Dividend growth model

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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


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