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


Related Articles
  1. Investing Basics

    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. Stock Analysis

    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?
  3. 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 ...
  4. Investing Basics

    Looking Deeper Into Capital Allocation

    Discover how companies decide how to spend their cash in a variety of market conditions.
  5. Stock Analysis

    High Return On Equity Businesses

    Companies with high returns on equity usually see an increasing stock price in the future.
  6. Fundamental Analysis

    Lessons On Corporate Dividend Payout And Retention Ratio

    Why are dividend payout and retention ratios important to consider when investing in company stock? What companies have high ratios?What constitutes a high dividend payout and retention ratio? ...
  7. Investing Basics

    How to Calculate Risk Premium

    Think of a risk premium as a form of hazard pay for risky investments.
  8. Real Estate

    How Interest Rates Affect Property Values

    Along with their impact on mortgages, interest rates affect capital flows, the supply and demand for capital, and an investor’s required rate of return.
  9. Stock Analysis

    Analyzing Microsoft's Return on Equity (ROE) (MSFT)

    Discover a detailed analysis of Microsoft's historical return on equity, and learn how its ROE stacks up to its competitors in the tech industry.
  10. Investing Basics

    Understanding the DuPont Analysis

    DuPont analysis measures assets at their gross book value, rather than at net book value, in order to produce a higher return on equity (ROE).
RELATED TERMS
  1. Retention Ratio

    The proportion of earnings kept back in the business as retained ...
  2. Basket Retention

    An insurance policy that covers exposures to several different ...
  3. Application Of Retention

    Insurance contract language that specifies how much loss the ...
  4. Plowback Ratio

    A fundamental analysis ratio that measures the amount of earnings ...
  5. Dividend Discount Model - DDM

    A procedure for valuing the price of a stock by using predicted ...
  6. Complete Retention

    A risk management technique in which a company facing risks decides ...
RELATED FAQS
  1. What is the average return on equity for a company in the oil & gas drilling sector?

    Investing in the oil and gas drilling sector can be a profitable endeavor for some investors, but it is first necessary to ... Read Answer >>
  2. How do I find the information needed for input into the Dividend Discount Model (DDM)?

    Learn where analysts and investors can find the three pieces of necessary information that allow them to calculate the dividend ... Read Answer >>
  3. How can I use the Dividend Discount Model (DDM) effectively for a stock with fluctuating ...

    Find out how the dividend discount model is applied to stocks with irregular dividend payments and how firms with irregular ... Read Answer >>
  4. Are companies with a negative return on equity (ROE) always a bad investment?

    Any metric that uses net income is basically nullified as an input when a company reports negative profits. Return on equity ... Read Answer >>
  5. What is the historical market risk premium?

    Learn what the historical market risk premium is and the different figures that result from an analyst's choice of calculations ... Read Answer >>
  6. What is the difference between a currency and interest rate swap?

    Learn what the average return on equity for a company in the electronics sector is and what factors influence changes in ... Read Answer >>
Hot Definitions
  1. White Squire

    Very similar to a "white knight", but instead of purchasing a majority interest, the squire purchases a lesser interest in ...
  2. MACD Technical Indicator

    Moving Average Convergence Divergence (or MACD) is a trend-following momentum indicator that shows the relationship between ...
  3. Over-The-Counter - OTC

    Over-The-Counter (or OTC) is a security traded in some context other than on a formal exchange such as the NYSE, TSX, AMEX, ...
  4. Quarter - Q1, Q2, Q3, Q4

    A three-month period on a financial calendar that acts as a basis for the reporting of earnings and the paying of dividends.
  5. Weighted Average Cost Of Capital - WACC

    Weighted average cost of capital (WACC) is a calculation of a firm's cost of capital in which each category of capital is ...
  6. Basis Point (BPS)

    A unit that is equal to 1/100th of 1%, and is used to denote the change in a financial instrument. The basis point is commonly ...
Trading Center