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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