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. Professionals

    Chinese Slowdown Affects Iron Ore Market

    The Chinese economy's ongoing slowdown is having a major impact on iron ore demand.
  2. Personal Finance

    Invest in Costco? First Understand Its Balance Sheet

    A strong balance sheet sets a company apart and boosts investor confidence. How healthy is Costco based on an analysis of its balance sheets from the last two years?
  3. Investing Basics

    Brokers and RIAs: One and the Same?

    Brokers and registered investment advisors have some key differences. Here's what you need to know.
  4. Professionals

    DCF Vs. Comparables: Which One To Use

    DCF and Comparables models are widely used in equity valuation. We explain the pros and cons of each method.
  5. Professionals

    How To Make Money Using Tobin's Q Ratio

    Although it seems simple, Tobin's Q Ratio is more complex than it appears. We explore some of its main strengths and weaknesses.
  6. Taxes

    3 Secrets You Didn't Know About Estate Planning

    Every advisor and saver needs to know these three estate planning secrets.
  7. Professionals

    Cash Flow Is King: How to Keep it Running

    Why is cash flow so important, and what steps can a business take to improve it?
  8. Entrepreneurship

    10 Ways to Nurse Cash Flow in Healthcare

    Running a business in healthcare? You might want to rethink cash flow management practices.
  9. Professionals

    How to Help Clients with Cash Flow Issues

    Sometimes your spending gets out of hand or income has a hiccup. Here's how financial advisors can help clients who have cash flow issues.
  10. Professionals

    How to Improve Your Cash Flow in Manufacturing

    Here are 10 ways to to improve a manufacturer's cash flow.
RELATED TERMS
  1. Personal Financial Advisor

    Professionals who help individuals manage their finances by providing ...
  2. CFA Institute

    Formerly known as the Association for Investment Management and ...
  3. Chartered Financial Analyst - CFA

    A professional designation given by the CFA Institute (formerly ...
  4. Security Analyst

    A financial professional who studies various industries and companies, ...
RELATED FAQS
  1. Can I use my IRA to pay for my college loans?

    If you are older than 59.5 and have been contributing to your IRA for more than five years, you may withdraw funds to pay ... Read Full Answer >>
  2. Can I use my 401(k) to pay for my college loans?

    If you are over 59.5, or separate from your plan-sponsoring employer after age 55, you are free to use your 401(k) to pay ... Read Full Answer >>
  3. What are the benefits of financial sampling?

    Financial sampling allows auditors to approximate the rate of error within financial statements. For accounting purposes, ... Read Full Answer >>
  4. What are the differences between a Chartered Financial Analyst (CFA) and a Certified ...

    The differences between a Chartered Financial Analyst (CFA) and a Certified Financial Planner (CFP) are many, but comes down ... Read Full Answer >>
  5. How do I become a Chartered Financial Analyst (CFA)?

    According to the CFA Institute, a person who holds a CFA charter is not a chartered financial analyst. The CFA Institute ... Read Full Answer >>
  6. What types of positions might a Chartered Financial Analyst (CFA) hold?

    The types of positions that a Chartered Financial Analyst (CFA) is likely to hold include any position that deals with large ... Read Full Answer >>
Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!