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 per period = $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

• Cost of equity
• Corporate finance
• Ex-dividend
• Perpetuity

Other resources

The real deal, The Treasurer student article