Ratio stocks with high dividend yields to be

Chapter 13 - Equity Valuation
13-16
ii. The following limitations of the DDM are not addressed by the FCFE model.
Both two-stage valuation models allow for two distinct phases of growth, an
initial finite period where the growth rate is abnormal, followed by a stable
growth period that is expected to last indefinitely.. These two-stage models
share the same limitations with respect to the growth assumptions. First, there
is the difficulty of defining the duration of the extraordinary growth period. For
example, a longer period of high growth will lead to a higher valuation, and
there is the temptation to assume an unrealistically long period of extraordinary
growth. Second, the assumption of a sudden shift form high growth to lower,
stable growth is unrealistic. The transformation is more likely to occur
gradually, over a period of time. Given that the assumed total horizon does not
shift (i.e., is infinite), the timing of the shift form high to stable growth is a
critical determinant of the valuation estimate. Third, because the value is quite
sensitive to the steady-state growth assumption, over- or under-estimating this
rate can lead to large errors in value. The two models share other limitations as
well, notably difficulties inaccurately forecasting required rates of return, in
dealing with the distortions that result from substantial and/or volatile debt
ratios, and in accurately valuing assets that do not generate any cash flows.
25.