Gordon Growth Formula
Gordon Growth formula has been shown below. This formula is used to calculate or predict the expected growth of the dividend.
g=Br |
g=Growth
B= Proportionate of profit retained
r= Return on equity
Application of Gordon Growth Model
Growth calculated by using Gordon growth model may be used to calculate
- Cost of equity and
- Market value of share
Calculation of Gordon Growth Model
Gordon Growth model believes that dividend will grow, if some of the profit is retained and reinvested in the company operations. It means profit retained and dividend growth has direct relationship.
Dividend Growth will increase with the increase in profit retention, this concept has been explained below.Assume that cost of equity is constant , but profit retained is increasing (Changing). Then this will result increase in Dividend Growth.
Dividend Growth will increase with the increase in profit retention, this concept has been explained below.Assume that cost of equity is constant , but profit retained is increasing (Changing). Then this will result increase in Dividend Growth.
20% retention x cost of equity 12% = 2.4%
30% retention x cost of equity 12% =3.6%
70% retention x cost of equity 12% = 8.4%
Cost of Equity Example
Total Number of Share = 200,000
Value of Net Asset = 300,000
Market Value Per Share = 3
Dividend Paid = 40,000
After Tax profit = 70,000
Calculate cost of equity and Dividend Growth?
Solution
1. Dividend Growth
Return on Equity = Profit Post Tax
Net Asset
Return on Equity = 70,000 .
300,000
Return on Equity = 23.33%
Profit Retained = 30,000
70,000
=42.8% (profit retention ratio)
Growth = 42.8% x 23.33%
= 9.98% (Growth)
2. Cost of Equity
Cost of Equity = [ Do ( 1+g) ] +g
Share Price
= Cost of Equity =[ 40,000 ( 1+9.98%) ] + 9.98%
200,000 x 3
= 17.3% (Cost of Equity)
Share Valuation Example
Current year announced dividend = 1.5
Profit retained= 30%
Cost of equity=13%
Calculate share price?
Solution
Growth = cost of equity x profit retention
= 13% x 30%
= 3.9%
Share Price = Do ( 1+g)
Ke-g
Do=Current Dividend
Ke =Cost of equity
g= Dividend Growth
Share Price = 1.5(1+3.9%)
13%-3.9%
Share Price = 1.5(1+.039)
9.1%
Share Price = 17.126
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