Cost of Equity Calculator (DGM)

Use the Dividend Growth Model (Gordon Growth Model) to calculate the required rate of return for common stock.

Expected Dividend Next Year (D₁):
$2.10

Dividend Yield (D₁ / P₀):
4.20%

Growth Component:
5.00%

What is the Cost of Equity using Dividend Growth Model?

Knowing how to calculate cost of equity using dividend growth model is a fundamental skill for corporate finance professionals and investors. The Dividend Growth Model (DGM), also known as the Gordon Growth Model (GGM), assumes that a stock’s value is derived from its future dividend payments, which are expected to grow at a constant rate forever.

The cost of equity represents the return that a company must pay its shareholders to compensate them for the risk of investing in the stock. While other models like CAPM focus on market risk (beta), the DGM focuses on the cash flow returns provided directly to the investor. It is primarily used for mature companies with stable dividend policies.

Common misconceptions include the idea that this model can be used for all stocks. In reality, it only works for companies that pay dividends and where those dividends are expected to grow at a predictable, constant rate.

How to Calculate Cost of Equity Using Dividend Growth Model: The Formula

The formula for how to calculate cost of equity using dividend growth model is mathematically elegant and straightforward:

K_e = (D₁ / P₀) + g

Where D₁ = D₀ × (1 + g).

Variable	Meaning	Unit	Typical Range
Ke	Cost of Equity	Percentage (%)	7% – 15%
D0	Most Recent Dividend	Currency ($)	$0.50 – $10.00
D1	Expected Dividend Next Year	Currency ($)	Calculated
P0	Current Stock Price	Currency ($)	Market Price
g	Dividend Growth Rate	Percentage (%)	2% – 6%

Practical Examples of Dividend Growth Model Calculations

Example 1: The Stable Utility Company

Suppose a utility company is trading at $100 per share. It just paid an annual dividend of $4.00, and analysts expect dividends to grow at a steady 3% per year. To figure out how to calculate cost of equity using dividend growth model here:

• D₁ = $4.00 * (1 + 0.03) = $4.12
• Yield = $4.12 / $100 = 4.12%
• Cost of Equity = 4.12% + 3% = 7.12%

Example 2: The High-Yield Dividend King

A consumer staple stock is priced at $60. The last dividend was $3.00, with a projected growth of 4%.

• D₁ = $3.00 * (1.04) = $3.12
• Yield = $3.12 / $60 = 5.2%
• Cost of Equity = 5.2% + 4% = 9.2%

How to Use This Cost of Equity Calculator

Using our tool to master how to calculate cost of equity using dividend growth model is simple:

1. Enter the Stock Price: Input the current trading price of the equity.
2. Provide the Last Dividend: Enter the most recent full-year dividend per share paid.
3. Input Growth Rate: Estimate the long-term annual growth rate of the dividends. This is usually based on historical data or company guidance.
4. Review Results: The calculator instantly provides the total Cost of Equity, broken down into dividend yield and growth components.

Key Factors That Affect Cost of Equity Results

• Interest Rates: When risk-free rates rise, investors usually demand higher returns from equities, increasing the required yield.
• Payout Ratios: Companies that pay out most of their earnings as dividends may have lower growth rates (g), affecting the total K_e.
• Company Maturity: Younger companies rarely pay dividends, making the DGM unusable for them.
• Inflation: High inflation usually leads to higher nominal growth rates and higher required returns.
• Market Volatility: While not explicitly in the DGM formula, high volatility often depresses P₀, which mathematically increases the dividend yield.
• Taxation: Changes in dividend tax rates can shift investor preference, influencing the price they are willing to pay (P₀).

Frequently Asked Questions (FAQ)

Why is the DGM growth rate (g) constant?

The model simplifies reality by assuming a perpetual constant growth. While unrealistic for many years, it serves as a long-term “terminal” average for valuation purposes.

Can the growth rate be higher than the cost of equity?

No. In the Gordon Growth Model, if g > K_e, the stock price would theoretically be infinite. For the model to be valid, the required return must exceed the growth rate.

What happens if a company doesn’t pay dividends?

If a company pays no dividends, you cannot use the Dividend Growth Model. You must use the Capital Asset Pricing Model (CAPM) instead.

Is the dividend growth model better than CAPM?

Neither is “better.” DGM uses company-specific cash flows (dividends), while CAPM uses market-based risk (beta). Analysts often use both and take an average.

How do I find the growth rate (g)?

You can use the formula: g = Retention Ratio × Return on Equity (ROE), or look at historical dividend increases over the last 5-10 years.

Does this work for preferred stock?

Yes, but for preferred stock, the growth rate is usually zero, simplifying the formula to K_p = D / P.

How does stock price affect the cost of equity?

There is an inverse relationship. If the stock price falls while dividends remain stable, the dividend yield increases, thereby increasing the cost of equity.

What are the limitations of this model?

The biggest limitation is the assumption of constant growth. It also doesn’t account for stock buybacks, which are another way companies return capital to shareholders.

Related Tools and Internal Resources

• CAPM Calculator – Calculate cost of equity using market risk and beta.
• WACC Guide – Learn how cost of equity fits into the Weighted Average Cost of Capital.
• Dividend Payout Ratio Tool – Check if a company’s dividend is sustainable.
• Intrinsic Value Calculator – Use the Gordon Growth Model to find a stock’s fair price.
• ROE to Growth Link – How to calculate the sustainable growth rate.
• Equity Risk Premium Explanation – Understand the extra return investors demand over bonds.