Wednesday, March 31, 2010


The Dividend Growth Model: Normal Growth

The dividend valuation model for a firm whose dividends are expected to grow at a consistent rate of growth (g) is as follows:

Po = DIV 1 / (Ke-g)

Where DIV1 = DIVo (1+g)
Equation can be solved for calculating the cost of equity Ke as follows:

Ke = (DIV 1 / Po) + g

The cost of equity is, thus, equal to the expected dividend yield (DIV1 /Po) plus capital gains as reflected by expected growth in dividends (g). It may be noted that equation is based on following assumptions.
  • The market price of the ordinary share, Po, is a function of expected dividends.
  • The dividend, DIV 1, is positive
  • The dividends grow at a consistent growth rate g, and the growth rate is equal to the return on equity, ROE, times the retention ration, b (g = ROE x b)
  • The dividend payout ration is consistent.

The cost of retained earnings determined by the dividend valuation model implies that if the firm would have distributed earnings to shareholders, they could have invested it in the shares of the firm or in the shares of other firms of similar risk at the market price (Po) to earn a rate of return equal to Ke. Thus, the firm should earn a return on retained funds equal to Ke to ensure growth of dividends and share price. If a return less than Ke is earned on returned earnings, the market price of the firm’s share will fall. It may be emphasized again that the cost of returned earnings will be equal to the shareholders’ required rate of return since no flotation costs are involved.

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