Dividend discount models rely on dividend projections derived from analysts’ forecasts of earnings and dividend payout rates. Substantial valuation errors can result if the payout rate does not take into account the cash consequences of expected operating, investment and financing decisions on a company’s dividend-paying ability.
A standard dividend discount model, assuming transition from a supernormal to a normal growth period for a company, will usually understate the dividend a company can afford to pay in the first year of its normal growth period, because it does not explicitly recognize that a slowdown in sales growth also precipitates a slowdown in investment requirements. An affordable dividend approach, which explicitly incorporates the cash consequences of any discontinuities in growth, corrects for this error, and generally results in a larger dividend (and higher expected return). Valuation differences between the two models are potentially largest when large changes in sales growth rates are forecast and when the company is relatively investment-intensive.