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If Pn is far in the future, it will not affect P0 Therefore, the model can be rewritten as:
t P0 = S D /(1 + k ) t e t=1
Computing the present value of an infinite stream of dividends can be difficult. Simplified models have been developed to make the calculations easier.
D0 = the most recent dividend paid g = the expected growth rate in dividends ke = the required return on equity investments
Disadvantages:
By using an industry average PE ratio, firmspecific factors that might contribute to a longterm PE ratio above or below the average are ignored.
The market price is set by the buyer who can take best advantage of the asset.
Errors in Valuation
Problems with Estimating Growth
Growth can be estimated by computing historical growth rates in dividends, sales, or net profits. But, this approach fails to consider any changes in the firm or economy that may affect the growth rate.
Competition, for example, will prevent high growth firms from being able to maintain their historical growth rate. Nevertheless, stock prices of historically high growth firms tend to reflect a continuation of the high growth rate. As a result, investors receive lower returns than they would by investing in mature firms.
Errors in Valuation
Problems with Estimating Risk
The dividend valuation model requires the analyst to estimate the required return for the firms equity. However, a share of stock offering a $2 dividend and a 5% growth rate changes with different estimates of the required return.
Errors in Valuation
Problems with Forecasting Dividends
Many factors can influence the dividend payout ratio. They include:
The firms future growth opportunities a Managements concern over future cash flows
Conclusion:
Analysts are seldom certain that the stock price projections are accurate. This is why stock prices fluctuate widely on news reports.