Why is the Value Estimated from the Constant Dividend Growth Model not an

Equilibrium Value?

Joseph Cheng
Ellen Jiao

Abstract

For dividend discount models, the intrinsic value of stock is estimated by discounting all the future
dividends of the stock. In the simplest assumption where growth is constant forever, the Constant
Dividend Growth Model formula is expressed as P = D1 / (k-g). The premise is that the firm will
pay future dividends that will grow at a constant rate.

In this paper, we show that the price generated by this traditional formula is not stable if ROE is
not equal to k. In the long run where capital can be varied, the company’s ROE should be equal
to k. Otherwise, firms will have the incentive to boost share value by increasing or reducing
capital accordingly. We show that the long run equilibrium state is attained when the return on
equity is equal to the required return (k = ROE). In such case, the Constant Dividend Growth
Model can be simplified to : V = EPS1 / k. Interestingly, the derived valuation formula for the
long run equilibrium condition is based on only EPS and required return, which means that the
model can also be applied to firms which pay no dividends.

Background

The Constant Dividend Growth Model has been the classical model for valuing equity for many
years. It is appealing because of its simple application. It is based on discounting future
dividends which are assumed to grow at a constant rate forever. All future dividends are
discounted by the required return adjusted for the time period.

One drawback of this model is that this is a form of Dividend Discount Model which is only
applicable if the firm pays dividends. However, many stocks do not pay dividends. In such
case, the Dividend Discount Model cannot be applied.

Literature Review

John Burr Williams proposed that asset price should be based on estimates of the future income in
The Theory of Investment Value (1938). He elaborated on the concepts of discounted cash flow
valuation, which is generally regarded as the basis for the DDM.

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Franco Modigliani and Merton Miller proposed the MM theorem in the Cost of Capital, Corporate
Finance and the Theory of Investment (1958) that value of assets should be based on future cash
flows and that share value maximization should be the goal of firms.

Gordon (1963) proposed the use of single discount rate to value the expected dividends in the
future, which is a function of growth. In such environment, share price is determined by the
expected dividends.

All these concepts contribute to the development of dividend discount models.

Introduction

The underlying assumption of the constant growth model is that the capital structure does not
change as the company grows, which implies that equity and debt grow at the same rate in order
for the debt ratio remains constant over time.

This paper shows that the traditional Constant Dividend Growth Model does not yield a value that
is consistent with the long run equilibrium condition. Because in the long run, a firm can issue
equity or buy back equity in order to enhance share value. If this is done, then the share price
can change so that the price estimated by the traditional model is no longer valid.

To illustrate this important concept, we begin with analyzing the Sustainable Growth Rate, which
is assumed to equal retention ratio times ROE (Return on Equity):
g = b x ROE
To see this, we need to carefully analyze ROE, which is defined as net income dividend by book
value of equity. Book value of equity is based on historical or actual cost of acquiring physical
assets to be used in the firm, such as plant and equipment. From this perspective, ROE can be
viewed as the after-tax return of physical assets to be used in the firm or the return on CAPEX
(capital expenditure). Whereas k, the required return for equity, is the expected return for
investing in the stock of the firm. Thus, k can be viewed as the financial return (after corporate
tax) for the stockholders; but from the firm perspective, k is the after-tax cost of issuing equity.
(The term “after-tax” is used here even though dividend is not tax deductible for the firm because
we want to emphasize that corporate taxes have already been considered in calculating these
returns).
In the long run, firms can increase the amount capital or size by issuing equity or decrease the
amount of capital or size by buying back equity. If the goal of the financial managers is to
maximize share price, then the firm would choose to either issue or buy back equity, depending on
which action would lead to higher share price. From the firm’s perspective, if stock is issued, it
would cost the firm k to raise the fund, and the fund will be invested in physical assets which will
earn ROE. On the other hand, if the firm buys back equity, it will forgo the ROE that is currently
being earned by some of the existing capital in firm being liquidated in order to obtain the fund

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received from liquidating such asset to obtain fund for buying back equity, which will save the
firm the cost of equity (k).

