The Dividend Growth Model and Capital Asset Pricing Model - Assignment Example

Valuation of equity and other assets is an important aspect in any business setting as it not only encompasses forecasting future performance of the company but also providing potential investors with the information regarding the company that in turn helps the investors to make their decision whether to invest their resources in the company or not (Perold, 2004). Dividend growth model and Capital asset pricing model (herein CAPM) will form the basis of our analysis including the merits and demerits of each model. These models are the two most prominent models that are used for the evaluation of potential investment. The CAPM model can be used to calculate the possibilities of the growth of investment. CAPM takes into account the risk involved in the marketplace as well as the risk bored by the company that issued the stock. Dividend –growth model Dividend-growth model is a model that is used in valuation of a company’s stock (Lally, 2013). Essentially, the Dividend growth model is a model of stock valuation that primarily deals with the dividends and their consequent growth discounted to present day. The models are divided into two as; i. Gordon growth model Gordon growth model commonly referred to as the dividend discount model is a method that is used to calculate the intrinsic value of stocks. However, the model is based on the assumption that the dividend growth rate is constant (Henry, 1999). The formula employed by this model is as follows; P = D / k – g Where P is the stock price D represents the dividend payout ratio k is the required rate of return g is the expected growth rate ii. Multi-stage dividend discount model Multi-stage dividend discount model is a dividend growth model that can take any pattern of the future expected dividends; that is to mean that dividends are not expected to grow at a constant rate (Henry, 1999). The investor is therefore expected to evaluate dividends separately for each year while putting into consideration each year’s expected dividend growth rate (Lally, 2013). This model is given by the formula; P = D (1+g) / (1 + k) + D (1+g) (1+g) / (1+r) (k - g) Capital asset pricing model (CAPM) Capital asset pricing model or CAPM is a model that specifies the relationship between risk and required rate of return on assets held by an investor in a well-diversified portfolio. The required rate of return obtained using the CAPM formula is used as the cost of equity of the company (Lee, Tsai, and Lee, 2009). The model has several basic assumptions; first, investors are assumed to be rational in the sense that they choose among alternative portfolios on the basis of the expected return and standard deviation of the portfolio held. Secondly, CAPM model also assumes that investors have homogeneous expectations with regard to asset return (Lee, Tsai, and Lee, 2009). This implies that all investors will perceive the same efficient set. Investors in this model are risk averse and the capital market is said to be efficient and perfect. In addition, capital asset pricing model is a single period model, that is, investors maximize the utility of end of period wealth (Lee, Tsai, and Lee, 2009). Consequently, in a capital asset pricing there exist a risk-free asset also known as a zero-beta asset, and all investors can borrow and lend at this rate (Yang, Xie, and Yan, 2012). The CAPM formula is given as follows; Ri = RF + [E (RM - RF)] ß Where Ri represents the required return of security i RF is the risk-free rate of return E (RM) is the expected market rate of return ß represents the beta coefficient (Yang, Xie, and Yan, 2012) Advantages of CAPM Just like other financial management tool, the capital asset pricing model has numerous merits in its application; Easy to use Calculations involved in capital asset pricing model are simple and very straightforward in generating the returns and risks associated with the assets under consideration. This merit of CAPM has in turn made this model very popular in computing cost of equity also known as required rate of return (Bollerslev, Engle, & Wooldridge, 1988). Diversified portfolio One of the assumptions of CAPM is that investors hold assets in a well-diversified portfolio while trying to imitate the market portfolio (Bollerslev, Engle, & Wooldridge, 1988). By so doing the investors eliminates the unsystematic (diversifiable) risk so as to achieve an efficient portfolio. Systematic risk (Beta) In a CAPM, both systematic and unsystematic risks are considered as opposed to other models such as the dividend discount model that tend to ignore the systematic or non-diversifiable risk (Bollerslev, Engle, & Wooldridge, 1988). Systematic risk is the risk that continues to exist in all well diversified efficient portfolios, this type of risk is an important component in portfolio analysis since it is the unanticipated and that which cannot be completely eliminated. Business and financial risk In analyzing business opportunities open to a company, some differences may emerge between the business mix and the financing needed and in this situation other methods such as WACC that are used to calculate the required rate of return also known as the hurdle rate cannot be applied but capital asset pricing model is can be used (Lee, Tsai, and Lee, 2009). Applicable to all companies Capital asset pricing model can be used by all companies in valuing and assessing different investment projects provided that the company is in a position to compute the beta coefficient (Perold, 2004). Disadvantages of CAPM Notwithstanding the aforesaid merits (advantages) and like other financial tools, CAPM model has its fair share of demerits that are as a results of the basic assumptions that are used in constructing a portfolio under CAPM (Gallagher, and Andrew, 1997). Return on the market The return on the market usually denoted as RM is the sum of the capital gains generated plus the dividends in the market. The return is not always positive and in such cases when the return will be negative then an alternative is sought so as to smooth out the return. The alternative that is used is the long-term market return. Another issue that arises by using the return on market is the fact that the rate is retrospective and this