Why Do We Use Next Year’s Dividend to Calculate Cost of Equity?

Understanding an investment’s true worth means looking beyond its current market price to the future benefits investors expect. This forward-looking perspective is fundamental to financial decision-making, as the goal is to generate future returns. A company’s value is not based on past achievements but on its potential to create and distribute value to owners in the future.

What is Cost of Equity

The cost of equity represents the rate of return a company must provide to its equity investors to compensate them for the risk they undertake. From an investor’s standpoint, this is the minimum acceptable return required to justify purchasing and holding a company’s stock. It reflects the opportunity cost of investing in one company versus other available investments with similar risk profiles.

From the company’s perspective, the cost of equity is a component of its overall cost of capital, the expense incurred to finance operations and growth. Companies use this metric as a threshold when evaluating projects. If a project’s expected return does not meet or exceed the cost of equity, it would not adequately compensate shareholders for their investment risk.

This financial metric is unobservable directly from market data and must be estimated using various models. It is an input in capital budgeting decisions, guiding management in allocating resources. A higher cost of equity indicates investors perceive greater risk, demanding a larger return to make their investment worthwhile.

The cost of equity is distinct from the cost of debt, the interest rate paid on borrowed funds. Equity financing typically costs more than debt because equity investors face higher risk. Unlike lenders, they have no guaranteed payments and are last in line to be paid if a company faces financial distress. Consequently, equity investors expect greater compensation for their increased risk exposure.

The Gordon Growth Model

The Gordon Growth Model (GGM) is a method for calculating the cost of equity, particularly for companies that consistently pay dividends. It estimates a stock’s intrinsic value based on the present value of its expected future dividend payments, assuming these dividends grow at a constant rate indefinitely. The model is a specific form of the dividend discount model.

The formula for the Gordon Growth Model is: P0 = D1 / (r – g). Each variable determines the stock’s theoretical value. P0 represents the current intrinsic value or price. D1 signifies the expected dividend per share for the next year, not the most recently paid dividend.

The variable ‘r’ is the required rate of return, equivalent to the cost of equity. This discount rate brings future dividends back to their present value. ‘g’ denotes the constant growth rate at which dividends are expected to increase perpetually. The model discounts an infinite series of growing dividends back to the present.

To find the cost of equity (‘r’), the equation can be rearranged: r = (D1 / P0) + g. This transformation highlights how the expected dividend for the next period, relative to the current stock price and combined with the expected dividend growth rate, yields the cost of equity. The model is useful for companies with stable dividend growth patterns.

The Forward-Looking Nature of Valuation

Asset valuation, including stocks, derives worth from the present value of expected future cash flows. For equity investments, these cash flows primarily come as dividends. To determine a stock’s true value, one must consider the future economic benefits an investor anticipates.

Current or past dividends are historical data and do not reflect what an investor expects to gain. Investors purchase stocks expecting future returns, whether through capital appreciation or dividend distributions.

The “next year’s dividend” (D1) represents the first anticipated cash flow an investor expects. Its use in models like the Gordon Growth Model aligns valuation with a company’s future earning power and ability to distribute earnings, rather than relying on past performance.

Investors evaluate potential investments based on future income-generating capacity. A stock’s appeal is influenced by its expected future dividends, which represent tangible returns. By focusing on D1, the model captures the initial step in the stream of future benefits, providing a basis for calculating the required return that compensates for investment risk.

Assumptions of the Gordon Growth Model

The Gordon Growth Model relies on several assumptions for its validity and accurate application of D1. One assumption is that dividends will grow at a constant rate indefinitely. This implies a stable, mature business environment where the company’s dividend policy remains consistent.

Another assumption is that the required rate of return (r) must be greater than the dividend growth rate (g). If ‘g’ were equal to or greater than ‘r’, the denominator (r – g) would be zero or negative, leading to an undefined or nonsensical stock value. This condition ensures a sound and logical valuation.

The model also assumes the company is a mature entity with a predictable, consistent dividend payment history. It applies to companies with stable business models and a consistent policy of distributing earnings. Companies with erratic dividend payments or those that do not pay dividends, such as many growth-oriented firms, are not suitable for this model.

The GGM implicitly assumes dividends are the appropriate metric for valuation and that the company’s capital structure and cost of capital remain relatively stable. These assumptions simplify valuing a company by focusing on a perpetual stream of growing dividends, providing a straightforward method to derive the cost of equity.