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.
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:
|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?
g = (retention rate)(ROE)
g = (0.60)(0.15)
g = 0.09 or 9%
Developing Input Estimates Used in the DDM
InvestingAn investor can use dividend payout and retention ratios to gauge an investment’s possible return, and compare it to other stocks.
InvestingIt pays to invest in companies that generate profits more efficiently than their rivals. This is where ROE comes in.
InvestingExamine the return on equity (ROE) for British Petroleum, the slumping international energy company that seems to be falling behind its competitors.
InvestingMarket risk premium is equal to the expected return on an investment minus the risk-free rate. The risk-free rate is the minimum rate investors could expect to receive on an investment if it ...
InvestingLearn about UPS's return on equity (ROE), an important metric for investors. It is useful to compare the historical ROE and in relation to peers.
InvestingGet a deeper understanding of ROE with these three-step and five-step calculations.
InvestingHow can you use the dividend discount model to estimate the value the common stock of Microsoft?
InvestingLearn how the expected extra return on stocks is measured and why academic studies usually estimate a low premium.
InvestingThe payback ratio and retention ratio collect different information and are useful in different situations.
InvestingThink of a risk premium as a form of hazard pay for risky investments.