Question

What is the expected return of a stock given stock price and dividend information? (show formula)

What is dividend yield and capital gain yield of stock investment? (show formula)

Answer 1

1. DIVIDEND DISCOUNT MODEL

Using DDM formula => stock price = dividend paid (1 + growth rate) / (cost of equity - growth rate)

Since the variables used in the formula include the dividend per share, the net discount rate (represented by the required rate of return or cost of equity and the expected rate of dividend growth), it comes with certain assumptions.

Since dividends, and its growth rate, are key inputs to the formula, the DDM is believed to be applicable only on companies that pay out regular dividends. However, it can still be applied to stocks which do not pay dividends by making assumptions about what dividend they would have paid otherwise.

The most common and straightforward calculation of a DDM is known as the Gordon growth model (GGM), which assumes a stable dividend growth rate and was named in the 1960s after American economist Myron J. Gordon.1 This model assumes a stable growth in dividends year after year. To find the price of a dividend-paying stock, the GGM takes into account three variables

Using these variables, the equation for the GGM is:

Po = D / r - g

Examples of the DDM

A third variant exists as the supernormal dividend growth model, which takes into account a period of high growth followed by a lower, constant growth period. During the high growth period, one can take each dividend amount and discount it back to the present period. For the constant growth period, the calculations follow the GGM model. All such calculated factors are summed up to arrive at a stock price.

Assume Company X paid a dividend of $1.80 per share this year. The company expects dividends to grow in perpetuity at 5 percent per year, and the company's cost of equity capital is 7%. The $1.80 dividend is the dividend for this year and needs to be adjusted by the growth rate to find D₁, the estimated dividend for next year. This calculation is: D₁ = D₀ x (1 + g) = $1.80 x (1 + 5%) = $1.89. Next, using the GGM, Company X's price per share is found to be D(1) / (r - g) = $1.89 / ( 7% - 5%) = $94.50.

2.

What is Capital Gains Yield (CGY)?

Capital gains yield (CGY) is the price appreciation on an investment or a security expressed as a percentage.

Capital Gains Yield Formula

CGY = (Current Price – Original Price) / Original Price x 100

Capital Gain is the component of total return on an investment, which occurs as a result of a rise in the market price of the security.

Calculating Capital Gains Yield

Consider the following example. John buys a share of company XYZ at a market price of $100. Over the course of one year, the market price of a share of company XYZ appreciates to $150. At the end of the year, company XYZ issues a dividend of $5 per share to its investors.

The Capital Gain Yield for the above investment is (150-100)/100 = 50%.

Also note that:

The Dividend Gain Yield for the above investment is 5/100 = 5%.

The total return from the investment is therefore 55%.

3.

What is Dividend Yield?

The Dividend Yield is a financial ratio that measures the annual value of dividends received relative to the market value per share of a security. In other words, the dividend yield formula calculates the percentage of a company’s market price of a share that is paid to shareholders in the form of dividends.

Dividend Yield Formula

The dividend yield formula is as follows:

Dividend Yield = Dividend per share / Market value per share

Where:

• Dividend per share is the company’s total annual dividend payment, divided by the total number of shares outstanding
• Market value per share is the current share price of the company

Example

Company A trades at a price of $45. Over the course of one year, the company paid consistent quarterly dividends of $0.30 per share. The dividend yield ratio for Company A is calculated as follows:

Dividend Yield Ratio = $0.30 + $0.30 + $0.30 + $0.30 / $45 = 0.02666 = 2.7%

The dividend yield ratio for Company A is 2.7%. Therefore, an investor would earn 2.7% on shares of Company A in the form of dividends.