Thus, the manager whose goal is to maximize share price should always be comparing the value
of ROE to the value of k. If ROE exceeds k, then it would be beneficial for the firm to raise fund
costing k and to invest the fund in physical capital earning ROE that is higher than k. By doing
so, EPS and share price will rise. On the other hand, if ROE is less than k, then it would be
beneficial for the firm to liquidate some of the existing capital in the firm and use the fund to buy
back equity because this will lead to higher EPS and share price. With these possibilities, the
manager will have the incentive to expand or reduce the size of the firm unless ROE equals k.
This implies that the equilibrium condition where both the size of the firm and share price are at
their stable levels occurs when ROE equals k.

To demonstrate the long run stable equilibrium condition for the constant growth model, we shall
use a simple numerical example below.

Below is the table of symbols that will be used in this paper:

Symbol Variables
𝐸1 EPS for Year 1 with no change in shares at time 0 (time 0 is today)
𝐸1 ′ EPS for Year 1 if new stock is issued at time 0
𝐵0 Book Value of Equity per share at time 0 (time 0 is today)
𝐵0 ′ Book Value of Equity per share at time 0 if new stock is issued
𝑅 ROE: return on equity
𝐷1 Dividend per share for Year 1 (1 year from time 0)
𝐷1 ′ Dividend per share for Year 1 if new stock is issued
𝑔 growth rate in earnings per shares
𝑘 required return for equity or cost of raising fund with equity
𝑏 Retention percentage rate
𝑃0 Estimated stock price in time 0 from the traditional formula with no change in shares
𝑃0 ′ Estimated stock price in time 0 from the traditional formula if new stock is issued
𝑆0 Total shares outstanding at time 0 if no new shares are issued
𝛥𝑆 The number of shares issued or bought back at time 0

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First, we will show that g is equal to retention percentage rate times return on equity.

The following timeline will help us to see how to calculate ROE or R.

𝐸1 𝐸2

𝐵0 𝐵1 𝐵2

𝐸1 can be calculated from 𝑅 ∗ 𝐵0 .

Since book value 𝐵1 equals 𝐵0 plus retained earnings, we can write:

𝐸2 = 𝑅 ∗ (𝐵0 + 𝑏 ∗ 𝐸1 )
where the parenthesis term above is 𝐵1 .

g is the growth in EPS and is written as:

𝐸2 −𝐸1
g= Using the above formula to substitute 𝐸2 , g can be written as:
𝐸1
𝑅∗(𝐵0 +𝑏∗𝐸1 )−𝐸1
=
𝐸1
𝑅∗𝐵0 +𝑅∗𝑏∗𝐸1 −𝐸1
=
𝐸1
𝐸1 +𝑅∗𝑏∗𝐸1 −𝐸1
=
𝐸1
=b*R

Under sustainable growth, constant growth rate implies that both retention rate and ROE are
𝐸1 𝐸2 𝐸3
constant over time. And constant ROE over time means that = = …. and so on.
𝐵0 𝐵1 𝐵2

A Numerical Example

To illustrate the Constant Dividend Growth Model under the following three scenarios, we use a
simple numerical example of an all-equity firm with three possible values for ROE (R) :
1. ROE > k
2. ROE < k
3. ROE = k

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We assume that the firm’s required return k = 0.12 for all three scenarios, and that its return on
equity 𝑅 = 15%, 9%, and 12% in the above three scenarios, respectively.

Let us assume that the book value of equity per share at the beginning of the first year 𝐵0 = 100,
retention ratio is constant over the time b = 0.4, current outstanding shares of stock 𝑆0 = 50, and
that the firm can choose to issue two more shares or buy back two existing shares(𝛥𝑆 = 2 𝑜𝑟 − 2)
if it would increase share value.

