# 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 = (D_{1} / P_{0}) + g

*or (rearranging the formula)*

P_{0} = D_{1} / (Ke - g)

*Where:*

P_{0} = ex-dividend equity value today.

D_{1} = 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:*

D_{1} = 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%.

P_{0} = D_{1} / (Ke - g)

= 10 / (0.10 - 0.02)

= 10 / 0.08

= $**125**m.

**Example 2: Cost of equity**

Or alternatively calculating the current market __cost of equity__ using the rearranged formula:

Ke = (D_{1} / P_{0}) + g

Where:

D_{1} = expected future dividend at Time 1 = $10m.

P_{0} = 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

## Student article

*Real rates of corporate decline often lead to miscalculation, overpaying for acquisitions and disastrous losses.*

*This article shows how to avoid the most common errors and add value for your organisation.*