makes it to be a poor representative of the future market returns (Gallagher, and Andrew, 1997). Ability to borrow at risk free rate As mentioned earlier in the basic assumptions of capital asset pricing model, one of the assumption that is unrealistic in the real world is the one that states that investors can lend and borrow at a risk-free rate (Gallagher, and Andrew, 1997). A risk-free rate includes the government Treasury bill and Treasury bonds, borrowing and lending at this rate is not possible in real life (Ross, 1976). Therefore, the minimum required return line might actually be less steep than the model actually calculates. Determination of the proxy beta When making investment decision, a company need to find a beta that is a reflection of the project, a proxy beta is very important (Ross, 1976). However, it is a daunting task to determine accurately a proxy beta that will help in assessing the project properly and this affects the reliability and accuracy of the results. Testing CAPM empirically It is not possible to assess the expectations of investors in terms of risk and returns (Fama, & MacBeth, 1973). This is because some investors prefer higher returns while taking high risk and others prefer low returns and low risk. Due to this fact capital asset pricing model cannot be tested empirically. Risk-free rate Risk-free rate is commonly denoted as Rf is defined as the accepted rate used as the yield on short-term government securities. A problem arises when using this rate since it is prone to changes that arise on a day to day basis thus creating volatility in the outcome (Rahman, Baten, and Alam, 2006). Single-period time frame It is evident that capital asset pricing is used in investment appraisal decisions. However, since CAPM is a single period model it contradicts with the multi –period nature of several investment appraisals (Yang, Xie, and Yan, 2012). Although it can be assumed constant in the future, research has shown that this assumption is not true in the real world (Jensen, Black, and Scholes, 1972). Advantages of dividend growth model Since the dividend growth model are classified into two major categories (Yang, Xie, and Yan, 2012); Gordon growth model and multi-stage dividend discount models, we will seek to analyze the advantages of each model. 1. Gordon growth model. This valuation model has several advantages as discussed below; Simplicity and clarity The Gordon growth model values companies’ growth at a constant growth rate and due to this fact, the model is simple to use and the calculations are straightforward and clear thus making this model suitable in valuation of different companies (Reinganum, 1981). Estimating required rate of return The required rate of return is used in cost of capital for companies as well as a discounting rate in capital budgeting and investment projects (Jensen, Black, and Scholes, 1972). Gordon growth model is one of the financial tool that is useful in calculating and estimating the required rate of return (Reinganum, 1981). Understanding the relationship between different valuation components The formula utilized by this model incorporates various components such as growth, value, required rate of return and the dividend payout ratio (Miller, and Scholes, 1972). Therefore, the Gordon growth model helps to understand this components clearly and how they are used in the formula to obtain the desired outcome. Additionally, the inputs of data for this growth model are readily available for computational purposes (Rahman, Baten, and Alam, 2006). Broad – based equity indices Gordon growth model as a type of dividend discount model for valuing companies is very crucial in valuing broad-based equity indices for firms (Jensen, Black, and Scholes, 1972). Valuing stable-growth dividends The Gordon growth model is useful for the companies that have positive cash inflow which helps to maintain the stability of dividend payments by the said company. The company should also have a stable leverage pattern (Miller, and Scholes, 1972). 2. Multi-stage dividend discount models Just like the Gordon growth model, multi-stage dividend discount model as a valuation tool provides more than a few advantages. Flexibility The multi-stage growth model unlike the Gordon growth model takes any pattern on future dividends thus allowing significant flexibility when estimating the patterns of the future dividends of the company (Rahman, Baten, and Alam, 2006). Matching investor’s model with their expectations. Multi-stage dividend discount models allows the investors to suit the model with their expectations as opposed to a one fit all model (Reinganum, 1981). Can be easily reversed This dividend discount model allows room for reversal such that the current stock price can be used to ascribe the assumptions of the market for growth and the required rate of return. company (Roll, 1977). This is all due to the flexibility nature of the model (Jensen, Black, and Scholes, 1972). In addition, when the underlying assumptions are well specified, then this enables testing and analyzing the market trends to the fast-changing circumstances both inside and outside environment surrounding the company (Roll, 1977). Disadvantages of dividend growth model. Despite the advantages stated above, the dividend growth models have some weaknesses or disadvantages just like any other valuation model (Miller, and Scholes, 1972). Ideally, every model has its own weaknesses. The disadvantages will be analyzed for each model separately since the two models under consideration have their differences. 