Mastering Equity Capital Cost Estimation: Dividend Discount Models Explained

Understanding the Cost of Equity Capital through Dividend Discount Models

When it comes to evaluating investments and understanding the cost of equity capital, one fundamental concept is the Dividend Discount Model (DDM). This model provides a way to value a stock by estimating future dividends and discounting them back to their present value.

Basics of the Dividend Discount Model

The DDM is grounded in the premise that the value of a stock is the present worth of all its future dividends. The basic formula to calculate this is:

Value of stock = Dividend_1 / (Required rate of return - g)

Where Dividend_1 is the expected dividend in the next period, and g is the constant growth rate of dividends.

Calculating the Expected Return

To estimate the return on a stock, we can rearrange the DDM formula:

R = (Dividend / P0) + g

Here, R represents the required rate of return or the cost of equity capital, Dividend is the expected annual dividend, P0 is the current stock price, and g is the growth rate of dividends.

Real-World Example: Northwest National Castor Stock

Let's consider a practical example. Northwest National Castor's stock was valued at $49.43, and the forecasted dividend is $2 per share with no growth expected. The dividend yield, or expected return, would be calculated as follows:

Dividend yield = Dividend / Current share price

This gives us a dividend yield of 4.1%, which is the expected return or the cost of equity capital.

Impact of Dividend Growth on Expected Return

If dividends are expected to grow, the formula adjusts to account for this growth:

Expected return = (Dividend / P0) + g

For instance, with a growth rate of 7.7%, the expected return would be higher, reflecting the anticipated increase in dividends over time.

Summary of Key Formulas

• Dividend yield (no growth): Dividend / Price
• Stock price (with constant dividend growth): Dividend / (Required rate of return - g)
• Expected return (with dividend growth): Dividend / P0 + g

Understanding Return on Equity (ROE) and Growth Rate

ROE is the profit generated by a firm on its equity capital, calculated as:

Earnings per share (EPS) / Book equity per share

To determine the growth rate of dividends, we use the formula:

Growth rate = ROE x Retention ratio

The retention ratio, also known as the plowback ratio, is the part of the profit that is reinvested in the firm, and it's calculated as 1 - Dividend payout ratio.

Example: Evaluating Stock Value Pre- and Post-Plowback Decision

Consider a company that decides to reinvest 40% of its earnings, which previously distributed 100% as dividends. If the required return is 15% and the ROE is 25%, we can calculate the value of the stock before and after this decision:

• Without growth: Value of stock = Dividend / Required return

• With growth: First, we calculate the growth rate ( 25% ROE x 40% retention ratio), then the stock value ( Dividend x (1 - Payout ratio) / (Required return - Growth rate)).

Conclusion

Understanding the cost of equity capital through dividend discount models is crucial for investors. The model not only provides a way to value stocks based on expected dividends but also shows how growth expectations can significantly influence stock prices. By mastering these concepts, investors can make more informed decisions when evaluating potential investments.

For a more detailed explanation and examples of how to estimate the cost of equity capital using dividend discount models, watch the full video here.