I know the formula for Cost of Equity without using CAPM is (Dividends per Share / Share Price) + Growth Rate of Dividends, but I don't understand the logic behind it. Can anyone explain the logic behind this formula? Thanks
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As an investor, you have a required rate of return for your investment. That is the dividend you receive. In order to receive that dividend, you bought a share of stock. So, the [dividend/share price] gives you your return on investment. We add the growth rate when we expect future dividend payments to grow at a constant rate. From the businesses perspective, the dividends are the COST to the firm for their outstanding equity.
This formula is using the dividend discount model to back into cost of equity, also known as dividend capitalization.
Given the following...
P = current share price
D = estimated dividends per share, next year
g = constant growth rate of dividends, in perpetuity
r = cost of equity (this is what you are solving for)
Dividend discount model formula:
P = D / (r - g)
To solve for r:
P = D / (r - g)
P * (r - g) = D
r - g = D / P
r = (D / P) + g
Hope this helps
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