Dividend Discount Model

Practice Question

Intro to Finance
Equity Valuation
Dividend Discount Model
MCQs

Which of the following statement regarding the DDM is correct?

A) The constant growth rate equals to ROE * dividend payout ratio
B) The constant growth rate equals the dividend yield.
C) The DDM cannot be used to value firms who do not pay any dividends.
D) The DDM cannot be applied to firms with negative earnings.

Answer +
Final Answer: C) The DDM cannot be used to value firms who do not pay any dividends.
Explanation +

Explanation:

  • A) Incorrect. The growth rate is actually calculated using the retention formula: \( g = ROE \times (1 - \text{dividend payout ratio}) \).
  • B) Incorrect. The dividend yield is \( \frac{D_1}{P_0} \), which is not equivalent to the growth rate in the DDM.
  • C) Correct. DDM values a firm based on its future dividend payments. If no dividends are paid, there are no future cash flows to discount.
  • D) Incorrect. Firms can have negative earnings but still pay dividends. The DDM uses dividends, not earnings, as its input.

Conclusion: C is the only statement that accurately describes a key limitation of the Dividend Discount Model.