The numerical values used in this example are summarized in the following table :

Numerical Values for

Symbol
this firm
𝐵0 100
𝑏 0.4
𝑘 0.12
𝑆0 50
𝑅 15%, 9%, 12%

Scenario 1: 𝑹 =15% > k = 12%

In this scenario, it would cost the firm 12% to raise the fund through issuing new equity. The
fund will be invested in physical assets, which will earn ROE of 15%. In this case, there is a 3%
spread from the difference between ROE and k, which means that EPS and the new share price
(𝑃0 ′) will rise if they issue more stocks even at the lower original price (𝑃0 ).

Assume that the numbers of new shares (Δ𝑆) is 2. After issuing new shares, the total value of
equity will become larger, but the number of shares would also rise so that the book value of equity
per share can rise or fall, depending on whether the numerator or denominator increase more in
proportion. Thus, a complete calculation is needed to show how the price per share might change
if the firm issues stock.

The calculations for EPS for year 1 (𝐸1 ), Dividend for year 1(𝐷1 ), growth rate in earning per share
(g) and the value of stock at the beginning of the year (𝑃0 , 𝑃0 ′) are shown in the following table:

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 Formulas Numerical Values
𝐸1 = 𝐵0 * 𝑅 100*15% = 15
𝐷 = 𝐸1 ∗ (1 − 𝑏) 15*(1-0.4) = 9
With no new issuance of 1
𝑔 =𝑏∗𝑅 0.4*0.15 = 0.06
shares 𝐷1 9
𝑷𝟎 = = 150
𝑘−𝑔 0.12−0.06
𝐵0 ∗ 𝑆0 + 𝑃0 ∗ ∆𝑆 100∗50+150∗2
𝐵0′ = = 101.92
𝑆0 + ∆𝑆 50+2
′
With issuance of two new 𝐸1 = 𝑅 ∗ 𝐵0 ′
0.15*101.92 = 15.29
𝐷1 ′ = 𝐸1 ′ ∗ (1 − 𝑏) 15.29*(1-0.4) = 9.17
shares
𝑔 =𝑏∗𝑅 0.4*0.15 = 0.06
𝐷1 ′ 15.29
𝑷𝟎 ′ = = 152.88
𝑘−𝑔 0.12−0.06

From the above calculations, we can see that the estimated stock price goes up if new stock is
issued.

𝑷𝟎 =price if no new 𝑷𝟎 ′= price if new

𝑷𝟎 is stable
stock is issued stock is issued
Estimated stock price
𝐷 150 152.88 No
based on
𝑘−𝑔

Share price rises after issuing stock because the physical return of capital (R) is higher than the
financial return of capital (k) so that gains can be realized by shifting investment from financial to
physical.

Thus, in the scenario where ROE is higher than k, the manager whose objective is to maximize
share price has the incentive to issue stock, which means that the desired level of capital is higher
than the existing level of capital. This implies that the traditional constant growth model yields
a stock price that is not stable because share price will be higher than the price generated by the
traditional model ($150) if the manager issues stock. Thus, it would be considered a case of
mispricing by the traditional model, unless one makes a highly restrictive assumption that no
stocks can be issued, which would be rather unrealistic in the long run. After all, the traditional
constant dividend growth pricing formula is a long run model because it assumes that dividend
will grow at a constant rate for a very long time.

Scenario 2: 𝑹 =9% < k = 12%

In this case where R is lower than k, the firm will have the incentive to sell some physical assets
in order to raise the fund for buying back some stocks. That is because the firm should be willing
to give up 9% ROE in order to save 12% for cost of equity k. In this numerical example, let us
assume the firm liquidate some physical assets to buy back 2 shares.

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The calculations for EPS (𝐸1 ), dividend for year 1(𝐷1 ), growth rate in earning per share (g) and
the value of stock at the beginning of the year (𝑃0 , 𝑃0 ′) are shown in the following table:

