Question

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1. What determines g and R in the DGM?

Answer 1

This problem is solved assuming that DGM means Dividend Growth Model (or) Gordon Growth Model

Equity Value under the Gordon Growth Model Formula

​

​Where,

P is the current stock price

g is the expected constant growth rate

R is the Company’s Cost of Equity (or) required rate of return

D₁ is the Dividend in next year

g = b*r where b is the retention ratio and r is the average rate of return of the company. Retention ratio means the proceeds that are retained by the company instead of paying out as a dividend. Therefore, g is determined by the dividend payout ratio and percentage of return that the company is able to generate.

R = Cost of Equity = R_f + Beta*(R_m – R_f) where R_f is the risk-free interest rate, R_m is the market return and Beta is the sensitivity of company’s stock with respect to movement in market factors. therefore, R is mainly determined by the industry expectations, market return, Risk-free rate of interest and company's Beta