Calculating cost of equity using Gorden Model:
In the first section of this paper, we will calculate the cost of equity of Nike Inc. using the Gorden Model as part of which, recent dividend payment will be used for estimating the cost of equity multiple. Followed are the calculations:
Value of Stock: Current Dividend(1+Growth Rate)/ (Required Rate- Growth Rate)
58.02= 0.62/( Required Rate- 0.1209)
= 13.15%
Here:
Growth Rate= Compounded Annual Growth Rate for past 5 years
= (0.62/0.35)0.20- 1
= 12.09%
Therefore, following Gorden Model, we found that the cost of equity for Nike Inc is 12.09%. However, because of the limitations of Gorden Model, which are discussed below, we cannot accept this multiple as the true cost of equity for the company. Below are some limitations of the Gorden Model and literature evidence that confirms only the theoretical acceptability of the model while practical application is denounced:
Limitations of Gorden Model:
a)
First, the model assumes that the company will continue to pay dividends at a constant growth rate. This assumption is highly impractical in the real world as many a time, companies aligns the dividend growth rate with their profit figures and if they are looking for investment opportunities, it might suspend dividend payment for a few years. Moreover,many new companies do not pay dividend for years as they retain their profit for future expansion. Therefore, Gorden model is ineffective in valuing a stock or its required return if it does not pay dividend at all.
b)
Even though the model is simple to apply, however, the model is highly sensitive over the calculation for growth rates. Different analysts may use different methods to calculate growth rates and this result in multiple valuations and many a times, wrong one. Even literature evidence has confirmed that no growth rate shall be higher than the growth rate of economy and 4% growth rate is the ideal one for Gordon one. However, as we may notice, even our calculation above used the growth rate of 12.09%, which is way ahead than the growth rate of US .
Capital Asset Pricing Model(CAPM)
CAPM is one of the most fundamental financial model that is profoundly used in the industry for calculation of cost of equity. The most distinguished feature of the model is that it establish a direct relation between cost of equity and systematic risk, measured through beta. In other words, the model is based on the postulation of portfolio theory that the investors should only be compensated for bearing systematic(market risk) and not for unsystematic risk, which can be easily eliminated through diversification. Therefore, following the validated theory, CAPM calculates the cost of equity using the following expression:
Cost of Equity: Risk free rate+ Beta(Market Risk Premium)
Here:
Risk Free Rate:
Generally assumed to be equal to 10-year US treasury bond yield
Beta:
Beta measures the responsiveness of the stock to the changes in the market index.
Market Risk Premium:
This refers to the excess of return of the market index over the risk free rate of return
Summary: CAPM scores over Gorden
Following the above discussion,we witnessed that even though Gorden model is more simple in approach, however, since CAPM is more practical in approach and calculates cost of equity through systematic risk, it has wide popularity and acceptability in both practical and academic arenas.
References
ACCA. (n.d.). CAPM: THEORY, ADVANTAGES, AND DISADVANTAGES. Retrieved September 3, 2016, from http://www.accaglobal.com/in/en/student/exam-support-resources/fundamentals-exams-study-resources/f9/technical-articles/CAPM-theory.html
Damodaram, A. (2014). Dividend Discount Model. New York: New York University.
Fama, E. (2003). Capital Asset Pricing Model.
