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))
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?
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%
D1 = D0(1+g) = $1.00(1+.096) = $1.096
P1 = D1/(r - g) = $1.096/(22.2% - 9.6%) = $8.70
InvestingHow can you use the dividend discount model to estimate the value the common stock of Microsoft?
InvestingAn investor can use dividend payout and retention ratios to gauge an investment’s possible return, and compare it to other stocks.
InvestingThe 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 ...
InvestingWhy 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? ...
InvestingTo find the best dividend stocks, focus on total return, not yield.
InvestingDiscover details about fundamental analysis ratios that could help to evaluate dividend paying stocks, and learn how to calculate these ratios.
InvestingApple's dividend has had healthy growth ever since its 2012 reinstatement, thanks to Apple's continuously rising revenue, earnings and operating cash flow.
InvestingUnderstanding dividends and how they work will help you become a more informed and successful investor.
InvestingDividend stocks offer enticing yields, but a lot can go wrong on the way to collecting that dividend payout.
InvestingLearn some of the primary reasons why dividends constitute a critical factor in the overall performance of a stock investor's portfolio.