Cost of Equity (Constant Dividend Growth)
Gordon’s dividend growth model proposes that current market prices are a reflection of the present value of future dividends of a company discounted with an appropriate cost of equity. The model has established a relationship between three variables i.e. Current Market Price, Dividends, and Cost of Equity. Further, there are 3 possible situations for future dividends:
- Future dividends uncertain or not following any trend
- Future dividends having a Constant Growth Rate
- Dividends having Phased Growth Situation in future. 5% for 3 Years, then 3% forever.
In the current post, the calculator will focus 2nd situation i.e. the constant growth rate.
The formula for calculating a cost of equity using the dividend discount model is as follows:
Ke = D1/P0 + g
Ke = Cost of Equity
D1 = Dividend for the Next Year, It can also be represented as ‘D0*(1+g)‘ where D0 is Current Year Dividend.
P0 = present value of a stock.
Most common representation of a dividend discount model is P0 = D1/(Ke-g). This formula is meant for calculating the present value of the stock when the cost of equity is known. The formula mentioned above for calculating the cost of equity (Ke) when the other parameters are known.
Assume a firm’s share is traded at 300$ and the current dividend is $8 and a growth rate of 6%. We have the following:
D1 = 8 * (1+6%) = $8.48,
P0 = $300,
g = 6%
Therefore, Ke = 8.48 / 300 + 6% = 8.83%
How to Calculate using Calculator?
Cost of Equity (Constant Dividend Growth) calculator is easy to calculate the accurate cost of equity. There are 3 basic inputs required for calculating and they are as follows:
- Current Year Dividend
- Constant Growth Rate
- Current Market Price
Cost of Equity Calculator
Interpret Results / Analysis
The cost of equity calculated using this method has its pros and cons. The calculator calculates the cost of equity with certain assumptions which are not necessarily true all the times. Therefore, this ratio can be used as a reference point. It is advisable to use other tools also along with this.