2. Estimating the Cost of Equity

2.6. Cost of Equity from Dividend Discount Models

An alternative way to obtain an estimate of the cost of equity of a (mature) listed firm is to use a simple dividend discount model and solve it for the cost of equity.

 

The dividend discount model states that the current stock price corresponds to the present value of all future dividends that the stock pays. In one of its simplest forms, the Gordon-Shapiro version of the model assumes that dividends will take the form of a growing perpetuity. Consequently, the stock price is:

 

Stock price = P = \( \frac{Div_0 \times (1+g)}{k_E - g} \),

 

where \( Div_0 \) is the stock's last dividend, g is the perpetual growth rate, and \( k_E \) is the firm's cost of equity.

 

When we solve the above equation for the cost of equity, we find:

 

\( k_E = \frac{Div_0 \times (1+g)}{P} + g \).

 

We can use this expression to derive the model-implied cost of capital given the firm's current stock price, dividend payout, and future expected growth rate.

 

Let's practice this approach with a simple example.

 

Towards the end of November 2016, the stock of Hershey's was trading at a price of 97. Over the previous year, Hershey's has paid a dividend of 2.4 (split in quarterly dividends). Let's assume that the market expects the annual dividend payments to increase by 3% per year. These numbers imply that Hershey's cost of equity is approximately 5.5%:

 

\( k_E = \frac{Div_0 \times (1+g)}{P} + g = \frac{2.4 \times 1.03}{97} + 0.03 \) = 5.54%.