Cost of Equity – Dividend Discount Model

Cost of equity can be worked out with the help of Gordon’s Dividend Discount Model. The model focuses on dividends, as the name suggests. According to the model, the cost of equity is a function of the 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 that an investor will get as per the current situation. 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.

The following equation can be used to find out the cost of equity represented by:

Cost of Equity – Dividend Discount Model

Cost of Equity – Dividend Discount Model

P0 = the current market price

Cost of Equity Dividend - Discount Model

D = the dividend year wise

Ke = the cost of equity

There is no direct method to solve this equation; we need to use the 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.

Estimating Future Dividends

This may not be easy 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 the following small equation/formula.

Formula for Dividend Discount Model

Cost of Equity – 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%

You can also use the Cost of Equity (Constant Dividend Growth) Calculator to calculate quickly.

Phased Growth Situation

Many companies may have higher or lower growth for some initial 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 situation, first, two phases have to be dealt with the basic model and then last with the constant growth formula.

Advantages and Disadvantages of the Dividend Discount Model

The advantage is in the form of its simplicity and logical correctness. In this model, our basis of the analysis is based on the fundamental general and rational rule of giving and taking the comparison.

Disadvantages are mainly due to the impractical assumptions. One such is assuming correct market situations, which are very fluctuating and are influenced by big traders. Another one is that it does not apply to those not listed shares because their current market price cannot be found.

Refer to Models for Calculating Cost of Equity to learn about other models.

Sanjay Borad

Sanjay Bulaki Borad

MBA-Finance, CMA, CS, Insolvency Professional, B'Com

Sanjay Borad, Founder of eFinanceManagement, is a Management Consultant with 7 years of MNC experience and 11 years in Consultancy. He caters to clients with turnovers from 200 Million to 12,000 Million, including listed entities, and has vast industry experience in over 20 sectors. Additionally, he serves as a visiting faculty for Finance and Costing in MBA Colleges and CA, CMA Coaching Classes.

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