Cost of Equity Calculation using Dividend Growth/Discount Model.
Cost of equity is the minimum rate of return which a company must generate to provide to its investors. It is the rate of return, a company pays back to its shareholders for their investment on the company through shares. It is also known as Common Stock or the required rate of return.
Given below is the dividend growth model for calculating the Cost of Equity. This method is also known as the dividend discount model, dividend valuation model, gordon growth model. Dividend discount model is useful only when the stock is dividend-paying. In situations where stocks that do not pay dividends, the CAPM (capital asset pricing model) is useful. Use this simple step by step tutorial to learn how to calculate cost of equity using dividend growth model.
Dividend Growth Model Formula:
Cost of Equity = (Next Years Annual Dividend / Current Stock Price) + Dividend Growth Rate
Step 1: Consider below Example:
Let us assume a Companys Dividends and Stock Price as follows:.
Next years dividend = Rupee 1
Current stock price = Rupees 10
Dividend growth rate = 3%
Step 2: Substituting Values in the Dividend Growth Method Formula
Cost of Equity = (1/10) + 3 %
= (1/10) + (3/100)
= 13 / 100
Converting it into rate, we have
= (13/100) x 100
= 13 %
Hence the Cost of Equity, which the company should provide to its investors is 13 % based on the dividend growth method, for the given values of dividend growth rate and stock price.