Wednesday, October 26, 2011

Developing Input Estimates Used in the DDM

CFA Level 1 - Equity Investments

To determine a company's stock price using the DDM the following inputs must be available:
  1.  Dividend 
  2.  Future price
  3.  Required rate of return
  4. Expected growth rate
Required Rate of Return

This return can be derived from the CAPM model (Rcs = Rf + Bcs(Rmarket - Rf)

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. 

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

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