What is Required Rate of Return
The common stock valuation formula used by this stock valuation calculator is based on the dividend growth model, which is just one of several stock valuation models used by investors to determine how much they should be willing to pay for various stocks.
The dividend growth model for common stock valuation assumes that dividends will be paid, and also assumes that dividends will grow at a constant pace for an indefinite period. Of course, neither of these assumptions rarely, if ever, occur in real life.
How to Calculate the Value of Stocks
To determine the value of common stock using the dividend growth model, you first determine the future dividend by multiplying the current dividend by the decimal equivalent of the growth percentage (dividend x (1 + growth rate)).
Lastly, the future dividend is divided by the difference between the decimal equivalent of the expected rate of return and the decimal equivalent of the growth percentage (future dividend ÷ (expected rate of return - growth rate)).
To illustrate how to calculate stock value using the dividend growth model formula, if a stock had a current dividend price of $0.56 and a growth rate of 1.300%, and your required rate of return was 7.200%, the following calculation indicates the most you would want to pay for this stock would be $9.61 per share.
| Stock Price Calculation Using Dividend Growth Model | ||
|---|---|---|
| Variable | Formula | Result |
| Future dividend = | Dividend x (1 + (growth rate / 100)) | |
| Future dividend = | 0.56 x (1 + (1.3 / 100)) | |
| Future dividend = | 0.56 x (1 + (0.013)) | |
| Future dividend = | 0.56 x 1.013 = | 0.57 |
| Rate difference = | Required rate - Growth rate | |
| Rate difference = | 0.072 - 0.013 = | 0.059 |
| Stock price = | Future dividend / Rate difference | |
| Stock price = | 0.57 / 0.059 = | $9.61 |
What is Required Rate of Return?
Unlike bonds, where the risk of principal loss is minimal, and dividends are paid on a fixed percentage, stocks come with an increased risk of losing your principal and stock dividends are never guaranteed, and the dividend per share is not fixed.
These added risks and uncertainties of investing in stocks explain why investors expect to earn a better return on investment on stocks than they do on bonds. In other words, more risk equates to a higher expected rate of return.
This difference between a low-risk expected rate of return (such as the T-Bill rate) and the higher expected rate of return that comes from increased risk is often referred to as the risk premium.
Risk premium can be thought of as the percentage that would need to be added to a risk-free return on investment to entice an investor into investing in the risky investment being offered. Once this percentage is added, the result is referred to as the required rate of return.