Dividend growth model
Equity valuation and cost of capital
(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.
Applications of the DGM
Common applications of the dividend growth model include:
(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.
DGM formulae
The DGM is commonly expressed as a formula in two different forms:
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: Market value of equity
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: Cost of equity
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, ex-dividend = $125m.
g = constant periodic rate of growth in dividend from Time 1 to infinity = 2%.
Ke = (10 / 125) + 2%
= 8% + 2%
= 10%.
The dividend growth model is also known as the Dividend discount model, the Dividend valuation model or the Gordon growth model.
See also
