Cost of equity can be worked out with the help of Gordon’s Dividend Discount Model. The model focuses on the dividends as the name suggests. According to the model, the cost of equity is a function of current market price and the future expected dividends of the company. The rate at which these two things are equal is the cost of equity.
It is the simple phenomenon of ‘what is the cost of buying equity’ and ‘what will I get from it’. Here, ‘what is the cost of buying equity’ represents the current market price of that equity share and ‘what will I get from it’ is represented by the expected future dividends of the company. By comparing the two, we can get the actual rate of return which an investor will get as per the current situations. That rate of return is the cost of equity. The underlying assumption here is that the current market price is adjusted as per the required rate of return by the investor in that share.
Following equation can be used to find out the cost of equity represented by:
Cost of Equity – Dividend Discount Model
P0 = the current market price
D = the dividend year wise
Ke = the cost of equity
There is no direct method to solve this equation; we need to use trial and error method as explained in the article “Internal Rate of Return”. In the current world, there is a most convenient way of doing it i.e. Microsoft excel. With the help of the formula of “IRR”, we can solve the following equation. In that, we should consider the current market as the initial cash outflow and all the dividends as the future cash flows.
Table of Contents
Estimating Future Dividends
This may be a difficulty if the dividend does not follow a particular trend. If the dividends are constantly growing at a particular rate say ‘g’, the calculations get simplified to following small equation/formula.
Formula for Dividend Discount Model
- Cost of Equity – Dividend Discount Model
Suppose a firm’s share is traded at 120$ and the current dividend is $4 and a growth rate of 6%. We have the following:
D1 = 4 * (1+6%) = $4.24
P0 = $120
g = 6%
Therefore, Ke = 4.24 / 120 + 6%
Ke = 9.53%
Phased Growth Situation
Many companies may have higher or lower growth for initial some years. For example, a company may grow at 4% for 2 years, 6% for the next 4 years and at 5% for further years. Under this type of situations, first, two phases have to be dealt with the basic model and then last with the constant growth formula.
Advantages and Disadvantages of Dividend Discount Model
The advantage is in the form of its simplicity and logical correctness. In this model, our basis of analysis is based on the very basic general and rational rule of giving and take the comparison.
Disadvantages are mainly due to the impractical assumptions. One such is assuming correct market situations which are very fluctuating and is influenced by big traders. Another one is that it is not applicable to those shares which are not listed because their current market price cannot be found.