While calculating the value of a stock using the dividend discount model, an important input is the assumed growth rate. Analysts can estimate this growth rate using a variety of methods.
- Analysts can observe the historical growth in dividends of the company and assume a future growth rate based on this observation.
- Analysts can observe the dividend growth rate in the industry that the company operates in and use the median industry dividend growth rate.
- Analysts can use the sustainable growth rate calculated using return on equity (ROE), and dividend payout ratio.
Sustainable Growth Rate
Sustainable growth rate is the rate at which the company can continue to grow without securing any additional funding, i.e., without borrowing additional money or issuing new equity.
Sustainable growth rate can be calculated using the following formula:
Let’s say that a company has an ROE of 10%, and it pays out 40% in dividends. The company’s sustainable growth rate (g) will be:
G = 10%*(1-0.40) = 6%
This suggests that with an ROE of 10% and a payout ratio of 40%, the company can sustain a growth rate of 6% forever.