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

Related Articles
  1. Investing

    Dividend Ratios: Payout And Retention

    The dividend payout ratio and retention ratio measure how much profit a company gives back to shareholders as dividends. When a business earns money, it must decide whether to use all of its ...
  2. Investing

    Corporate Dividend Payouts And the Retention Ratio

    An investor can use dividend payout and retention ratios to gauge an investment’s possible return, and compare it to other stocks.
  3. Investing

    How Return On Equity Can Help You Find Profitable Stocks

    It pays to invest in companies that generate profits more efficiently than their rivals. This is where ROE comes in.
  4. 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?
  5. Investing

    Understanding Market Risk Premium

    Market 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 ...
  6. Investing

    Analyzing BP's Return on Equity (ROE)

    Examine the return on equity (ROE) for British Petroleum, the slumping international energy company that seems to be falling behind its competitors.
  7. Investing

    The Equity-Risk Premium: More Risk For Higher Returns

    Learn how the expected extra return on stocks is measured and why academic studies usually estimate a low premium.
  8. Managing Wealth

    Looking Deeper Into Capital Allocation

    Discover how companies decide how to spend their cash in a variety of market conditions.
  9. Investing

    Decoding DuPont Analysis

    Get a deeper understanding of ROE with these three-step and five-step calculations.
  10. Investing

    Payout Ratio vs. Retention Ratio: When to Use Which

    The payback ratio and retention ratio collect different information and are useful in different situations.
Frequently Asked Questions
  1. Depreciation Can Shield Taxes, Bolster Cash Flow

    Depreciation can be used as a tax-deductible expense to reduce tax costs, bolstering cash flow
  2. What schools did Warren Buffett attend on his way to getting his science and economics degrees?

    Learn how Warren Buffett became so successful through his attendance at multiple prestigious schools and his real-world experiences.
  3. How many attempts at each CFA exam is a candidate permitted?

    The CFA Institute allows an individual an unlimited amount of attempts at each examination.Although you can attempt the examination ...
  4. What's the average salary of a market research analyst?

    Learn about average stock market analyst salaries in the U.S. and different factors that affect salaries and overall levels ...
Trading Center