock value.

D? Can’t remember much about beta, but from memory the initial stages don’t have a huge impact on price, therefore they shouldn’t result in an “extremely” high price.

I agree with D. A, B, and C all affect the terminal value which determines the majority of the PV of the DDM.

maybe having a brain freeze here, but does A even make sense?

Vo = D1/(1+r)^1 + D2/(1+r)^2 + D3/(1+r)^3 + [D4/(r-g)]/(1+r)^3 Here TV is most impt, unlike RI models. So any playing-around with the factors that affect TV (example: DRP [choice A], Beta [Choice B] and g-stable [choice C]) will drastically affect Vo. Hence gotta be D

Im going to say A

cfasf1: A high dividend payout rate in the stable period leads to a smaller retention rate. G = (1 - pay out rate) * ROE So a smaller retention rate equates to a smaller g which decreases value.

For those of you saying D, could you explain why an extended High period growth would not effect value? If you are valuing a stock and you assume that the growth phase of 15% (for example) will persist for 10 years as opposed to 5, would that not increase the value of the stock? I could be missing something here so please let me know your rationale

makes sense. but will that offset the larger dividend in the stable period? we’re discounting back at the required rate in the earlier periods, aren’t we? this isn’t for the terminal value.

My rationale is based solely on the fact that the TV of a DDM is where a majority of the value comes from. High growth periods occur at the beginning of the model, discounted at (1+r)^n. The terminal value will usually dominate whatever occurs prior to it. cfasf1 I thought about what you said, but I think the TV calculation is more affected by the spread between r-g than the dividend in the numerator. I could be wrong though.

nib, what you said makes a lot of sense too. and i’m not very confident on this one anyway, considering my brain is only being kept awake by a venti iced americano with an extra shot.

If C is a problem… how is A least likely to be a problem? I mean g and payout rate are inversely related, right? “Your answer: D was incorrect. The correct answer was A) stable period payout ratio may be too high resulting in an extremely low value. If the stable period payout ratio is too low it may result in an extremely low value because the terminal value will be lower due to the smaller dividends being paid out.” Worse yet this explanation clearly contradicts itself “A) stable period payout ratio may be too high resulting in an extremely low value… If the stable period payout ratio is too low it may result in an extremely low value…” well which is it? a high payout rate --> low RR --> low g --> low V.

I think the trick to this question was recognizing that the statement A was incorrect. If the stable period payout ratio is too High it will lead to a value that is too HIGH (not low)

I think that is where I am having trouble. I was thinking that if the payout ratio was too high then the g will be too low and r-g will be too big and thus the V will be low. instead the higher payout results in a higher dividend and that dominates even though the r-g is too big?

Here is a quick calculation I did: Ke = 10% ROE = 15% EPS = $1 DPR----------Div-------------g-------------D(1+g)------------D(1+g)/(k-g) 95%----------.95----------.75%----------.957125------------10.35 75%----------.75----------3.75%---------.7775---------------12.44 50%----------.50----------7.5%----------.5375---------------21.50 25%----------.25----------11.25%-------.278125-------------na 5%-----------.05----------14.25%-------.057125--------------na Looks to me that a high DPR leads to a lower value.

When I looked at this I considered the payout ratio independent of its effect on g. (ie. I assumed that the person who made the model made an error and increased payout ratio, thus g was not recalculated to reflect the decrease in the retention rate). If, all else equal, the div payout ratio increase, the value calculated will increase. However if you increase the payout ratio and adjust the growth rate to reflect this, the relation will not hold. The denominator will have a greater effect than the numerator resulting in a lower value (in this case).

**Edit Niblita is quicker on the BA II draw. So I am an idiot and cleared this up with 20s and my TI. ke= 0.20 ROE = 0.15 Eo = $5 First payout ratio = 0.20 g = 0.80 * 0.15 = 0.12 so D1 = 5*(1.12)(0.20) = 1.12 and Vo = 1.12 / (0.20 - 0.12) = 14.00 Next make the payout ratio “too high” = 0.80 g = 0.20 * 0.15 = 0.03 so D1 = 5*(1.03)(0.80) = 4.12 and Vo = 4.12 / (0.20 - 0.03) = 24.23 That clears that up. done and done. wow, I think I am losing ground.

definitely A high payout ratio increases stock price during stable stage because ROE is relatively small.

Hold on here… I think the correct statement is : Stable period payout ratio may be too high resulting in an extremely high or low value depending on if ROE is greater than r(e) or if ROE is less than r(e) look here… Slousicar’s examples has an r(e) > ROE and he concludes that as DPR increases, value Increase Nibilta’s examples has an ROE>r(e) and he concludes that as DPR Increases, value decreases

actually during stable period ROE = r(e) //normal profit … payout ratio has no impact on P/E ratio.