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John Moffat.
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- October 7, 2014 at 9:54 pm #203794
One of the limitations of Dividend valuation model is that it requires constancy of growth rate therefore, it is not practicable for firms with variable and high dividend pay out ratio.
Kindly explain.
October 8, 2014 at 4:50 pm #203860The dividend growth formula does assume that shareholders are expecting a constant rate of growth in dividends (it is what shareholders are expecting that matters, because it is shareholders who determine the market price of shares).
Obviously in practice it is impossible to know exactly what shareholders are expecting. However it is very common for companies to try and maintain a fairly rate of growth and they do this by paying out a fairly low proportion of their earnings as dividends.
Obviously some years profits are likely to go up a lot and other years they might go down, but provided they are paying only a fairly small proportion of their earnings they can try and maintain reasonably constant growth in dividends.However, if they are paying out a large proportion of their earnings as dividends, then as profits fluctuate they will be forced to change the amount of the dividend and it becomes much hard, if not impossible, to maintain a fairly constant rate of dividend growth.
If they have been maintaining a reasonably constant rate of dividend growth in the past, then it is reasonable usually that shareholders will be expecting that rate of growth to continue in the future. However, if that is not the case, then it becomes almost impossible to estimate what rate of growth shareholders are expecting the future.
October 8, 2014 at 8:40 pm #203909I am most greatful. It means it is advisable for firms to maintain low pay out ratio.
October 8, 2014 at 9:03 pm #203915It would be wrong to state it as a ‘rule’, but in general (certainly for big companies) shareholders do prefer stable growth in dividends and so it is certainly something that companies will take into account when deciding on their dividend policy.
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