Dividend growth model
(DGM). 1. 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 dividend at Time 1 period hence. 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.
2. For example calculating the market value of equity: D1 = expected dividend at Time 1 period hence = $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] = $10m/[0.10 - 0.02 = 0.08] = $125m.
3. Or alternatively calculating the current market cost of equity using the rearranged formula: Ke = D1/P0 + g
D1 = expected dividend at Time 1 period hence = $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 = $10m/$125m + 2% = 10%.
Also known as the Dividend discount model, the Dividend valuation model or the Gordon growth model.
