The cost of the equity capital is also the required rate of return. The price that you pay is only a theoretical value for the stock that you will pay to give the required rate of return.
Those stocks that are strong can be assumed to have the same historical rate of dividend growth. Read a full review of it.
The issue with the dividend discount model
The dividend discount model is not perfect and it has some shortcomings. This model assumes that the dividend will keep increasing year on year at a constant rate. The reality, however, is far from this assumption. In the real scenarios, the dividends that grow per year may not grow at a constant rate.
The equation used in the dividend distribution model is sensitive to the values that are inputted. Even if the cost of equity or the dividend growth rate is changed by a small percentage it will cause a big change in the stock’s valuation.
The dividend distribution model fails to calculate the stocks that do not give dividends. It cannot also be used for the growth stocks that pay lesser amounts of dividends.
How can the dividend discount model be used
The ideal way to use the dividend discount model is to see it as a single piece. You should not purchase a stock because it looks cheap when using the dividend discount model. Also, do not remove a stock from your portfolio because the model tells you that the stock is expensive. You need to consider the other factors like the price to earnings ratio, return on equity as well as the earnings and revenue growth of the company to decide whether to buy a stock or not.
The discounted cash flow valuation
You may know that a particular company is promising and has a huge potential. You want to buy it and add it to your portfolio. But every time you go to buy it the same question comes to your mind. Is this the right price to buy it at?
In investing you need to find a critical value of the stock. It is not hard to value a stock but for that, you need practice and logic.
The DCF model is used a lot to find the value of a stock. TheDCF model finds the sum of the future cash flows of the business and it then discounts its back to the present value. You will need a discount rate to apply to your calculation.