Definition
The Dividend Growth Model (DGM), also known as the Gordon Growth Model (GGM), is a method for calculating the cost of equity or the intrinsic value of a company’s stock. It is based on the principle that the value of a stock is worth the sum of all its future dividend payments, discounted back to their present value. The model assumes that dividends will grow at a constant rate indefinitely.
Formula
The basic formula for the Dividend Growth Model is expressed as follows: \[ P_0 = \frac{D_1}{r - g} \] where:
- \( P_0 \) = Current stock price
- \( D_1 \) = Dividends expected in the next period
- \( r \) = Cost of equity or the required rate of return
- \( g \) = Growth rate of dividends
Calculation
To estimate the cost of equity, the formula is rearranged as follows: \[ r = \frac{D_1}{P_0} + g \] This expresses the cost of equity as the dividend yield plus the growth rate of dividends.
Examples
Company A:
- Next period’s dividend (\(D_1\)): $2 per share
- Current stock price (\(P_0\)): $40
- Growth rate of dividends (\(g\)): 5% (0.05)
Calculating cost of equity (\(r\)): \[ r = \frac{2}{40} + 0.05 = 0.05 + 0.05 = 0.10 \text{ or } 10% \]
Company B:
- Next period’s dividend (\(D_1\)): $3.50 per share
- Current stock price (\(P_0\)): $50
- Growth rate of dividends (\(g\)): 7% (0.07)
Calculating cost of equity (\(r\)): \[ r = \frac{3.50}{50} + 0.07 = 0.07 + 0.07 = 0.14 \text{ or } 14% \]
Frequently Asked Questions (FAQs)
Q: What assumptions does the Dividend Growth Model make?
A: The Dividend Growth Model assumes that dividends will grow at a constant rate indefinitely and that the growth rate is less than the cost of equity (required rate of return).
Q: Can the DGM be used for companies that do not pay dividends?
A: No, the DGM is not suitable for companies that do not pay dividends. Alternative methods such as the Capital Asset Pricing Model (CAPM) may be used instead.
Q: What are some limitations of the Dividend Growth Model?
A: Limitations include the requirement for constant dividend growth, which may not be realistic for all companies, and the model’s sensitivity to the estimated growth rate and required rate of return.
Q: How does the growth rate affect the valuation in the DGM?
A: A higher estimated growth rate increases the stock’s valuation, while a lower growth rate decreases it. Therefore, accurately estimating the growth rate is crucial.
Q: Can the DGM be applied to all stocks?
A: No, the DGM is best used for mature companies with a history of steady dividend payments. It is less reliable for young, rapidly growing companies or companies that do not pay regular dividends.
Related Terms
- Cost of Capital: The return rate that a company needs to achieve to cover the cost of generating funds from debt and equity.
- Dividends: Earnings distributed to shareholders, usually in the form of cash or additional shares.
- Gordon Growth Model (GGM): Another name for the Dividend Growth Model, named after Myron J. Gordon who popularized it.
- Capital Asset Pricing Model (CAPM): A model used to determine the expected return on an asset, which accounts for its risk relative to the market.
Online Resources
Suggested Books for Further Studies
- “Principles of Corporate Finance” by Richard A. Brealey, Stewart C. Myers, and Franklin Allen
- “Valuation: Measuring and Managing the Value of Companies” by McKinsey & Company Inc., Tim Koller, Marc Goedhart, and David Wessels
- “Investment Valuation: Tools and Techniques for Determining the Value of Any Asset” by Aswath Damodaran
Accounting Basics: “Dividend Growth Model” Fundamentals Quiz
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