I’m trying to calculate the cost of common equity for this company. I figured I could use the Gordon Dividend Growth Model to solve for the investor’s required rate of return. However, its dividends have made wide swings. How could I apply the Gordon Model if I’m supposed to assume that
g is at a constant rate?
This is one of those situations I’ve been dreading where I can learn the stuff out of a book but am sitting like a deer in headlights when it comes to applyin it in the real world.
Well, obviously it doesn’t work very well. You could try regressing the log of the dividend against time to get an estimated average and growth rate and back out the average, then subtract a quantity to reflect the effect of volatility.
If you have another way to estimate the growth rate, you can simply shave a bit off of it to reflect volatility drag and try the GGM. Or try to normalize the dividend by some kind of averaging (the regression method above helps with this). The GGM tells you a fair price for a company that is growing steadily, so if here are bumps, you simply shave some off to account for this.
Usually, when you have uneven cash flows or dividends, it means that the company is either growing or - alternately - beginning to stall. Generally that means you need a different valuation method than GGM.
But backing out the required rate of return is generally not a good idea to do for a stock, because the whole point of the required rate is to have an outside-determined standard of how much the stock needs to return (generally considering it’s risk) to be a good investment. However, it is perhaps justified if you are using it as a method of relative valuation, provided you are using the result to compare stocks of similar risk levels.
Check that model I sent you. I had dividends growing at individual rates for 5 years before leveling off at a terminal rate starting in year 6.