Question

Explain in words, why is the share price of a firm (calculated using the DDM model) most sensitive, to the variable of 'return on equity'?

Answer 1

~ Under the dividend discount model, a value of share is computed by discounting the future dividends that an investor will get throughtout the life of the company.

~ The future dividends can be constant throughout or they can be in a growing phase.

~ The growing dividends will lead to a higher discounted value than the ones where the dividends are constant all throughout.

~ Now, the growth in dividends is nothing but what company earns (Return on Equity) on its retained earnings. Hence, higher the ROE, the higher will be the growth rate. Further, the higher growth rate will result in higher future dividends, which will lead to a higher discounted value of dividends.

~ On the other hand, a lower Return on Equity will lead to a lower growth rate, which will reduce the future dividends of the company. This will result in a lower discounted value of dividends, thereby a lower share valuation.

~ Hence, the share price is very sensitive to the Return on equity as there exist an indirect relation between the share price and Return on Equity, as discussed above.