Calculate Cost of Equity Using Dividend Growth Model

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Reviewed for Accuracy by: David Chen, CFA. This calculator is based on established financial theory.

Use the Dividend Growth Model (DGM), also known as the Gordon Growth Model (GGM), to estimate a company’s cost of equity by dividing the next year’s dividend by the current stock price and adding the expected long-term dividend growth rate.

Cost of Equity Using DGM Calculator

Calculated Cost of Equity ($R_e$)

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Cost of Equity Using DGM Formula:

$$R_e = \frac{D_1}{P_0} + g$$
Formula Source: Investopedia – Gordon Growth Model

Variables:

  • $R_e$ (Cost of Equity): The required rate of return for the company’s shareholders. This is the value we solve for.
  • $D_1$ (Expected Dividend Per Share Next Year): The dividend expected to be paid to shareholders over the next year.
  • $P_0$ (Current Stock Price): The current market price of the stock. This acts as the denominator.
  • $g$ (Expected Dividend Growth Rate): The annual rate at which the company’s dividend is expected to grow indefinitely.

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What is the Cost of Equity using the Dividend Growth Model?

The Dividend Growth Model (DGM), or Gordon Growth Model (GGM), is a method used to value a stock based on the present value of its expected future dividends. Crucially, it can be rearranged to *solve* for the Cost of Equity ($R_e$), which represents the minimum rate of return a company must offer to justify the risk of holding its stock.

This model assumes that dividends grow at a constant rate ($g$) perpetually. It is most suitable for stable, mature companies that have a history of paying and consistently increasing dividends. The cost of equity calculated via DGM is essential for valuation, especially in discounted cash flow (DCF) analysis where it’s used as the discount rate for dividends.

How to Calculate Cost of Equity (Example):

  1. Identify $D_1$: Determine the expected dividend for the next year. Example: $D_1 = \$3.00.
  2. Find $P_0$: Find the current market price of the stock. Example: $P_0 = \$75.00.
  3. Estimate $g$: Estimate the perpetual dividend growth rate. Example: $g = 4.0\% (0.04).
  4. Calculate Dividend Yield: Divide $D_1$ by $P_0$. Example: $\$3.00 / \$75.00 = 0.04 (4.0\%).
  5. Add Growth Rate: Add the growth rate ($g$) to the dividend yield. Example: 0.04 + 0.04 = 0.08.
  6. Final Result: The Cost of Equity ($R_e$) is $8.0\%$.

Frequently Asked Questions (FAQ):

Is the DGM suitable for all companies?
No. The DGM assumes perpetual, constant growth, which is unrealistic for startups or companies with cyclical/unstable dividend payments. It works best for mature, stable, dividend-paying businesses.

What happens if the growth rate (g) is higher than the Cost of Equity ($R_e$)?
The model mathematically breaks down, resulting in a negative or undefined current stock price. In reality, $R_e$ must be greater than $g$ for the model to produce a sensible valuation.

What is the main limitation of the Dividend Growth Model?
Its primary limitation is the difficulty in accurately estimating the future constant growth rate ($g$) and the assumption that the growth rate will remain constant indefinitely.

How is $D_1$ calculated if only the current dividend ($D_0$) is known?
$D_1$ is calculated as $D_0 \times (1 + g)$. If the user only has $D_0$, they must first calculate $D_1$ before using this calculator.

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