Cost of Equity Calculator (Gordon Growth Model)

An expert tool for calculating the cost of equity based on the Gordon Growth Model, a key metric for investors and financial analysts.

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Chart: Components of the Cost of Equity

Deep Dive into the Cost of Equity and the Gordon Model

What is calculating cost of equity using gordon model?

Calculating the cost of equity using the Gordon Growth Model is a fundamental technique in finance to determine the rate of return a company must theoretically pay to its equity investors to compensate them for the risk they undertake by investing their capital. This model, a variant of the dividend discount model (DDM), is particularly useful for stable, mature companies that pay regular dividends expected to grow at a constant rate. The resulting “cost of equity” percentage is a critical input in various financial analyses, including stock valuation, investment project appraisal (as part of the WACC), and corporate strategy decisions.

The Gordon Growth Model Formula and Explanation

The model is elegant in its simplicity. It posits that the cost of equity (Ke) is the sum of the expected dividend yield and the constant dividend growth rate. The formula is derived by rearranging the stock valuation formula `P₀ = D₁ / (Ke – g)`.

Ke = (D₁ / P₀) + g

Here’s a breakdown of the variables:

Table: Variables used in the Gordon Growth Model for calculating the cost of equity.

Variable	Meaning	Unit	Typical Range
Ke	Cost of Equity	Percentage (%)	5% – 20%
D₁	Expected Annual Dividend per Share Next Year	Currency (e.g., $, €)	Varies by company
P₀	Current Market Price per Share	Currency (e.g., $, €)	Varies by company
g	Constant Dividend Growth Rate	Percentage (%)	0% – 5% (typically below long-term economic growth)

Practical Examples

Example 1: A Stable Utility Company

Imagine a large utility company, “Stable Power Inc.”

• Inputs:
  • Current Share Price (P₀): $60
  • Expected Dividend (D₁): $3.00
  • Dividend Growth Rate (g): 2.5%
• Calculation:
  • Dividend Yield = $3.00 / $60 = 5.0%
  • Cost of Equity (Ke) = 5.0% + 2.5% = 7.5%
• Result: The cost of equity for Stable Power Inc. is 7.5%. This is the return shareholders expect for holding its stock. For more on valuation, see our WACC Calculator.

Example 2: A Mature Technology Firm

Consider “Innovate Corp,” a well-established tech firm.

• Inputs:
  • Current Share Price (P₀): $150
  • Expected Dividend (D₁): $4.50
  • Dividend Growth Rate (g): 4.0%
• Calculation:
  • Dividend Yield = $4.50 / $150 = 3.0%
  • Cost of Equity (Ke) = 3.0% + 4.0% = 7.0%
• Result: Innovate Corp has a cost of equity of 7.0%. The lower dividend yield is compensated by a higher expected growth rate. Learn more about valuation with our guide on the Dividend Discount Model.

How to Use This calculating cost of equity using gordon model Calculator

Using our calculator is straightforward:

1. Enter the Current Share Price (P₀): Input the current market value of a single share. Select the appropriate currency.
2. Input the Expected Annual Dividend (D₁): Provide the total dividend anticipated per share over the next 12 months.
3. Set the Dividend Growth Rate (g): Enter the perpetual growth rate you expect for the company’s dividends. For example, enter ‘3’ for 3%.
4. Review the Results: The calculator instantly provides the Cost of Equity (Ke), along with the intermediate Dividend Yield. The chart helps visualize the contribution of yield versus growth.

Key Factors That Affect the Cost of Equity

• Dividend Policy: A higher dividend payout (relative to price) directly increases the dividend yield and thus the cost of equity.
• Company Growth Prospects (g): Higher sustainable growth expectations increase the cost of equity, as investors demand a return that includes this growth. This is a core part of the Gordon Growth Model valuation.
• Stock Price Volatility: While not a direct input, higher perceived risk often leads to a lower stock price (P₀), which in turn increases the dividend yield and the calculated cost of equity.
• Overall Market Interest Rates: If risk-free rates rise, investors will demand higher returns from equities, which can depress stock prices and increase the cost of equity.
• Economic Health: A strong economy can boost growth expectations (g), while a recession might lower them, directly impacting the cost of equity calculation.
• Industry Stability: Companies in stable, predictable industries (like utilities) often have lower costs of equity than those in volatile sectors (like biotech), as their growth rates and dividends are more certain. Understanding this is key to Capital Asset Pricing Model (CAPM) analysis.

Frequently Asked Questions (FAQ)

What if a company doesn’t pay dividends?

The Gordon Growth Model cannot be used for calculating the cost of equity for companies that do not pay dividends. For such firms, other methods like the Capital Asset Pricing Model (CAPM) are more appropriate.

What is a reasonable dividend growth rate (g)?

The growth rate ‘g’ must be sustainable indefinitely. It should not exceed the long-term growth rate of the economy in which the company operates. A rate between 1% and 4% is typically considered reasonable.

Why must the cost of equity (Ke) be greater than the growth rate (g)?

Mathematically, if ‘g’ were equal to or greater than ‘Ke’, the denominator in the valuation formula `P₀ = D₁ / (Ke – g)` would be zero or negative, leading to an infinite or meaningless stock price. This reflects that a company cannot grow faster than its required rate of return forever.

Is the cost of equity the same as the required rate of return?

Yes, in the context of this model, the terms are used interchangeably. The cost of equity is the return an investor requires to invest in the company’s stock.

How does changing the currency affect the calculation?

It doesn’t. As long as the Share Price (P₀) and the Dividend (D₁) are in the same currency, the ratio (dividend yield) is a dimensionless percentage. The currency selector is for user clarity.

Can I use last year’s dividend?

No, the model specifically requires D₁, the dividend expected in the *next* year. If you only have the most recent dividend (D₀), you can estimate D₁ by using the formula: D₁ = D₀ * (1 + g).

Is this model reliable for all types of companies?

No, it is most reliable for mature, stable companies with a long history of regular and steadily growing dividends. It is not suitable for high-growth startups or companies with erratic dividend policies. Explore other methods like the DCF analysis for different company types.

What are the main limitations of this model?

The primary limitation is its sensitivity to the growth rate ‘g’ and required return ‘k’. A small change in either input can significantly alter the valuation. It also relies on the major assumption of constant, perpetual growth, which is rarely true in practice.