Dividend growth model: Difference between revisions
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Revision as of 09:48, 31 December 2017
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
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.