1. Gordon growth model The disadvantages for this model are less compared to the advantages and are explained as follows; Sensitivity to the underlying assumptions Gordon growth method is based on the assumption that the growth rate of dividends is constant throughout the period. The outcome obtained using this model becomes highly sensitive to this assumption for growth rate and the required rate of return (Sharpe, 1991). Valuation of unstable dividend growth patterns. The model is not suitable in valuing company’s dividends that have unstable growth rate characteristics. This demerit of Gordon growth model is countered by the use of the multi-stage dividend discount model, which has no fixed expectations on the future dividend streams (Merton, 1973). This limitation makes the model less favorable for companies with rapid changing dividend streams. Valuation of non-dividend paying companies. In the market set up, not all companies pay out dividends and in such cases Gordon dividend model cannot be applied in this companies. This is because the model is a valuation model of the company’s stocks at a given constant growth rate of dividends (Breeden, 1979). Calculations are based on future assumptions. The calculations that are employed in the Gordon growth model are based on the future prospects which are prone to market changes based not only on the economic conditions but also other market factors, it is difficult to incorporate future fluctuations in the market since they are unpredictable (Merton, 1973). Therefore, posing a major challenge to the model suitability and making it less preferable. Problem with the simple calculations. In spite of the fact that the model is simple to use and understand, the simple calculations concentrates on the use of quantitative figures while ignoring the qualitative ones which are also important in the valuation of stocks (Yang, Xie, and Yan, 2012). 2. Multi-stage dividend discount model Regardless of the numerous advantages rendered by this model, some weaknesses or demerits of the model suitability and applicability in the market and companies are as follow; Over-reliance Some companies often over-rely on the computations obtained using this method that is based on different dividend patterns while in the actual sense the results are just a mere estimate that should not be given too much attention (Yang, Xie, and Yan, 2012). The results in many instances are not very accurate and thus misleading. Sensitivity to input assumptions The model uses various inputs such as the growth, dividend payout and the required rate of return. Any slight changes to thee input assumptions affects the model highly thus distorting the expected outcomes (Rahman, Baten, and Alam, 2006). That means that multi-stage dividend discount model is highly sensitive to changes in the input underlying assumptions. Highly subjective The inputs used in the computations are subjective and can result in poor models and undesired outcomes or results (Rahman, Baten, and Alam, 2006). Another problem arises in data entry and formula errors when the computations are being carried out in a spreadsheet. Conclusion Dividend growth model, one of the basic methods of computing the required rate of return. The model is based on the dividends paid out by companies thus its usefulness in most dividend-paying companies (Miller, and Scholes, 1972). Valuation of the company’s stocks is fundamental in determining amount of dividends paid by the company as well as the growth rate of the dividends. However, the assumptions made by the Gordon growth model that the expected dividend growth rate are constant renders the stock price to be highly sensitive even to the slightest fluctuations that are unanticipated (Breeden, 1979). In spite of the of the recommendable success of this model in big companies, it is not appropriate in upcoming companies that have high cash inflow and outflow since it not flexible enough to incorporate the fluctuation of the dividend growth rates (Gupta, 2010).. The weakness of this model have however been overcomed by the multi-stage dividend discount model that is flexible and expects any dividend pattern in the future. This dividend growth models have however been considered greatly in business and financial investment projects. Capital asset pricing model (CAPM) a another basic financial management tool in providing the required rate of return which is used as a discounting rate in most companies has in the recent past been very crucial to many companies (Fama, & French, 2004). Despite the many assumptions made in this model some which are unrealistic and not applicable, the model has continued to gain popularity in the market and companies most especially in the computation of the company’s cost of equity based on the risk of the cash flows and also in portfolio analysis (Merton, 1973). Investors tend to utilize the outcomes from this model in making investment decisions and assessing the effect of the government risk-free rate on the required rate of return (Fama, & MacBeth, 1973). The required rate of return which is the minimum compensation expected by investors must be such that the investments held by an investor are able to yield at least the minimum return so as to compensate the financing provided company (Roll, 1977). In most cases, when a firm is not able to attain the minimum returns required then it is evident that the firm will have a difficult time in raising the capital to provide returns to the shareholders (Merton, 1973).. Regardless of the limitations of CAPM, its ability to incorporate systematic risk makes it more preferable in computing the cost of equity (Fama, & MacBeth, 1973). This is because it incorporates even the unforeseen risks that may arise in the future rather than ignoring the risk which is inevitable in any diversified portfolio held by an investor at a given time. Therefore, the required return is well adjusted in this case and represents the true outcome of the future inflows (Gupta, 2010). In conclusion, the two methods of computing the cost of equity also known as the required rate of return are applicable in different situations as described above and are equally important in providing the company with the discounting rate (hurdle rate) (Rahman, Baten, and Alam, 2006). Reference List Bollerslev, T., Engle, R. F., & Wooldridge, J. M. 1988. A capital asset pricing model with time-varying covariances. The Journal of Political Economy, 116-131. Breeden, D. T. 1979. An intertemporal asset pricing model with stochastic consumption and investment opportunities. Journal of financial Economics, 7(3), 265-296. Fama, E. F., & French, K. R. 2004. The capital asset pricing model: Theory and evidence. Journal of Economic Perspectives, 18, 25-46. Fama, E. F., & MacBeth, J. D. 1973. Risk, return, and equilibrium: Empirical tests. The Journal of Political Economy, 607-636. Gallagher, T.J., and Andrew, J.D., 1997. Financial management: principles and practice. 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