How this instrument works
Cost of equity is the return a company must offer its shareholders to keep them holding the stock rather than selling it for something else. It is not a rate management sets; it is inferred from how the market already prices the shares. The Gordon Growth version used here — also called the dividend discount model — backs that rate out of three observable numbers: the dividend expected next year, the price investors are currently willing to pay, and the rate that dividend is expected to keep growing forever. Divide the dividend by the price and you get a dividend yield; add the growth rate and you get the total return a buyer at today's price is implicitly accepting.
The formula is shaped the way it is because a share's value under this model is the present value of an infinitely growing dividend stream, and solving that valuation equation for the discount rate leaves exactly D₁ ⁄ P₀ plus g. That is convenient — no beta, no market index, no regression — but it only holds together for firms with a genuine, stable dividend policy. A CFO building a weighted average cost of capital for a mature utility or a real-estate investment trust reaches for this version precisely because those firms pay steady, growing dividends; an analyst valuing a young company with no payout has no D₁ to divide by and needs a different route to the same number, typically CAPM.
The model also assumes the growth rate you enter is sustainable indefinitely and stays below the cost of equity itself — feed in a growth rate at or above the answer and the underlying valuation math breaks down, since the implied share price would be infinite or negative. Treat g as a long-run ceiling, not a forecast of next quarter, and treat the output as what the current price already implies the market requires, not a target you should engineer toward.
- Enter the dividend you expect the stock to pay over the next twelve months into Expected next dividend, $.
- Enter the stock's current market price into Current share price, $.
- Enter the long-run rate you expect that dividend to keep growing into Expected dividend growth rate, %.
- Read Cost of equity, % — the dividend yield implied by your price plus the growth rate you supplied.
- Hold price fixed and raise the dividend or the growth assumption to see how directly each one lifts the required return.
Worked example — a $2 dividend on a $50 stock
Take a stock expected to pay a $2 dividend next year, trading today at $50, with dividends expected to keep growing at 4% a year. The dividend-yield term comes first: D₁ ⁄ P₀ × 100 = 2 ⁄ 50 × 100 = 4.0%. Add the 4% growth rate and the cost of equity is re = 4.0% + 4% = 8.0% — the return a buyer at $50 is implicitly accepting to keep holding the stock.
Change only the dividend to zero and the same formula collapses to re = g, since a firm paying nothing has no yield term to add — cost of equity then rides entirely on the growth assumption, a sign the model is stretched past what it was built for. Change only the growth rate to zero instead and cost of equity equals the plain dividend yield, the figure a mature, no-growth payer would settle at.
Questions
Why does cost of equity depend on the share price at all?
Because this model infers the required return from what buyers are already paying, not from a rate anyone announces. A higher price for the same expected dividend and growth means investors are accepting a lower return to hold the stock; a lower price for the same dividend and growth means the opposite. The price is the market's revealed answer to how much return is enough.
How is this different from the CAPM approach to cost of equity?
CAPM prices risk from a risk-free rate, a beta, and an expected market return, and works for any stock whether or not it pays a dividend. This Gordon Growth version instead reads the required return straight out of a dividend, a price, and a growth rate, which only makes sense for firms with an established, growing payout — young or non-dividend-paying companies need CAPM or another route instead.
Where does the expected growth rate, g, actually come from?
Analysts typically anchor it to a company's sustainable growth rate — retention rate times return on equity — or to its historical dividend growth trend over five to ten years, sometimes blended with long-run GDP growth as a ceiling for a mature firm. It is an assumption you supply, not something the instrument derives, so the answer is only as good as that input.
What happens if I enter a growth rate close to or above the cost of equity?
The underlying valuation the formula rests on requires growth to stay below the required return, since it prices a dividend stream growing forever. A growth rate at or above the answer implies an infinite or negative share price under the same model, which is a sign the input is not sustainable long-run — treat it as a red flag on the assumption, not a usable output.
Why doesn't this include a risk adjustment like beta?
The dividend and price you enter already embed the market's collective judgment about that stock's risk — a riskier stock trades at a lower price for the same expected dividend, which mechanically raises the yield term and therefore the answer. Risk is priced implicitly through P₀ rather than through an explicit beta term, which is the trade-off for not needing beta or a market-return forecast at all.
Can this number be used directly inside a WACC calculation?
Yes — cost of equity is one of the two components a weighted average cost of capital blends alongside after-tax cost of debt, weighted by each source's share of the firm's capital structure. This instrument produces the equity leg only; it does not weight it against debt or apply a capital-structure mix, so treat the output as an input to that larger calculation, not the finished figure.
References
- U.S. SEC Investor.gov — investing basics, risk, and glossary
- NYU Stern (Damodaran) — cost of capital and dividend discount model resources
Read this first: This instrument shows arithmetic, not advice. Real offers add fees, taxes and terms that vary by lender and place — verify the figures against your actual paperwork before deciding anything.