Question

Hello please explain me his question in detail.

Explain Why and when the dividend growth model can be preferably used over the capm model.

Answer 1

The Dividend Growth Model also commonly referred to as Gordon’s Dividend Growth model takes into account the Dividends and its growth over a period of time related to the required return on equity or the current Price of security. Its relation between the two can be symbolized with the help of the below calculations involved in the Dividend Growth Model:

P = D/(Ke – g)

OR

Ke = (D/P) + g

Where,

P = Current Market Price of stock

Ke = Cost of Equity or required rate of return

D = Dividend per share for end of period

g = Growth rate

Now, the CAPM (Capital Asset Pricing Model) considers the market returns and risk free rate of the return n the market. The beta applied to the difference of both returns (market and risk-free returns) is primarily a measure of the company’s stock price performance against the market.

Ke = rf + Beta(Rm – Rf)

Where,

Ke = Cost of Equity or required rate of return

Beta = risk measure factor

Rm = Market rate of return

Rf = Risk free rate of return

Now, imagine a stock for Company Ralco Ltd. is trading at a current market price of $25, The Dividend for next year has been declared $2.50 per share and is expected to grow 10% thereon for every year.

Current market conditions indicate an expected market return of 12% in the next year with the expected risk free return of 8%. The company’s beta as against the market index is 0.8.

As per the dividend growth model,

The cost of equity = (1.25/25) + 0.10

= 0.05 + 0.10 = 0.15 i.e. 15%

For the same company if we are to calculate cost of equity by CAPM method, it would be:

Cost of equity = Rf of 0.08 + Beta of 0.8 x (Rm of 0.12 – Rf of 0.08)

= 0.08+0.8(0.04)

= 0.08+0.032

=0.112 i.e. 11.2%

In the above example, since the company pays a small amount of dividend compared to market return however, promises a growth rate of 10% in dividends which can attract long-term investors highly focused on the stability and growth of the company fundamentals. On the other hand, to calculate cost of equity completely based on the market conditions and the index values (CAPM method) would show the expected returns based on the volatility in the market.

A company with adequate assets and stronger projected balance sheet with an ability to pay stable dividends would require a more dividend based approach rather than the market approach.

Another scenario can be created when the same company has a beta of less than 0.5 or greater than 1.5, the cost of equity under both the scenarios will be 10% and 14%. However, this would also show the higher volatility of the stock against the market prices and returns and it would not be a preferred method to base the expected returns on the market dynamics.