Estimating Market Capitalization and Dividend Growth Rates

Estimating Market Capitalization and Dividend Growth Rates : Generally, investors buy common stocks for two reasons. Stocks typically offer investors a cash dividend, and they also have the potential to provide the investor with capital gains. In this publication, we will present a method for calculating stock prices based on a constant growth model, which uses a discounted cash flows approach.



Now that we have a simple formula to calculate a stock's price, we need to figure out how to calculate all of the individual variables in that formula. Specifically, we need to calculate the projected growth rate in dividends and the market capitalization rate (discount rate or expected return).



Estimating Dividend Growth Rates



An estimate of a company's dividend growth rate can be made by examining a company's projected earnings growth rate. This estimate assumes that the return on equity for a company and its payout ratio remain constant.



Dividend growth can then be estimated using the following calculation:



Dividend Growth (G) = Plowback Ratio x Return on Equity



Where:



* Plowback Ratio = 1 - Payout Ratio, and

* Payout Ratio = Dividends Paid / Earnings per Share, and

* Return on Equity = Earnings per Share / Book Equity per Share



All of these variables can be easily calculated when you're researching a stock. They are often calculated for you by many of the online stock research tools. We explain the significance of many of these variables in our article on financial ratios.



Sticking with our example, if Stock A has a payout ratio of 60%, which means they pay out 60% of earnings in terms of dividends, their plowback ratio is 1 - 60% or 40%. Let's also assume the company's return on equity is 10.0%. That means their estimated dividend growth rate is:



Dividend Growth (G) = 40% x 10% = 4.0%



Estimating Market Capitalization Rates



If we go back to our simplified stock price formula, we can use that same calculation to develop an estimate of the discount rate (or market capitalization rate). Rearranging this formula we have:



Discount Rate (R) = (Dividends (Div) / Stock Price (P0)) + Dividend Growth Rate (G)



If we are going to develop estimated prices for stocks, then we're going to need to figure out the proper discount rate (expected stockholder return), based on stocks of equivalent risk. That means we need to calculate the discount rate for stocks that are of equivalent risk to the one we're thinking about buying.



We've already discussed how the dividend growth rate can be calculated, so we only need to solve for this portion of the discount rate equation:



Dividends / Stock Price



Fortunately, this particular ratio is a commonly published stock ratio, and is known as the dividend yield. In this example, we are examining a stock of equivalent risk to Stock A. Let's assume that Stock B has:



* Dividend Yield of 7.0%

* Payout Ratio of 45%

* Return on Equity of 12%



First, solving for the dividend growth rate:



Dividend Growth (G) = 55% x 12% = 6.6%



Finally, solving for the discount rate:



Discount Rate (R) = 7.0% + 6.6% = 13.6%



We now have a method for calculating a stock's price based on some fundamental information about the stock itself, and information on stocks of equivalent risk. That is, we've explained how to calculate all of the variables in our stock pricing formula:



Stock Price = Div / (R - G)