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Instead such a return must be estimated. There are two approaches to determining the cost of equity: the Dividend Growth Model Approach and the Security Market Line (SML) Approach.
The easiest way to estimate the cost of equity capital is to use the dividend growth model. In such a model, it is assumed that the firm?¦s dividends will grow at a constant rate g, the current price per share of stock P0 can be written as:
P0 = D0 ?N (1+ g) = D1
RE ?V g RE ?V g
Where D0 is the dividend just paid, and D1 is the next period?¦s projected dividend, and RE is the Required Rate of Return on Equity. This formula can be re-arranged to calculate RE as follows:
RE = D1
P0+g
The primary advantage of such a model is its simplicity, although it also has some disadvantages...
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