(168)---CAPM VS DIVIDEND GROWTH MODEL

Capital Asset Pricing Model VS Dividend Growth Model

The dividend growth model approach limited application in practice because of its two assumptions.

1. It assumes that the dividend per share will grow at a constant rate, g, forever
2. The expected dividend growth rate, g, should be less than the cost of equity, Ke, to arrive at the simple growth formula.

The growth formula is,

Ke = (DIV1 / Po) + g

These assumptions imply that the dividend growth approach cannot be applied to those companies, which are not paying any dividends, or whose dividend per share is growing at a rate higher than Ke, or whose dividend policies are highly volatile. The dividend growth model approach also fails to deal with risk directly. In contrast, the CAPM has a wider application although it is based on restrictive assumptions. The only condition for its use is that the company’s share is quoted on the stock exchange. Also, all variables in the CAPM are market determined and expect the company specific share price data; they are common to all companies. The value of beta is determined in an objective manner by using sound statistical method. One practical problem with the use of beta, however, is that it does not probably remain stable over time.