The dividend growth model places emphasis on a constant never ending growth (The Free Dictionary, 2010). The dividend growth model essentially determines the "value of stock based on a future series of dividends that grow at a constant rate" (Investopedia, Gordon Growth Model, 2010. paragraph 1). Because the dividend growth model has a continuous growth rate, those companies or corporations that are well established, would benefit the most from this model as their growth rate tends to be "low to moderate" (Investopedia, Gordon Growth Model, 2010, paragraph 2). However, this easy to use but powerful model has its limitations, in that the model is vulnerable to the information entered for the growth rate, and if this information is not entered correctly, it will produce wrong and inaccurate information (Stern-NYU, n.d.) which can lead to many problems.
There are many advantages that the Dividend Growth Rate has to offer. The model ties to assign "a valuation on shares, based on forecasts of the sums to be paid out to investors" (QFinance, Using Dividend Discount Models, 2009, Paragraph 4). In reality this should offer a solid and accurate way to determine the "share's true value in present terms" (QFinance, Using Dividend Discount Models, 2009, Paragraph 4). The model is more effective for short term use in addition for those companies that are well established the Dividend Growth Rate model can offer a company substantial value if used over an extended period of time only if "investors are prepared to make the assumption that current dividend payout policies will remain in place (QFinance, Using Dividend Discount Models, 2009, Paragraph 4).
Although the Dividend Growth Rate Model offers many advantages, there are just as many disadvantages. The model offers no real value in trying to estimate a company's dividend return, especially for companies that that are associated with technology, such as cell phone companies, or internet providers (QFinance, Using Dividend Discount Models, 2009). However, well established companies, and for those industries such as food and utilities can benefit form this model the most (QFinance, Using Dividend Discount Models, 2009). The fact that this model has slow and steady growth rate over a substantial period of time, the model doesn't offer a clear and accurate prediction, as it "rely heavily on the validity of the data inputs, making them of questionable value given the challenges associated with accurately forecasting growth rates beyond five years" (QFinance, Using Dividend Discount Models, 2009, Paragraph 5). The accuracy of the model is based on the input data, which is vulnerable to "inaccurate inputs" (QFinance, Using Dividend Discount Models, 2009, Paragraph 6). The formula below is used to calculate the Dividend Growth Rate:
Stock Value = D / k - G
D = Expected dividend per share one year from now
k = Required rate of return for equity investor
G = Growth rate in dividends (in perpetuity) (Investopedia, Gordon Growth Model, 2010).
Capital Asset Pricing Model
The Capital Asset Pricing Model (CAPM) is a model that allows a company or corporation the ability to determine the "risk and expected return" that are associated with the "pricing of risky securities" (Investopedia, Capital Asset Pricing Model, 2010, paragraph 1). The model itself it built upon the premise that compensation is generated by the time value of money and associated risks (Investopedia, Capital Asset Pricing Model, 2010). The CAPM helps businesses and companies, to determine their level of risks on investments (McClure, 2010).
According to QFinance (2009), the Capital Asset Pricing Model, "is only a simple calculation built on historical data of market and stock prices" (QFinance, Capital Asset Model, 2009, Paragraph 11). The model does not show any predictions on the company "whose stock is being analyzed (QFinance, Capital Asset Model, 2009, Paragraph 11). The CAPM offers a generalized theory with effective results, and is the front runner in financial management (McClure, 2010). Although the Capital Asset Pricing Model is heavily used by corporations, many question its effectiveness (McClure, 2010). According to McClure (2010), the model does provide a precise way to measure the risk of investing and it also allows financial mangers to "determine what return they deserve for putting their money at risk" (McClure, 2010, Paragraph 17). The formula below is used to calculate Capital Asset Pricing:
(Investopedia, Capital Asset Pricing Model, 2010
Arbitrage Pricing Theory
The Arbitrage Pricing Theory (APT) is a model that assumes that based on cretin risk factors, a company can predict its expected return based on its current assets (Investopedia, Arbitrage Pricing Theory, 2010). According to Stephen Ross as reported by Investopedia (2010), the APT "predicts a relationship between the returns of a portfolio and the returns of a single asset through a linear combination of many independent macro-economic variables" (Investopedia, Arbitrage Pricing Theory, 2010, Paragraph 1). Utilizing the arbitrage pricing theory, a company is able to determine the correct price of an item, which other wise has been mis-priced. The fact that this theory offers great flexibility, many companies prefer to use this theory rather than the Capital
Asset Pricing Model (Investopedia, Arbitrage Pricing Theory, 2010), however there are several weaknesses associated with the Arbitrage Pricing theory. The model does not indicate what the correct factor and such factors are not consistent, as they may change over a substantial period of time (Wang, 2003).
Of the three models it appears that the CAPM is the best model for determining the required rate of return for a company, as the Capital Asset Pricing Model helps determines the risk involved in investing money as well as determines what you should get based on your investment (McClure, 2010). The Dividend Growth Model is based on never ending growth at a steady pace. This is difficult to determine especially with today's ever changing market. Today's economy is growing at a very slow pace, and unsteady, and the Arbitrage Pricing Theory is just that, a theory. A theory based on a prediction, or educated guess, hypothetical assumptions that do not produce facts. All three models appear to provide accurate information that is based upon inputs.
The Capital Asset Pricing Model is more effective in calculating a company's assets, equity and investment, as well as determining how much cash the company actually have on hand (Agarwal & Satish, 2010). In general it can be used to determine a company's worth.
