A:

First, a quick review: the required rate of return is defined as the return, expressed as a percentage, that an investor needs to receive on an investment in order to purchase an underlying security. For example, if an investor is looking for a return of 7% on an investment, then she would be willing to invest in, say, a T-bill that pays a 7% return or higher.

But what happens when an investor's required rate of return increases, such as from 7% to 9%? The investor will no longer be willing to invest in a T-bill with a return of 7% and will have to invest in something else, like a bond with a return of 9%. But in terms of the dividend discount model (also known as the Gordon growth model), what does the required rate of return do to the price of a security?

The required rate of return will adjust the price that an investor is willing to pay for a given security. For example, let's assume the following: an investor has a required rate of return of 10%; the assumed growth rate of dividends for a firm is 3% indefinitely (a very large assumption in itself); and the current dividend payment is $2.50 per year. According to the Gordon growth model, the maximum price the investor should pay is $35.71 ($2.50/(0.1 - 0.03)). As the investor changes her required rate of return, the maximum price she is willing to pay for a security will also change. For example, if we assume the same data as before but we change the required rate of return to only 8%, the maximum price the investor would pay in this scenario is $50 ($2.50/(0.08 - 0.03)).

This example just looks at the actions of a single investor. What would happen to stock prices if all investors changed their required rates of return?

A market-wide change in the required rate of return would spark changes in the price of a security. Take the second example given above (the reduction to 8% in the required rate of return): if all investors in a market reduced their required rate of return, they would be willing to pay more for a security than before. In such a scenario, security prices would be driven upward until the price became too high for the remaining investors to purchase the security. Should the required rate of return increase instead of decrease, the opposite would hold true.

To learn more, see Digging Into The Dividend Discount Model and How And Why Do Companies Pay Dividends?

RELATED FAQS
  1. How is the expected market return determined when calculating market risk premium?

    Find out how the expected market return rate is determined when calculating market risk premium and how these figures are ... Read Answer >>
  2. Why is the Gordon Growth Model not more widely used?

    Learn why the Gordon growth model is not more widely used in valuing the stock price of a company. Understand its inefficiencies ... Read Answer >>
  3. What are the advantages and disadvantages of the Gordon Growth Model?

    Understand the advantages and disadvantages of using the Gordon Growth Model to value a company's publicly traded stock. ... Read Answer >>
  4. How is perpetuity used in the Dividend Discount Model?

    Learn about how the concept of a stock perpetuity is used in the basic dividend discount model, which is also known as the ... Read Answer >>
  5. What's the difference between absolute and relative return?

    Knowing whether a fund manager or broker is doing a good job can be a challenge for some investors. It's difficult to define ... Read Answer >>
Related Articles
  1. Investing

    Explaining Expected Return

    The expected return is a tool used to determine whether or not an investment has a positive or negative average net outcome.
  2. Investing

    Digging Into The Dividend Discount Model

    The DDM is one of the most foundational of financial theories, but it's only as good as its assumptions.
  3. Investing

    What Investors Should Know About Interest Rates

    Understanding interest rates helps you answer the fundamental question of where to put your money.
  4. Investing

    What is a Return?

    A return is the gain or loss a security generates over a period of time.
  5. Retirement

    Can Your Retirement Portfolio Rely on High Rates of Return?

    Some experts speculate that stock market returns may be headed downward and investors should strategize accordingly. But are they right?
  6. Investing

    Returns and Financial Planning Projections

    Return expectations continue to be a necessary part of any investment strategy discussion.
  7. Investing

    Microsoft Is Paying Dividends. Is Its Share Price Undervalued Or Overvalued Based On DDM? (MSFT)

    How can you use the dividend discount model to estimate the value the common stock of Microsoft?
  8. Investing

    4 Benefits of Holding Stocks for the Long Term

    Discover some of the benefits that come from buying and holding stocks for longer periods of time, such as tax savings and risk minimization.
  9. Small Business

    Understanding the Internal Rate of Return Rule

    The internal rate of return rule is a popular method used to compare investments or projects.
  10. Investing

    How to Calculate Risk Premium

    Think of a risk premium as a form of hazard pay for risky investments.
RELATED TERMS
  1. Gordon Growth Model

    A model for determining the intrinsic value of a stock, based ...
  2. Total Return

    When measuring performance, the actual rate of return of an investment ...
  3. Gross Rate Of Return

    The total rate of return on an investment before the deduction ...
  4. Expected Return

    The amount one would anticipate receiving on an investment that ...
  5. Abnormal Return

    A term used to describe the returns generated by a given security ...
  6. Annual Return

    The return an investment provides over a period of time, expressed ...
Hot Definitions
  1. Leveraged Buyout - LBO

    The acquisition of another company using a significant amount of borrowed money (bonds or loans) to meet the cost of acquisition. ...
  2. Current Assets

    A balance sheet account that represents the value of all assets that can reasonably expected to be converted into cash within ...
  3. Tax Liability

    The total amount of tax that an entity is legally obligated to pay to an authority as the result of the occurrence of a taxable ...
  4. Preferred Stock

    A class of ownership in a corporation that has a higher claim on its assets and earnings than common stock. Preferred shares ...
  5. Net Profit Margin

    Net Margin is the ratio of net profits to revenues for a company or business segment - typically expressed as a percentage ...
  6. Gross Margin

    A company's total sales revenue minus its cost of goods sold, divided by the total sales revenue, expressed as a percentage. ...
Trading Center