The Prediction Accuracy of Gordon’s Dividend Discount Model in the Valuation of Banking Sector Stocks Listed in Nairobi Securities Exchange

Abstract

This study tests the prediction accuracy of Gordon’s Dividend Model in the valuation of common stock with emphasis on listed banking sector stocks of Nairobi Securities Exchange. Market participants need valuation models in order to limit the risk of poor choice of investment alternatives to achieve efficient allocation of resources and make optimal investment decisions. The DDM model is a form of discounted cash flow model used to find the intrinsic value of common stock for firms. It adopts dividends as cash flows. The objective of the study was to establish the accuracy of Dividend Discount Model by comparing market values and intrinsic values of listed banks at NSE. The study entailed calculating monthly stock market values and comparing with the monthly market prices for the period Jan 2002 to June 2015. To estimate the market value, market price forecasts for all study periods were conducted 3 periods into the future using dividend growth rate as well as finding the market price terminal value at the end of period 3 for all the periods. This was then capitalized using a discount rate which was estimated using CAPM. The Net Present value (NPV) of dividends for year 1 through to year 3 and the NPV of the terminal value of the market price at the end of period 3 was summed up to find the total NPV. The total NPV is the equivalent of market value for each period. To test for the significance of the differences between the estimated intrinsic values and actual market prices of the common stocks. A two tailed t-test was conducted since the test required the comparison of two means from independent samples. This was done at 95% confidence interval. The results from the study showed that DDM model is a poor predictor of market prices at the NSE. Other studies that incorporate flexible multi-factor models in estimating the cost of equity should be conducted to better reflect prevailing market conditions