Cost of Equity calculated under "Dividend Growth Model" and "CAPM "

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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 −

$$\mathrm{𝐏𝐫𝐢𝐜𝐞 =\frac{𝐂𝐮𝐫𝐫𝐞𝐧𝐭\:𝐀𝐧𝐧𝐮𝐚𝐥 \:𝐃𝐢𝐯𝐢𝐝𝐞𝐧𝐝}{𝐃𝐞𝐬𝐢𝐫𝐞𝐝\: 𝐑𝐚𝐭𝐞 \:𝐨𝐟 \:𝐑𝐞𝐭𝐮𝐫𝐧 − 𝐄𝐱𝐩𝐞𝐜𝐭𝐞𝐝 \:𝐑𝐚𝐭𝐞 \:𝐨𝐟 \:𝐃𝐢𝐯𝐢𝐝𝐞𝐧𝐝 \:𝐆𝐫𝐨𝐰𝐭𝐡}}$$

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.

Updated on 28-Oct-2021 12:16:32