Friday, May 3, 2019

Sustainable Dividends for Gordon Growth Model



This post uses the Gordon growth model to back out estimates of sustainable dividend growth for three utilities.

Question:  The chart below has information on price per share and dividend per share for three utilities.  Assume that all three utilities have the same cost of capital 9 percent.   What dividend growth rate justifies these share prices based on the basic Gordon growth model?


Share Price and Dividend Per Share for Three Utilities
Price Per Share
Dividend  Per Share
Next Era
190.1
5
Duke
90.5
3.7
Dominion Power
77.5
3.4



Background:   The Gordon Dividend Growth Model treats the value of a stock as the discounted value of all future dividends.

The formula for the value of the stock can be written as

P=D/(R-G)


P is the value of the stock,
D is the annual dividend,
R is the required cost of equity,
G is the growth rate of dividends.


Resource on Gordon Growth Model.


Analysis:  We have values for P and D in the table and we are assuming R is 0.09.

Rearranging the Gordon Growth model formula to get


(PR-D)/P  = G


Calculation of G the estimated growth rate in dividends is below.



Share Price and Dividend Per Share for Three Utilities
Price Per Share
Dividend  Per Share
Estimated  Dividend Growth Rate(PR-D)/P
Next Era
190.1
5
6.37%
Duke
90.5
3.7
4.91%
Dominion Power
77.5
3.4
4.61%
R
0.09
Key assumption is a 9 percent cost of capital.   Spreadsheet is set up so one can alter the cost of capital assumption.


Can Next Era provide a 6.4% growth rate in Dividends to sustain its current share price?  A more complete analysis would consider whether Next Era has a lower cost of capital than the other two utilities.


No comments:

Post a Comment