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In this article, the assumed YoY growth is 10%. How is that number reached in the calculation? It seems to be an arbitrary choice given that we can't know what the growth is going to be or is it based on earnigs growth?
Company XYZ is a slowgrowing large firm that's currently trading for 301.8p and pays an annual dividend of 10.4p. Going forward, you expect the dividend to grow at an annualized rate of 6%, and consider the cost of equity (the required rate of return on the shares) to be 10.1%. From this, we calculate: Share price = Current Dividend * (1+Growth Rate) / (Cost of Equity – Growth Rate); or Share price = 10.40p * (1+0.06) / (0.1010.06) This gives us a fair value of 268.9p  by our estimates, then, Company XYZ is overvalued by 32.9p. But not many companies will be able to grow earnings and dividends at high rates in perpetuity  over time, tougher competition and larger size makes high sustainable growth improbable  so we need to develop a model from which we can project a high growth rate for a few years and over time slow that rate to a more reasonable assumption for perpetual growth.
http://www.fool.co.uk/news/investing/investingstrategy/2010...

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Hi SanMiguel101,
In this article, the assumed YoY growth is 10%. How is that number reached in the calculation? It seems to be an arbitrary choice given that we can't know what the growth is going to be or is it based on earnigs growth?
Well, Company XYZ was just an example so all the figures are made up, but here's a little more granularity on how you can get those figures you seek.
The example you cite is a onestage dividend discount model as it assumes that the company is now quite mature and will grow at the rate of the overall economy from here on out.
This will not be applicable for most companies you'll analyze  you'll typically want to use a two or threestage model (like the Tesco example further down in the article) because they can still grow at a higher rate than the economy for at least another 510 years.
The assumed growth rate you reference, I believe, is the cited 10.1% "cost of equity" figure, which isn't the same thing as the expected yearoveryear return. The cost of equity is the rate at which you'll discount your expected dividends to obtain a present value.
You can, however, get a feel for a company's potential earnings growth rate by multiplying return on equity by its retention ratio (1  dividend payout ratio). For example, Tesco's ROE is 16.96% and its dividend payout ratio is 41.6%, so 16.96% * (1  41.6%) = 9.9%.
The 9.9% figure is called the "sustainable growth rate" or the maximum growth rate the company can achieve without altering its capital structure (debt and equity mix).
Does this help at all? Valuation is always a complicated matter with a lot of vocabulary to learn.
Foolish best,
Todd Wenning Fool analyst

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For most cyclical HYP shares you should always factor in the possibility of a dividend slash every 10 years or so and a reduced growth rate from the 'slash point'.
Recessions do happen.

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Thanks. Why would you discount your expected dividends? Is it to do with discounting by inflation? Also, how is the ROE figure reached? Dividend payout ratio, is this just dividend yield?
Yes, lots of extra vocab to get around :)
So, in valuing a dividend company, what should I really care about? In the Tesco example above, we reach 9.9% YoY growth so I could expect that if I bought at 400p, then next year the share price would be 440p and I would also have taken some dividends at the same time (all things being equal and the market/news not causing issues).

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Why would you discount your expected dividends? Is it to do with discounting by inflation?
Time value of money (TMV)  fundamental principle of finance ie $10 today is worth more than $10 in a year's time

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Company XYZ is a slowgrowing large firm that's currently trading for 301.8p and pays an annual dividend of 10.4p. Going forward, you expect the dividend to grow at an annualized rate of 6%, and consider the cost of equity (the required rate of return on the shares) to be 10.1%. From this, we calculate: Share price = Current Dividend * (1+Growth Rate) / (Cost of Equity – Growth Rate); or Share price = 10.40p * (1+0.06) / (0.1010.06)
Cost of equity is the value I'm not really understanding as it seems to be an arbitrary figure.
The cost of equity is the rate at which you'll discount your expected dividends to obtain a present value.
only reasonable value I can see is the current dividend yield minus RPI. Still unsure about the 10.1% figure?

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Time value of money (TMV)
Whoops, just noticed the typo  meant to write TVM

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Cost of equity is the value I'm not really understanding as it seems to be an arbitrary figure.
http://en.wikipedia.org/wiki/Cost_of_equity
It's more the "How do you get to the expected equity appreciation" value? It seems like just picking COE near 10% is as good as doing detailed sums. Isn't there a better way we could use the expected earnings growth as the expected share price next year?

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The other way is: COE = Market Risk Premium * Equity Beta + Riskless rate (bonds) But, how do we get to the market risk premium?

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Hi SanMiguel101, et al.
Lots of questions here, so I'll try to be as concise as possible.
Q: Why do we use the cost of equity to discount expected dividends?
A: Because dividends are equitybased cash flows, as opposed to firmbased cash flows (payments to both debt holders and shareholders)
Q: What is the cost of equity?
A: It measures the *equity* risk in a business, as opposed to the cost of capital, which measures the overall risk in the business.
Q: How do we calculate cost of equity?
A: There are a number of ways to do it. The most widely used is the capital asset pricing model (CAPM), which is stated as:
Cost of equity = riskfree rate + beta (risk premium)
Where riskfree rate = typically the 10year gilt rate Beta = a regression of returns on a share against returns on a broad equity market index (i.e. FTSE 100 or FTSE AllShare). For example, a beta of 1.2 means that it has historically been 20% more volatile than the market. Risk premium = the premium investors demand for investing in equities, relative to the riskfree rate (this can change over time)
The risk premium is (expected return of risky asset  riskfree rate). For larger companies, the risk premium is traditionally in the 45% range. In December 2008, when things were really hairy, it was between 67%. Smaller companies will demand a bigger risk premium (perhaps 67% in normal periods).
So, for example, let's say we're analyzing a large company and the 10year gilt is 3.2%, the share's beta is 0.8, and the equity risk premium is 5%. The cost of equity would be 3.2% + 0.8 (5%) or 7.2%.
Another quick way to calculate cost of equity is to find its cost of debt (what a company's longer term bonds, if it has any, are currently yielding) and add 34% on top of that rate.
Hope this helps. If you're really interested in valuation, I recommend reading NYU finance professor, Aswath Damodaran's books  The Dark Side of Valuation (http://amzn.to/99JmYd) and Investment Valuation (http://amzn.to/a6STT0).
Foolish best,
Todd Wenning Fool analyst

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Thanks. So, let's take Halfords as an example: COE = 5% * 0.63 + bonds = 6.35%
Share price = Current Dividend * (1+Growth Rate) / (Cost of Equity – Growth Rate) = 23.12 * (1+0.10) / (0.0635  0.10) = 25.43 / 0.0365 = infinity 1 year growth rate of stock is 10% inc. in dividend but should we go further out than this? So, Halfords is cheap at whatever price ?

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