Dividend growth model

(DGM).

The Dividend growth model links the value of a firm’s equity and its market cost of equity, by modelling the expected future dividends receivable by the shareholders as a constantly growing perpetuity.

Its most common uses are:

(1) Estimating the market cost of equity from the current share price; and

(2) Estimating the fair value of equity from a given or assumed cost of equity.

Expressed as a formula:

Ke = D₁ / P₀ + g

OR (rearranging the formula)

P₀ = D₁ / ( Ke - g )

Where:

P₀ = ex-dividend equity value today.

D₁ = expected future dividend at Time 1 period later.

Ke = cost of equity per period.

g = constant periodic rate of growth in dividend from Time 1 to infinity.

This is an application of the general formula for calculating the present value of a growing perpetuity.

Example 1

Calculating the market value of equity.

Where:

D₁ = expected dividend at future Time 1 = $10m.

Ke = cost of equity per period = 10%.

g = constant periodic rate of growth in dividend from Time 1 to infinity = 2%.

P₀ = D₁ / ( Ke - g )

= 10 / ( 0.10 - 0.02 )

= 10 / 0.08

= $125m.

Example 2

Or alternatively calculating the current market cost of equity using the rearranged formula:

Ke = D₁ / P₀ + g

Where:

D₁ = expected future dividend at Time 1 = $10m.

P₀ = current market value of equity per period = $125m.

g = constant periodic rate of growth in dividend from Time 1 to infinity = 2%.

Ke = 10 / 125 + 2%

= 10%.

Also known as the Dividend discount model, the Dividend valuation model or the Gordon growth model.

See also

• CertFMM
• Cost of equity
• Corporate finance
• Perpetuity

Other resources

The real deal, The Treasurer student article