INTRODUCTION TO DIVIDEND GROWTH MODEL

Introduction:-
The Gordon Growth Model – otherwise described as the dividend
discount model – is a stock valuation model that calculates a stock’s
intrinsic value. Therefore, this method disregards current market
conditions. Investors can then compare companies against other
industries using this simplified model.
The Gordon Growth Model assumes the following conditions:-
Cont…
The company’s business model is stable; i.e. there are no significant changes in its
operations
The company grows at a constant, unchanging rate
The company has stable financial leverage
The company’s free cash flow is paid as dividends
Valuation of Equity in Zero Growth
In this case, the ordinary share promises a constant dividend with no growth.
Cont…
Formula
P0 = D 0
r
Where,
P0 = Market Price/Share
D0 = Current Dividend
r = required rate of return
1. The dividend of a company is expected to remain constant at Kshs.3 per share if the required rate
of return is 15%. Calculate the value of the share.
Cont…

P0 = D0
r
= 3
0.15
= 20 per share
Cont…
b) With a growth rate (evaluation of equity) dividend will not remain constant.
Earnings and dividends of Share Company grow overtime at least in line with
company retention policy.
Value of share P0 = D 1 (1+ g )
Where, P0 = Market price/ share
D 1 = Current dividend
G = Growth rate
Note: D0(1 + g) and D1 are the same thing. They both represent the forecasted
dividend next year. The only difference is that sometimes you will be given the
current dividend and sometime you will be given the forecasted dividend next year.
Cont…
Ex. Suppose a company paid a dividend of 0.2 per share and the share price is
currently sh. 5. The expected dividend supposed to grow by 8% using the dividend
growth model. Calculate the expected dividend and cost of equity-capital.
Expected Dividend = D0 ( 1+ g)
Cost of equity = D0 ( 1+ g) + g
P0
Cont…
Solution,
= 0.2(1 + 0.08)
= 0.216
= 0.2(1 + 0.08) + 0.08
5
= 0.1232
r = 12.32%
Cont…
 VALUATION OF PREFERENCE SHARE
Preference shares have some debt features. Dividend payable usually fixed the same
way as interest on debentures. The price of preference shares can be calculated as;
P0 = D0
r
Where = P0 - Market share of price
= D0 – Current dividend
= r – Required Rate of Return
Cont…
Ex. Suppose a company paid a dividend of 1sh on current market price and the cost
of capital is 10%. Find the market price of share.

P0 = D0
r
Cont…

= 1/ 0.1
= 10 per share

Ex. Consider that a company has 1000 irredeemable preference shares on which it
pays a dividend of 9sh. Assume that this type of preference share is currently
yielding dividend of 11%. What is the value of the preference share?
Cont…

= 9/0.11
= 81.82 per share

Calculation of cost of Equity Using CAPM:

CAPM allows investors to determine rate of return on a share based on the risk
associated with that share. The expected return on risk security investment depends
on three things;
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• Risk free investment
• Beta Co-efficient
• Market Risk premium
Thus cost of equity = Ke = rf + β (rm – rf)
rf = risk free rate
rm = market return
β = Beta factor
Ke = Cost of equity
Cont…

Ex. Suppose a company has a beta factor of 1.4 and market return of 12% and risk
free rate of 8%. Calculate the required rate of return of cost of capital.
Cont…

Ke = 0.08 + 1.4(0.12 – 0.08)

= 0.08 +0.056
= 0.136
= 13.6%
Cont…
Assumptions of Gordon’s Model
1. The firm is an all-equity firm; only the retained earnings are used to finance the
investments, no external source of financing is used.
2. The rate of return (r) and cost of capital (K) are constant.
3. The life of a firm is indefinite.
4. Retention ratio once decided remains constant.
5. Growth rate is constant
6. Cost of Capital is greater than growth rate
Cont…
Criticism of Gordon’s Model
1) It is assumed that firm’s investment opportunities are financed only through the
retained earnings and no external financing viz. Debt or equity is raised. Thus,
the investment policy or the dividend policy or both can be sub-optimal.
2) The Gordon’s Model is only applicable to all equity firms. It is assumed that the
rate of returns is constant, but, however, it decreases with more and more
investments.
3) It is assumed that the cost of capital (k) remains constant but, however, it is not
realistic in the real life situations, as it ignores the business risk, which has a
direct impact on the firm’s value.
4) Thus, Gordon model posits that the dividend plays an important role in
determining the share price of the firm.