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Cost of Equity calculated under "Dividend Growth Model" and "CAPM "
The Dividend Growth Model
The dividend growth model is an approach that assumes that dividends grow at a constant rate in perpetuity. The value of one stock equals next year's dividends divided by the difference between the total required rate of return and the assumed constant growth rate in dividends.
In other words, the dividend growth model is actually a mathematical formula that investors often use to determine a good fair value for a company's stock depending on its current dividend and its expected future dividend growth.
The basic formula for the dividend growth model is as follows −
$$\mathrm{๐๐ซ๐ข๐๐ =\frac{๐๐ฎ๐ซ๐ซ๐๐ง๐ญ\:๐๐ง๐ง๐ฎ๐๐ฅ \:๐๐ข๐ฏ๐ข๐๐๐ง๐}{๐๐๐ฌ๐ข๐ซ๐๐\: ๐๐๐ญ๐ \:๐จ๐ \:๐๐๐ญ๐ฎ๐ซ๐ง − ๐๐ฑ๐ฉ๐๐๐ญ๐๐ \:๐๐๐ญ๐ \:๐จ๐ \:๐๐ข๐ฏ๐ข๐๐๐ง๐ \:๐๐ซ๐จ๐ฐ๐ญ๐ก}}$$
The dividend growth model has limited application due to its basic two assumptions −
It assumes that the dividend growth rate will be constant.
The expected growth rate should be less than the cost of equity.
Both of these assumptions work well in theory, but in practice, assuming the dividend growth rate at a constant rate is often impossible. The assumptions also imply that the dividend growth model cannot be applied to companies that do not pay any dividends.
The Use of CAPM
The Capital Asset Pricing Model (CAPM) has numerous restrictions in comparison to the dividend growth model, but it is a better alternative in calculating the cost of equity.
The only requirement in using the CAPM model is that the stock we are dealing with must be quoted in the stock exchange.
CAPM variables are all market-determined, except the share price data of companies.
In CAPM, the beta is calculated in a sound statistical manner which helps the results be correct and closest to that we obtain in reality.
The beta is a determinant of the cost of equity, but it is highly unstable and hence calculations using beta often keep fluctuating over time.
Why CAPM is Better
We have already mentioned two assumptions of the dividend growth model that restrict it in becoming the preferred choice of financial analysts and accountants. The CAPM, on the other hand, has many its own set of restrictions, but in practice, it is a better way to deal with the cost of equity in general.
CAPM uses market-specific data, and hence, in a well-functioning market, the data obtained is trustable and of fair value. Therefore, the value of equity obtained via the CAPM model is more accurate.
As all the data is market-specific, it is easy to obtain and calculate at the same time.
These are the reasons why CAPM is a better alternative than the dividend discount model.
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