There are some drawbacks of the Dividend Valuation Models which include factors like the difficulty of perfect projections and the assumptions of income from dividend.
Although the principle behind the model is simple but applying the theory is challenging. The limitations of Dividend valuation Models are described below:
- The reality is that in some companies dividends grow over time and in some companies dividends will not grow at a specific rate until a certain period of time. Other companies may reduce their dividends or don’t pay at all. This means the model can be best applied only to those companies who have constant dividend payment policy.
- The model can be used on those stocks that pay dividend. In most small organizations or start-ups, the model cannot be applied to determine their value as they are not in a position to pay dividend. Investors may miss a number of opportunities if they only focus on Dividend Valuation Model.
- The model doesn’t consider non-dividend factors. There are many non-dividend factors like customer retention, intangible asset ownership, brand loyalty which can change the valuation of the company. Using a stable dividend growth rate when the model calculates the value it may not give expected result.
- The model ignores the effects of stock buyback. Stock buybacks can have a significant impact on stock value when shareholders receive the return. This means the model is conservative in nature and using the model investors ignore other factors which can affect the final value of stock.
- The model only values dividends as a return on investment. There are many ways of increasing portfolio by investing in stocks, bonds, mutual funds and other financial products. The model only looks at dividend stocks that means investor’s portfolio may not have the diversity that is required during a period of economic recession.
- The model is very sensitive to the quality of information involved. The model’s success or failure depends on the inputs provided to it. When information is accurate, the valuation may be accurate. When assumptions used by investors are mostly accurate, they will find the model to be working properly.
- When there are large variations in earnings and the maintenance of a stable dividend payout occurs, companies borrow money to ensure their status as a regular dividend provider. As the model assumes dividends are tied to earnings, in this case the model becomes worthless.
- The model is prone to personal bias because investors use their personal assumptions and experience to value the stock. If an investor as a good viewpoint for a stock the valuation result will come good although the real picture is different. In this case, involving a third party to look over the information can be helpful.
- There is a fact that the model is full of too many assumptions. The assumptions are the required rate of return, growth rate and tax rate. Most of the assumptions are not within the control of investors. So, this issue reduces the validity of the valuation model.
- The model is not worthwhile in another sense that it does not take into taxation rules. In most of the countries tax structure is created in such a way that paying dividends is not advantageous from taxation perspective. For this reason, many companies choose to invest their profits back to their business. So, considering taxation rules the model fails to guide investors.
- The Dividend Valuation model have limited use because it can only be used to mature and stable companies who pay dividends constantly. Investors generally invest in mature and stable companies and don’t focus on growing companies. Growing companies face lots of opportunities and want to develop in the future. For this purpose, they need more cash on hand and cannot afford paying dividends. Investors miss this companies because of the fact of not paying dividend.
The model is not applicable to large shareholders because they have a big shareholding and some degree of control and can influence the dividend policy. So, the model is not very useful for investors who are interested in investing in high risk-return companies.