Formulas Numerical Values

𝐸1 = 𝐵0 * 𝑅 100*9% = 9
𝐷1 = 𝐸1 ∗ (1 − 𝑏) 9*(1-0.4) = 5.4
With no buy back of shares 𝑔 = 𝑏 ∗ 𝑅 0.4*0.09 = 0.036
𝐷1 5.4
𝑷𝟎 = = 64.29
𝑘−𝑔 0.12−0.036
𝐵0 ∗ 𝑆0 + 𝑃0 ∗ ∆𝑆 100∗50−64.29∗2
𝐵0′ = = 101.49
𝑆0 + ∆𝑆 50−2
′ 9
With buy back of new 𝐸1 = 𝑅 ∗ 𝐵0 ′ 100
*101.49 = 9.13
shares 𝐷1 ′ = 𝐸1 ′ ∗ (1 − 𝑏) 9.13*(1-0.4) = 5.48
𝑔 =𝑏∗𝑅 0.4*0.09 = 0.036
𝐷1 ′ 5.48
𝑷𝟎 ′ = = 65.24
𝑘−𝑔 0.12−0.036

From the above calculations, we can see that the estimated stock price goes up if shares are bought
back.

𝑷𝟎 =price with no 𝑷𝟎 ′= price with

𝑷𝟎 is stable
buy back buy back
Estimated stock price
𝐷 64.29 65.24 No
based on
𝑘−𝑔

Thus, in this scenario where ROE < k, the managers whose objective is to maximize share price
has the incentive to buy back stock, which means that the desired level of capital is lower than the
existing level of capital. This implies that the traditional constant growth model yields a stock
price that is not stable because share price will be above the price as generated by the traditional
model ($64.29) if the manager liquidates some physical asset to raise fund for buying back stock.
This would be a case of mispricing by the traditional model, unless one makes a highly restrictive
assumption that no stocks can be bought back, which is rather unrealistic in the long term.

Scenario 3: 𝑹 =12% = k = 12%

In this scenario where ROE is equal to k, the share price for three possible cases are calculated
in this scenario- the first case with no issuance or buy back of stocks, the second case where new
stocks are issued, and the third case where stocks are bought back.

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The calculation for all three cases in this scenario are shown in the following table:

Formulas Numerical Values

𝐸1 = 𝐵0 * 𝑅 100*12% = 12
𝐷1 = 𝐸1 ∗ (1 − 𝑏) 12*(1-0.4) = 7.2
With no change in shares 𝑔 =𝑏∗𝑅 0.4*0.12 = 0.048
𝐷1 7.2
𝑷𝟎 = = 100
𝑘−𝑔 0.12−0.048
𝐵0 ∗ 𝑆0 + 𝑃0 ∗ ∆𝑆 100∗50+ 100∗2
𝐵0′ = = 100
𝑆0 + ∆𝑆 50+ 2
′
𝐸1 = 𝑅 ∗ 𝐵0 ′ 0.12*100 = 12
With issuing new shares 𝐷1 ′ = 𝐸1 ′ ∗ (1 − 𝑏) 12*(1-0.4) = 7.2
𝑔 =𝑏∗𝑅 0.4*0.12 = 0.048
𝐷1 ′ 7.2
𝑷𝟎 ′ = = 100
𝑘−𝑔 0.12−0.048
𝐵0 ∗ 𝑆0 + 𝑃0 ∗ ∆𝑆 100∗50−100∗2
𝐵0′ = = 100
𝑆0 + ∆𝑆 50−2
𝐸1′ = 𝑅 ∗ 𝐵0 ′ 0.12*100 = 12
With buying back shares 𝐷1 ′ = 𝐸1 ′ ∗ (1 − 𝑏) 12*(1-0.4) = 7.2
𝑔 =𝑏∗𝑅 0.4*0.12 = 0.048
𝐷1 ′ 7.2
𝑷𝟎 ′ = = 100
𝑘−𝑔 0.12−0.048

We can see that the estimated stock prices generated by the traditional model with and without
change in shares are the same for all three cases: with no change in share, with issuing stocks, and
with buying back of stocks. Note that this is the only scenario where there is no incentive to vary
the level of capital since share price would not rise by doing so. Since the physical return of
capital (R) is equal to the financial return of capital (k), there is no advantage in re-allocating
investments from physical to financial or vice versa.

