Formula & Calculator
Cost of Equity (Gordon Growth / Dividend Discount Model)
Estimates a company's cost of equity capital from its expected dividend yield plus its expected dividend growth rate.
Interpretation
Re = (D1 / P0) + g. The required return on equity based on future dividends and growth. Used in valuation and cost of capital calculations.
Variables
| Symbol | Quantity | Unit |
|---|---|---|
| Re | Cost of equity | % |
| D1 | Expected dividend next year | currency |
| P0 | Current stock price | currency |
| g | Expected constant dividend growth rate | % |
What it means
The Gordon Growth Model (or Dividend Discount Model) estimates the cost of equity by assuming that dividends grow at a constant rate g. The formula Re = (D1/P0) + g, where D1 is the expected dividend per share next year, P0 is the current stock price, and g is the constant growth rate. It is used in the CAPM and WACC to determine the cost of equity. It is simple but sensitive to growth assumptions. Understanding this model is essential for equity valuation and for estimating the required return for common stock.
Worked example
Cost of Equity (Gordon Growth) – Two Detailed Examples
Real‑World| Parameter | Value |
|---|---|
| D1 (next year dividend) | 2.1 |
| P0 (current price) | 50 |
| g (growth rate %) | 4 |
| Parameter | Value |
|---|---|
| D1 | 3.2 |
| P0 | 80 |
| g | 3 |
Common mistakes
- Gordon growth model: Used to estimate the cost of equity (Re) or intrinsic stock value.
- D1: The expected dividend per share in the next period – not the current dividend.
- P0: The current stock price.
- g: The expected constant growth rate of dividends.
- Assumptions: Dividends grow at a constant rate indefinitely – applicable to mature, stable companies.
- Limitations: Not valid if g ≥ Re – the model breaks down.
Applications
The Gordon Growth Model (also known as the Dividend Discount Model) estimates the cost of equity (Re) using the expected dividend per share (D1), the current share price (P0), and the expected constant growth rate of dividends (g). This is a fundamental valuation tool for companies that pay dividends and have stable growth. Investors use it to estimate the required return and to determine if a stock is fairly priced. By applying the model, analysts can value stocks and compare them to alternatives. It is also used in calculating WACC and in assessing the sustainability of dividend policy. While simple, it is a core equity valuation method.
- Equity valuation and stock pricing
- Cost of equity estimation for WACC
- Dividend policy evaluation and sustainability check
- Investment screening and portfolio construction
- Corporate finance and capital structure analysis
Frequently Asked Questions
Re = (D1 / P0) + g. It estimates the cost of equity by assuming dividends grow at a constant rate g. D1 is the expected dividend per share next year, P0 is the current stock price.
- Dividends grow at a constant rate indefinitely.
- The growth rate g is less than the required return Re.
- Payout ratio and return on equity are stable.
It is commonly used to value mature, stable companies with predictable dividend growth. It provides a cost of equity estimate that can be used in WACC.
The GGM is a special case of the dividend discount model (DDM) where dividends grow at a constant rate. The general DDM sums all expected future dividends.
CAPM uses market risk (beta) to estimate cost of equity. GGM uses dividend growth. They are alternative approaches; GGM is more appropriate for dividend‑paying stocks.
- It assumes a constant growth rate, which may not hold.
- It is sensitive to the growth rate estimate.
- It cannot be used for companies that do not pay dividends.
- It may not work for high‑growth companies where g > Re.
g can be estimated as the sustainable growth rate: g = ROE × Retention Ratio. Alternatively, historical dividend growth rates or analyst forecasts can be used.
A higher growth rate increases the cost of equity, because investors require a higher return to compensate for the higher expected growth (which also increases the stock price).
- Using the current dividend instead of the next year's dividend (D1).
- Assuming growth will continue beyond the forecast horizon.
- Using a growth rate that is too high (g > Re).
The model values a stock as P0 = D1 / (Re − g). This is the present value of all future dividends. It is used both for valuation and to estimate Re.