What are the pros and cons of using the dividend growth model approach to calculate the cost of
equity?
The dividend growth model (DGM), also known as the Gordon growth model, is a method used to estimate the cost of equity. It assumes that the value of a stock is based on the present value of its future dividends. Here are the pros and cons of using the dividend growth model approach:
Pros:
1. Simplicity: The DGM is relatively straightforward and easy to understand. It requires only a few inputs, such as the current dividend, expected dividend growth rate, and discount rate.
2. Long-term focus: The DGM is especially useful for valuing stocks of stable and mature companies that have a consistent dividend payout policy. It assumes that dividends will grow at a constant rate indefinitely, which aligns with the long-term perspective.
3. Sensitivity analysis: By adjusting the expected dividend growth rate or discount rate, you can perform sensitivity analysis to assess the impact on the estimated cost of equity.
Cons:
1. Assumptions and limitations: The DGM relies heavily on assumptions, such as a constant dividend growth rate, which may not always hold true in reality. It assumes that dividends will grow at a steady rate indefinitely, which might not be realistic for all companies.
2. Limited applicability: The DGM is most suitable for companies with a stable dividend payout history. It may not be suitable for companies that do not pay dividends or have volatile dividend patterns.
3. Sensitivity to inputs: The estimated cost of equity is sensitive to both the expected dividend growth rate and discount rate used in the model. Small changes in these inputs can significantly impact the calculated cost of equity.
To calculate the cost of equity using the DGM, you need the following inputs:
1. Current dividend per share
2. Expected dividend growth rate
3. Required rate of return or discount rate
The formula for the DGM is:
Cost of Equity = Dividend / Stock Price + Dividend Growth Rate
You can estimate the dividend growth rate by considering historical dividend growth rates, industry trends, and the company's growth prospects. The discount rate can be determined using various methods, such as the Capital Asset Pricing Model (CAPM).