With no change With Issuing With buying

𝑷𝟎 is stable
in share stocks back stocks
Estimated stock
𝐷 100 100 100 Yes
price based on
𝑘−𝑔

Since the estimated price in all three cases are the same in the scenario where R = k, there is no
incentive for the manager to change the capital level of the firm. This signifies that the current
level of capital is at the desired level, which means that the capital level of the firm has reached a
stable level in this scenario. Thus, the firm can be said to be in a stable equilibrium condition.
Note that this is the only scenario where the traditional constant growth model correctly prices the
stock in the long run because the price yielded by this traditional model is now stable. Note that
the necessary condition for this stable equilibrium state is R = k.

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Deriving the Constant Dividend Growth Formula Under Long Run Equilibrium

In this section, we develop the Constant Divident Growth model under the long run equilburim
condition where R =k.
𝐷1 𝐸1
Show that 𝑃0 = = in the long run equilibrium:
𝑘−𝑔 𝑘
𝐷1
1) 𝑃0 = since g = b* R, we can write:
𝑘−𝑔

D1
1b) = since in the long run, k = ROE , we can substitute R for K:
𝑘−𝑏∗𝑅
D1
2) =
𝑅−𝑏∗𝑅
D1
2b) =
(1−𝑏)∗𝑅
𝐷1 𝐷1 𝐷1
since 1 − 𝑏 = and = 𝐸1 , we can substitute with 𝐸1 , 2b) becomes
𝐸1 1−𝑏 1−𝑏

𝐸1
= since k = ROE in the long run, we can substitute R with k:
𝑅
𝑬𝟏
3) 𝑷 𝟎 = 𝑽𝟎 =
𝒌

(3) will be referred to as the long run equilibrium valuation formula. And to avoid confusion with
the traditional constant dividend growth model, we will use 𝑉0(instead of 𝑃0 ) to represent the
value today under the long run equilibrium condition.

Similarly, we can use numerical values to show that the long run constant dividend growth model
is the same as the traditional model in the case where R = k.

In Scenario 3, when R = k = 12%, the firm’s desired level of capital is equal to the existing level
and thus the firm has reached a stable condition. The value of stock (𝑉0 ) under this condition is
calculated by using the long run constant growth model shown in the following table:

Formulas Numerical Values

𝐸 𝐸1 = 𝐵0 * 𝑅 100*12% = 12
Estimated stock value based on 𝐸1 12
𝑘 𝑽𝟎 = = 100
𝑘 0.12

Note that the estimated value based on the long run equilibrium model above is $100, which is
exactly the same as derived by the traditional constant dividend growth model in scenario 3. Thus,
the derived long run model can be used as a Constant Dividend Growth Model under long run

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equilibrium where the desired capital level has reached a stable level. From the examples in all
three scenarios, we can see that the traditional model yields a stable stock value only when R = k.

Conclusion

The traditional constant dividend growth model is a long run model because it assume dividends
to grow at a constant rate for a very long time. In the long run, the amount of capital may be
subjected to change. From this long-term perspective, the traditional constant growth model
might be mispricing the stock since the stock value derived from the traditional model is not stable
in the long run. Thus, the long run model developed in this paper yields a stable value that is
more consistent with the long-term perspective.

Furthermore, with diminishing return where ROE declines with increase in the level of capital, g
would also decline with ROE under the sustainable growth relationship. In the long run where
the level of capital varies, g would no longer be constant in the real world of diminishing return.
Thus, the underlying constant growth assumption might not be realistic in a dynamic environment
where capital can be varied. If one has to make the constant growth assumption, then the only
viable constant growth model that is justifiable in such dynamic environment would be the long-
term equilibrium model developed in this paper.

Reference

Franco Modigliani and Merton H. Miller. (1958) The Cost of Capital, Corporation Finance and
the Theory of Investment. The American Economic Review, Vol. 48, No. 3, pp. 261-297

Gordon, M.J. (1963) Optimal Investment and Financing Policy. The Journal of Finance, 18, 264-
272.

John Burr Williams. (1983) The Theory of Investment Value. Cambridge, Mass: Harvard
University Press.

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