Dividend Growth Model (Cost of Equity)

Question 1

What is the DVM

Answer 1

DVM is merely a way calculating the cost equity finance to a company and the return investors expect to receive on their shares.

E.g. Able to determine the return investors expect by looking at how much they’re prepared to pay for a share:

Share price = Dividends paid in perpetuity discounted at shareholders rate of return

Question 2

DVM Assumptions

Answer 2

Future income stream are dividends
Dividends are paid in perpetuity
Dividends are fixed or will grow
always ex-div = after first dividend paid = P0

Question 3

DVM with no growth

Answer 3

P0 = D/re
re = shareholders required return
P0 = shareprice now (ex-div)
D = Dividend in perpetuity

For listed companies
re = D/P0

Question 4

DVM with growth

Answer 4

Re=D1/P0+g

Question 5

Cum-div and Ex-div

Answer 5

Cum-div = before dividend paid, ex-div = after dividend paid

Question 6

Limitations of using DVM for Ke

Answer 6

Current market price P0 - hard to say when it’s accurate e.g. subject to short-term influences such as takeover bids
Future dividends - using past dividends to estimate future dividends is mechanical and also subject to other influences e.g. economic conditions, market trends
Earnings - DVM doesn’t feature earnings, however they are an indicator of a company’s long-term ability to pay dividends and therefore in estimating growth in future dividends. e.g. Dividends grow at 10% but profit only 5%, the company will run out of funds