The dividend discount model:It's reliability on the valuation of common stock at the Nairobi stock exchange

Abstract

Valuation of common stock is very important yet a very complex process. The stock requires a deeper analysis compared to preferred stock or debts. The major techniques of valuation of common stock are: (i) Relative valuation models which is based on the earnings power of the firm, the book value and sales. (ii) The discounted cash flow techniques, where the value of stock is estimated based upon the present value of some measure of cash flow including dividends, operating cash flow among others. The study was conducted to establish the reliability of the dividend discount model (which is based on the discounted cash flow techniques) on the valuation of common stock at the Nairobi Stock Exchange. Data was collected in form of share prices, market indices and dividend per share from the Nairobi Stock Exchange secretariat, and were used to predict share prices for each of the eighteen companies studied. Market model was used as a model of equilibrium to provide a link between the expected values which are non observable and real values that were used in testing the model. Predicted share prices were compared with the actual prices by computing the differences between them. The differences were then subjected to t-test. The test of significance showed that out of the eighteen companies studied; only three showed that the differences were significant. I therefore concluded that the dividend discount model is not reliable in the valuation of common stock at the Nairobi Stock Exchange.