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
Thank you for embarking on this journey through our comprehensive accounting lexicon and tackling our challenging sample exam quiz questions. Keep striving for excellence in your financial knowledge!
