Equity Investments - Developing Input Estimates Used in the DDM

To determine a company's stock price using the DDM the following inputs must be available:

1. Required Rate of Return
This return can be derived from the CAPM model (Rcs = Rf + Bcs(Rmarket - Rf)

2. Expected Growth Rate
The expected growth rate can be derived from both the retention rate (1-payout rate) and the company's ROE. (g = (retention rate)(ROE))

3. Dividend
To determine the dividend to be used in the DDM, last year's dividend must first be calculated as the dividend in the DDM is next year's dividend. Given a company's earnings last year as well as the company's payout ratio, last year's dividend can be calculated. Using the growth rate derived above, next year's dividend can be determined.

4. Future Price
The future price for the company can be derived with next year's dividend divided by the difference in the company's required rate of return and its growth rate.

Example: Calculate the required inputs to be used in the DDM
Newco's annual EPS last year was $1.00. The company maintained its annual dividend payout ratio of 40% and ROE of 16%. Newco's beta is 1.3. Given a risk-free rate of 4% and an expected return on the market of 18%, determine Newco's required rate of return, expected growth rate and next year's dividend and price?

Answer:

Required rate of return
RNewco= 4% + 1.3(18% - 4%) = 22.2%

Expected growth rate
Retention rate = (1 - payout rate) = (1 - 0.40) = 0.60
gNewco = (0.60)(0.16) = 0.096 or 9.6%

Dividend
D1 = D0(1+g) = $1.00(1+.096) = $1.096

Future price
P1 = D1/(r - g) = $1.096/(22.2% - 9.6%) = $8.70

Earnings Analysis
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