Equity Investments - DDM and the Earnings Multiplier

The Components of An Investors' Required Rate of Return

  • Real risk-free rate - This rate assumes no inflation or risk is prevalent, but that it is simply generated by the supply and demand of the markets.
  • Expected rate of inflation - This rate anticipates the potential inflation that is going to occur in the market.
  • Risk premium - The premium is reflective of the risks inherent in the stock, as well as the market. Such risks include liquidity risk, business risk and general macroeconomic risk.

The Country Risk Premium
The country risk premium is the general risk of a security inherent with the foreign country related to the security.

Look Out!

A country's risk premium includes the risk from unexpected economic events in a country and the risk from associated political events.

The country risk premium should be added to the general risks a security faces when estimating the required return for a foreign security.

The Implied Dividend Growth Rate
A company's dividend growth rate can be derived from a company's ROE and its retention rate.

The retention rate of a company is the amount of earnings a company retains for its internal growth. A company's ROE is the return on the funds invested back into the company. Keep in mind that the growth rate of the firm is the identified ability of a firm to grow its operations and the ROE is the return the company is able to earn on invested funds. The company's growth rate can be calculated as follows:

Formula 13.7

Growth rate = (retention rate)(ROE)

Example: Estimate a dividend growth rate given ROE and retention rate
Newco assumes a constant ROE of 15%. The company anticipates a retention rate of 60% to fund new projects (indicating the firm will pay out 40% in dividends). What is Newco's dividend growth rate?

Answer:
g = (retention rate)(ROE)
g = (0.60)(0.15)
g = 0.09 or 9%

Developing Input Estimates Used in the DDM


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