ADVANTAGES OF THE CAPM The CAPM has several advantages over other methods of calculating required return, explaining

why it has remained popular for more than 40 years: It considers only systematic risk, reflecting a reality in which most investors have diversified portfolios from which unsystematic risk has been essentially eliminated. It generates a theoretically-derived relationship between required return and systematic risk which has been subject to frequent empirical research and testing. It is generally seen as a much better method of calculating the cost of equity than the dividend growth model (DGM) in that it explicitly takes into account a companys level of systematic risk relative to the stock market as a whole. It is clearly superior to the WACC in providing discount rates for use in investment appraisal. DISADVANTAGES OF THE CAPM The CAPM suffers from a number of disadvantages and limitations that should be noted in a balanced discussion of this important theoretical model.

Dividend Discount model

Model

Advantages

and

Disadvantages

The main advantage of the dividend discount model is that it is relatively easy to use. There are only a few calculations involved. This model is a good starting point for valuing stocks, since it connects dividend payments and dividend growth to the stock price.

The dividend discount model works best for companies that are experiencing stable growth. There is a version of the model that can be used for companies transitioning from rapid growth to more moderate growth, but the calculations are much more complicated.

There are also some drawbacks to using the dividend discount model. A major shortcoming of the model is that it works best for a stock that already pays dividends. But almost two-thirds of publicly traded companies don't pay a dividend. Instead, these companies retain all of their earnings so they can grow. You can use the DDM for non-dividend paying companies, but you need to make some pretty tenuous assumptions about when they will start paying a dividend and how much they'll pay.

Another flaw of the dividend discount model (and any model, for that matter) is that it requires numerous assumptions to be made. Investors must guess a company's growth rate as well as the required rate of return. The model is only as good as its inputs. Even a slight miscalculation in any of these inputs can result in dramatically overvaluing or undervaluing a stock. An odd weakness of the model is that it cannot value a company if that company is growing its dividend faster than the required rate of return. If the dividend is growing faster, the denominator in the dividend discount model becomes a negative value. For example, suppose Stock A pays a $3 dividend, has a 15% growth rate and has a required rate of return of only 10%. According to the dividend discount formula, the value of Stock A = ($3 x 1.15) /(0.10-0.15) = -$69. That's not terribly useful.

Despite these flaws, the dividend discount model remains a worthwhile analytical tool. It's simple to use and the model's basic premise -- that the value of a stock is equal to the sum of current and future dividend payments -- is sound. The dividend discount model is a good starting point for valuing a stock since the model encourages investors to think about the relationship between risk, returns and growth.

Earnings Capitalisation Model

Value is equivalent to the capital (invested at a reasonable rate of return) required to generate an income equal to an average of the firms recent, historical results. Strengths A simplified approach that arrives at an easily determined value. Does not rely on projections, but on an average of results from the recent past. Most useful for businesses with stable, predictable cash flows and earnings. Weaknesses May understate value for firms using aggressive strategies to reduce taxable income. May overlook value of tangible or intangible assets. Reliance on past earnings may ignore potential future growth.