Dividend Discount Model vs. Capital Asset Pricing Model

The vast majority of investment research supports the theory that proper asset allocation is more optimal for a portfolio than market timing. Attempting to value securities may be a fruitless task, however two models that have been used to determine intrinsic stock values are the dividend discount model and capital asset pricing model.

The dividend discount model (DDM) values equities based upon future dividend payments and discounting them to the present value. The DDM is most useful for dividend paying companies, however one glitch in the model is the prediction of future dividend payments. Regardless of skill and resources, it is nearly impossible to determine dividend payments of a firm due to a variety of risk factors, such as macroeconomic risk, industry risk and high inflation. The DDM is obsolete for the vast majority of individual equities. Utilizing the DDM for blue chip firms that have paid consistent dividends for many years may assist in determining the intrinsic value of a security.

The capital asset pricing model (CAPM) is considered more modern than the DDM and factors in market risk.  The value of a security in the CAPM is determined by the risk free rate (most likely a government bond) plus the volatility of a security multiplied by the market risk premium. This model stresses that investors who choose to purchase assets with higher volatility should be compensated with higher returns than investors who purchase less risky assets. This model is consistent with statistics that prove more volatile equities, such as small cap stocks have outperformed less volatile equities, such as large cap stock over many years. Please keep in mind that time horizon, liquidity needs and risk tolerance should be factored in when determining how to invest your assets.

Although the CAPM and DDM may potentially provide an estimate of a security’s price, research proves time and time again that valuing equities based upon future assumptions is not realistic.  A disciplined approach to investing based on asset allocation should prove more beneficial for your portfolio in the long run.

Please contact Mitlin Financial Inc. if you are concerned about your current portfolio allocation.

Disclaimer: This article represents the opinion of Mitlin Financial Inc. It should not be construed as providing investment, legal and/or tax advice.