Dividend Approach To Cost Of Equity Capital

In the past article we had discussed about the DCF model of valuation which helps investors to know the present value of future earnings to arrive at the fair value of their investments. In this article we will discuss another method of valuation which is known as the dividend approach to the cost of equity capital. Before we explain the method let us first understand what is cost of equity capital. It is the return expected by equity shareholders on the investments made by them in a company in order to retain the market price of the share they have invested in. In other words, it is the rate of return necessary to satisfy the commitments made by the common shareholders of a company. This method of valuing a company helps to assure the investor that the shares are being managed properly and that his investment remains safe. If the investor can get hold of the three basic numbers needed to calculate the cost of equity capital, it can be of very great advantage to the investor group to know how safe their investment is and will be in the coming days.

In this method, the cost of equity capital is calculated based on the required rate of return in terms of the future dividends paid by the company to the shareholders. The basic formula for cost of equity capital begins with dividing the dividends per share by the current market value. The resulting figure is then added to the dividend growth rate. After adding these two figures, the cost of equity capital as it relates to the shares is revealed, and can be shared with the shareholders. In others words, it is the discounted rate that equates the present value of all expected future dividends per share with the net proceeds of the sale of the share. To arrive at the net proceeds of sale of shares in the market, the cost of flotation as well as the discount/premium has to be adjusted. But in the case of dividends, it depends on the basis of expected growth. The dividend paid by a company can be constant or may increase over time according to the profitability of the company. For example, dividend paid by XYZ Ltd. from 2001 to 2007 is given below.

In the table we can see the dividend payment record of XYZ Ltd. over some period of time and the graphical representation of this data. The table shows that the company does not have a steady dividend payment which has varied over the years. But some companies follow a steady path of dividend payment. This makes the rate of growth of dividend an important factor in the calculation of future dividends.

Here is an example to understand the concept better. Let us suppose that the last dividend paid by XYZ was 9.5% in 2008 and company has estimated an annual growth rate of 8% for the next two to three years. The current market price of XYZ is Rs 1285. Assuming that the flotation cost (Flotation costs include both the underwriting spread and the costs incurred by the issuing company from the offering. Expressed as a portion of gross proceeds, costs generally increase as risks associated with the issue increase, or the size of the offering decreases.) for a new share is Rs. 19, the cost of equity can be estimated using the following formula:

Cost of Equity = [(Dividend Per Share / (Current Market Price - Flotation Cost) + Growth Rate of Dividends) * 100]

*Growth rate of Dividends which is shown as 0.095 (9.5/100) for easy understanding, is later multiplied by 100 to convert it into percentage.

= [((3/(1285-19))+0.095)*100]

= [((3/(1266))+0.095)*100]

= [(0.0024+0.095)*100]

= [0.0974*100]

Cost of Equity = 9.74%

The discussed method provides the investors with a tool to make their investment after checking the growth prospects of their proposed investment in the company.