Financial Management · Nature and purpose of the valuation of business and financial assets

Dividend Valuation Model and Dividend Growth Explained

Updated 11 October 2026 · Fact-checked

The dividend valuation model values a share as the present value of all its future dividends. With constant growth g, the ex-div price is P0 = D0(1 + g) ÷ (Ke − g). Estimate g from past dividends or from retention: g = b × r. Then rearrange the formula to find Ke or P0.

Understand Dividend Valuation Model and Dividend Growth

A share gives you a stream of dividends, so its value today is what that stream is worth today. You discount each future dividend at the shareholders' required return, the cost of equity (Ke). Add them up and you have the share price.

Summing dividends forever is hard, so the exam assumes dividends grow at a constant rate g. The sum then collapses into a simple formula: P0 = D1 ÷ (Ke − g). This is the dividend growth model, also called the Gordon growth model. If g = 0, dividends are a flat perpetuity and P0 = D ÷ Ke.

The formula gives the price ex-div, meaning just after the next dividend entitlement has gone, so the next dividend to be received is D1 in one year. If a share is cum-div, the buyer also gets a dividend about to be paid now. Then cum-div price = ex-div price + that dividend.

You need g. There are two ways. The historical method takes past dividends and finds the compound annual growth: g = (latest dividend ÷ earliest dividend)^(1 ÷ n) − 1, where n is the number of years of growth (one fewer than the number of dividends listed). The retention method (Gordon's growth approximation) uses g = b × r, where b is the proportion of earnings retained and r is the return on the new investment.

The model has limits. It assumes constant growth forever, g below Ke, a stable dividend policy and that past patterns continue. It is sensitive to g: a small change in g moves the price a lot. It ignores that growth in practice varies, and it is poor for firms paying no dividend. The retention formula assumes retained funds earn r and that the same retention ratio continues.

Key rules to remember

Dividend valuation model, constant growth (ex-div): P0 = D0(1 + g) ÷ (Ke − g) = D1 ÷ (Ke − g); Valid when Ke > g. D1 is the dividend due in one year. P0 is the ex-div price.
Cost of equity from the model: Ke = D1 ÷ P0 + g = D0(1 + g) ÷ P0 + g; Use the ex-div price. Rearrangement of the same formula.
No-growth dividend: P0 = D ÷ Ke; Flat dividend forever (g = 0).
Historical dividend growth: g = (Dn ÷ D0)^(1 ÷ n) − 1; n is the number of years of growth between the two dividends.
Retention (Gordon) growth: g = b × r; b = proportion of earnings retained = 1 − payout ratio. r = return on reinvested funds, often ROCE or ROE as given.
Cum-div and ex-div price: Cum-div price = ex-div price + dividend about to be paid; Remove the imminent dividend from a cum-div price before using the model.

How to solve Dividend Valuation Model and Dividend Growth questions

Use this order for any dividend valuation question. It stops you mixing up D0 and D1 or cum and ex-div prices.

1Identify what you must find: P0, Ke or g.
2Check whether the given price is cum-div or ex-div. If cum-div, subtract the dividend about to be paid to get the ex-div price.
3Find g. If given, use it. If you have past dividends, calculate compound growth. If you have retention and return, use g = b × r.
4Identify D0, the latest dividend already paid or just due, and compute D1 = D0 × (1 + g).
5Substitute into P0 = D1 ÷ (Ke − g), or Ke = D1 ÷ P0 + g, rearranging as needed.
6Check Ke > g and that the answer is sensible. Convert back to cum-div if the question asks.
7State the assumptions or limitations if the question asks for comment.

Quickest way: Rearrange once, then plug in

When to use it: Use it for Section A and Section B objective questions where you have about three minutes and need one number.

Write the formula you need first: P0 = D1 ÷ (Ke − g), or Ke = D1 ÷ P0 + g.
Get D1 by multiplying the latest dividend by (1 + g) once.
For growth over several years, take the root with your calculator: (last ÷ first)^(1 ÷ n) − 1.
Do the ex-div check last: if cum-div, subtract the dividend before using the formula, or add it back at the end.
Match your answer to the four options. Wrong options are usually D0 used as D1, or n miscounted.

