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

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

    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? ...
  3. Investing

    Digging Into The Dividend Discount Model

    The DDM is one of the most foundational of financial theories, but it's only as good as its assumptions.
  4. Investing

    The 3 Biggest Misconceptions of Dividend Stocks

    To find the best dividend stocks, focus on total return, not yield.
  5. Investing

    4 Ratios to Evaluate Dividend Stocks

    Discover details about fundamental analysis ratios that could help to evaluate dividend paying stocks, and learn how to calculate these ratios.
  6. Investing

    AAPL: Apple Dividend Analysis

    Apple's dividend has had healthy growth ever since its 2012 reinstatement, thanks to Apple's continuously rising revenue, earnings and operating cash flow.
  7. Investing

    Due Diligence On Dividends

    Understanding dividends and how they work will help you become a more informed and successful investor.
  8. Investing

    The Importance of Dividends in Your Portfolio

    Learn some of the primary reasons why dividends constitute a critical factor in the overall performance of a stock investor's portfolio.
Frequently Asked Questions
  1. What is the difference between yield and return?

    While both terms are often used to describe the performance of an investment, yield and return are not one and the same ...
  2. What are the Differences Among a Real Estate Agent, a broker and a Realtor?

    Learn how agents, realtors, and brokers are often considered the same, but in reality, these real estate positions have different ...
  3. What is the difference between amortization and depreciation?

    Because very few assets last forever, one of the main principles of accrual accounting requires that an asset's cost be proportionally ...
  4. Which is better, a fixed or variable rate loan?

    A variable interest rate loan is a loan in which the interest rate charged on the outstanding balance varies as market interest ...
Trading Center