For any company, the cost of equity is the cost of furnishing returns to shareholders in line with their expectations. Naturally, the objective will be to furnish the maximum possible return in the prevailing circumstances and this return will be both by way of dividends as well as capital growth. If new shareholders are offered terms that are different from existing shareholders, there will be a positive or negative impact on the current share price. Company managements try and keep share prices stable by ensuring that new share offers are priced to provide the same return as the existing shares. In other words, establishing the cost of equity or the valuation of equity boils down to establishing the expected rate of return on these shares.
The expected rate of return has two components namely the dividends received from the shares and the expected price when the shares are sold. In order to make an investment decision, the potential investor must value the stock to determine whether the current price justifies the investment or not. To do this, the anticipated stream of dividends and the anticipated selling price must be discounted to the present value at an acceptable rate of return. By the same token, a seller would have exactly the opposite sentiments. The difference in perception arises when different assumptions are made about dividends and future prices as well as different rates of return.
There are a number of drawbacks in using this model namely:
-all the figures used in this calculation are estimates that have to be made by the investor and differing assumptions could result in huge differences in the value of the stock
-the model makes the basic assumption that both investors and the markets behave rationally in setting prices
-investors unfamiliar with the concepts of discounting may find it difficult to follow the process.
A better variation of this model is known as the dividend discount method. This model specifically recognizes that shares exist in perpetuity and merely change ownership from time to time. The simplest form of this model concentrates on dividends within one time frame and discounts the anticipated cash inflows within this period. If this value arrived at is say $50, you would buy if the market price is less and sell if the market price is more. The same approach can be used for multiple time frames though the calculation is much more complicated.
To make the calculation more straightforward, you can use what is known as the Gordon Growth Model. This model concentrates on the anticipated growth in dividends rather than on the dividends themselves. The underlying assumptions are that the dividends will grow at the same rate over prolonged time and that the growth rate will be noticeably lower than the expected return rate. In theory, approaches that concentrate on dividends as the basis of valuation are among the most reliable. But if a company does not pay dividends, has an erratic track record of dividend payments or believes in rewarding shareholders through capital appreciation alone, these approaches will not work and other methods are required.