Dividend Growth Model

For a company to support a decision not to distribute all of its profits, it must be able to generate a greater return than the amount of the dividend plus a growth rate in the level of dividends paid.

The Dividend Growth Model (also called the Dividend Discount Model or Constant Growth Model) uses the dividends per share, the expected growth rate of the dividends, and the market price of the share in order to estimate the cost of retained earnings as a percentage of the stock’s market value.

The formula for calculating the cost of retained earnings using the Dividend Growth Model is:

Where:

Cre ⇒ Cost of retained earnings (investors’ required rate of return), expressed as a percentage

D1 ⇒ The next annual dividend to be paid per share (the previous annual dividend multiplied by [1 + the expected annual % growth rate in dividends] if the next annual dividend is not given)

P0 ⇒ Common stock price per share today

G ⇒ The annual expected % growth in dividends

If dividends are NOT expected to grow, the same formula can be used to find the cost. The value for G in this case will be 0.