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What is Dividend Discount Model used in cost of equity?


Cost of Equity: It is a rate of return which a share holder earns for holding that companies share. It includes dividend and capital gain.

Dividend Discount Model: It is also called Dividend Growth Model or Gordon’s Growth Model. It is used to calculate the stock value by adding the present value of all future dividends with assumption of constant growth rate in dividend.

Advantages of dividend discount model:
·         It helps to analyse the value of equity.
·         It helps to determine the current price of equity with growth.
·         It helps to build the image of a company.
·          
Disadvantages of dividend discount model:
·         It is not applicable on that companies which do not pay dividend.
·         It depends on assumption like growth rate.

Formula:

P0= D0 (1+g)/ (ke-g)
OR 
P0 = D1 / r-g
Ke= (D1 / P0) +g
Where,
P0 = Current price of equity
D0 = Dividend on equity
G = growth rate
Ke = required rate of return for equity investors
D1 = Expected future dividend

Example: Suppose dividend of stock XYZ is Rs.10 per share and dividend are expected to grow at 4% per year. The current value of stock is Rs.110. Find out cost of equity.

Solution:
Ke= (D1 / P0) +g
= (10/ 110) + 0.04
=13%

Example: A company declare dividend of Rs.5 per share and expected growth rate of 2% per year. The investors required rate of return is 12% and market share value is Rs.100. Find out the current market price of a share.

Solution:
P0 = D1 / r-g
= 5/0.12-0.02
= 50

Current price is Rs. 50 and market price is Rs.100 it shows that company Z share is overvalued and hence there is opportunity to sell shares in market.

Example: Company X estimated the growth rate of 8% for next two years and in third year the growth rate decreases to 5% and after there is constant growth rate of 6% and the required rate of return is 10.5%.The last dividend declare by company is Rs.5.6 per share. Find out the current price in fourth year and how investors determine the right time to invest in company X stocks?

Solution:
*D1= D0 (1+g)
*D2 = D1 (1+g)
*D3 = D2 (1+g)
*D4 = D3 (1+g)
P4 = D4 / r-g


 Present Values of 4 years dividend:

Formula for dividend
Dividend
Discounted value
Present Value
1.
5.6 (1+0.08)
6.05*
1.105
5.48
2.
6.05 (1+0.08)
6.53*
1.22
5.35
3.
6.85 (1+0.06)
6.85*
1.35
5.23
4.
7.26 / 0.105-0.06
161.33*
1.49
108.28
 Total
124.34

If market price is less than the Rs.124.34 then it is a right time to purchase those stocks.

Example: Company Y has issued 20, 000 ordinary shares and 20 debentures of Rs. 100 each @ 8% to raise capital for running the business. The products of a company are very good but due to its high price it faces a lot of competition in the market. So, to reduce the manufacturing cost and make that product competitive Company has decided to purchase new machine of Rs. 8, 00, 000. For that company wants to issue fresh 10,000 equity of Rs. 100 each. The required rate of return is 9% and shares issued at par. Find out the dividend value if the market value is Rs. 106.

Solution:
P0 = 106
R = 0.09
G = 0
P0 = D1 / r-g
= P0 * (r-g)
= 106 * (0.09 – 0)
= 9.54

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