Common mistakes in Dividend Valuation Model and Dividend Growth

Using D0 instead of D1 in the formula.
The latest dividend is given and it looks like the number to use.
Fix: Always multiply by (1 + g) unless the question states the next dividend. Write D1 = D0(1 + g) as a separate line.
Using a cum-div price directly in the model.
The word cum-div is easy to miss in the question.
Fix: Underline cum-div or ex-div. Subtract the dividend about to be paid from a cum-div price first.
Counting the wrong number of years when calculating historical growth.
Students use the number of dividends rather than the number of intervals.
Fix: Four dividends mean three years of growth. Use n = number of dividends − 1.
Taking the arithmetic average of annual growth rates.
It feels quicker than a root.
Fix: Use compound growth from the first and last dividend, unless the question tells you otherwise.
Using the payout ratio as b in g = b × r.
Mixing up dividend payout and retention.
Fix: b is the retention proportion: b = 1 − payout ratio.
Ignoring limits of the model in discussion questions.
Students focus only on the calculation.
Fix: Mention constant growth forever, sensitivity to g, the need for Ke > g, and unreliable estimates of g from past data.

Worked examples

Example 1

Hale Co has just paid a dividend of $0.40 per share. Dividends have grown at 5% a year and this is expected to continue. The cost of equity is 12%. Calculate the ex-div share price, and the cum-div price if the dividend of $0.40 is about to be paid to the buyer instead of having just been paid.

Show the solution

D1 = 0.40 × 1.05 = $0.42.
Ex-div price P0 = 0.42 ÷ (0.12 − 0.05) = 0.42 ÷ 0.07 = $6.00.
Cum-div price = ex-div price + dividend about to be paid = 6.00 + 0.40 = $6.40.

Answer: Ex-div price is $6.00 per share. Cum-div price is $6.40 per share.

Example 2

Dorn Co's dividends per share over the last five years were: Year 0 $0.50, Year 1 $0.54, Year 2 $0.57, Year 3 $0.62, Year 4 $0.65. Year 4 is the latest dividend. The current ex-div share price is $9.00. Estimate the growth rate from historical dividends and the cost of equity.

Show the solution

Five dividends mean four years of growth, so n = 4.
g = (0.65 ÷ 0.50)^(1 ÷ 4) − 1 = 1.30^0.25 − 1.
1.30^0.5 = 1.1402, and 1.1402^0.5 = 1.0678, so g = 6.78%, about 6.8%.
D1 = 0.65 × 1.0678 = $0.694.
Ke = D1 ÷ P0 + g = 0.694 ÷ 9.00 + 0.0678 = 0.0771 + 0.0678 = 0.1449.

Answer: Growth is about 6.8% a year and the cost of equity is about 14.5%.

Exam tips

Read for cum-div or ex-div before you start. It is a favourite trap in objective questions.
In OT cases, check which year the given dividend belongs to. Write D0 and D1 on your rough paper.
In constructed response answers, show the formula, D1 working and final figure on separate lines so method marks are visible.
When asked to comment, give two or three limits: constant growth assumption, sensitivity to g and reliance on past data for the future.
Use your calculator memory for the growth root to avoid rounding errors. Keep at least four decimals until the end.

Practice questions from Nature and purpose of the valuation of business and financial assets

Dividend Valuation Model and Dividend Growth in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Dividend Valuation Model and Dividend Growth: frequently asked questions

What is the difference between the dividend valuation model and the Gordon growth model?

They are the same constant-growth idea. The dividend valuation model is the general principle of valuing a share by discounting dividends. The Gordon growth model is the simplified form P0 = D1 ÷ (Ke − g) that you use in exams.

How do you calculate growth using retention?

Use g = b × r. Find b as the proportion of earnings retained, which is 1 minus the payout ratio. Multiply by r, the return earned on reinvested funds as given in the question. For example, retaining 40% and earning 15% gives g = 6%.

Why must the price be ex-div in the model?

The formula discounts dividends starting one year from now, so the first dividend a buyer receives is D1. A cum-div price includes a dividend that is due immediately. Subtract it first to get the ex-div price.

What are the main limitations of the dividend valuation model?

It assumes dividends grow at a constant rate forever and that Ke is above g. It is very sensitive to the growth estimate. Past growth may not continue, and it does not suit companies that pay no dividends.