Determining the required rate of return
The required rate of return refers to the return your company seeks on an investment funded with internal earnings, not debt. The resulting value should make investing in your stocks worthwhile relative to the risks involved.
You can determine this rate using the dividend capitalization model, which states that:
The required rate of return=(expected dividend payment /current stock price) + dividend growth rate
For example, say a company pays an annual dividend of $4 per share, and its shares are currently trading at $100. If said company has been constantly raising its dividend payments by 5%, the internal rate of return will equal:
The required rate of return = ($4/$100)+5% = 9%
To determine the dividend growth rate:
- Find a starting dividend value over a given period. It could be 2019 (V2019).
- Find an end dividend value over a second timeframe. It could be 2020 (V2020).
- Next, plug the values in the formula:
Dividend growth rate = [(dividend yearX / dividend yearX) - 1] x100
Let's say that dividend payment for year 2019 was $2.00 and for 2020 it was $2.05.
Dividend growth rate = [($2.05 / $2.00) - 1] X 100 = 2.5%
Once you have all these values, plug them into the constant growth rate formula.
Company X's stocks are valued at $200 per share and pay a $2 annual dividend per share. If the required rate of return (r) is 10%, what is the constant growth rate?
Based on the formula:
Constant Growth Rate = (Current stock price X r) - Current annual dividends / Current stock price + Current annual dividends x 100
Plugging the values into the formula results in:
Constant growth rate = (200 x 10%) - 2 / (200 + 2) X 100 = 8.9%