Constant Growth Dividend Discount Model

The constant growth dividend discount method assumes both a fixed growth rate for Dividends and a fixed growth rate for firms. The simplest form of the constant growth dividend discount model is the Gordon Growth Model, named after Myron J. Gordon. This formula calculates value from dividends which continue infinitely into the future. The basic formula for the Constant Growth Rate dividend is fairly simple.

You first begin with the firm’s financial statements. Locate the firm’s Dividends Paid and Net Income. Calculating the Dividend Payout Ratio by dividing Dividends Paid by the firm’s Net Income. This reveals the percentage of earnings actually paid out as dividends.

You also need to determine the firm’s Return on Equity, determined by dividing Net Income by Shareholder’s Equity.

Your next step is to calculate the Retention Rate, also called the plowback ratio or reinvestment rate. Subtract the Dividend Payout from one. The retention rate is the amount of earnings the company keeps for reinvestment. The reinvestment actually grows earnings in the future. Assuming that management maintains the same dividend payout ratio, this increases the actual value of dividends paid while the ratio remains the same.

The next calculation you need to solve is the Dividend Growth Formula. Simply multiply the Return on Equity of the firm by the Retention Rate.

You will additionally need to calculate the Market Risk Premium. The Market Risk Premium is the difference between the expected market’s return and the risk free rate. The risk free rate is the safest possible vehicle found in the financial markets. This is usually short term sovereign bonds of the safest 1^st world nations. The expected market return is the estimated future return analysts predict for the market based on current conditions.

The Capitalization Rate is attuned to the actual firm itself. This rate is the required rate of return which is needed for the actual firm. The formula for the capitalization rate is below.

Once you have acquired the Capitalization Rate, you can substitute this rate into the valuation for the actual firm itself. For the model to work, the Dividend Growth Rate must be lower than the capitalization rate. If the Dividend Growth Rate exceeds the Capitalization Rate the equation will give a negative value in the denominator. Your result for share value will be highly inaccurate.

In addition to its other hindrances, the constant growth Dividend Discount Model requires making two crucial assumptions. These reduce the total amount of firms that can be accurately evaluated with the model.  The first assumption is that growth will be static. The second assumption is that dividend policy, represented by the retention ratio, will be static. As long as these remain in place for the indefinite future, the valuation will be valid. If they change, the valuation will be invalid. This model is best reserved for mature firms that grow at a steady rate. It cannot be used on firms with no dividends, and should not be used on firms where dividends are uncertain or dividend policy is likely to change.