There are two basic methods for estimating the excepted total return. One involves using the dividend discount model. Mathematically, it is the sum of an infinite series of discounted growing dividends. Another relies on the capital asset pricing model. It says that the expected return on a stock is equal to the risk free rate plus the amount of the stock’s systematic risk multiplied by the price of systematic risk.
Dividend Discount ModelStep 1
Determine the expected capital gains yield. Given a current stock price of $20 and an expected price next year of $21, the capital gains yield is the percent change: $21 minus $20 divided by $20 equals .05 or 5 percent.Step 2
Determine the expected dividend yield. Given a current stock price of $20 and an expected dividend next year of 50 cents, the dividend yield is the dividend divided by the current stock price: 50 cents divided by $20 equals 0.025 or 2.5 percent.Step 3
Add the expected capital gains yield (5 percent) and expected dividend yield (2.5 percent) together: 5 plus 2.5 equals 7.5 percent. This is the expected total return.
Capital Asset Pricing ModelStep 1
Determine the price of systematic risk. Given an expected return on the market of 5 percent and a risk-free rate of 1 percent, the price of systematic risk, also called the market risk premium, is found by subtracting the risk-free rate from the expected market return: 5 minus 1 equals 4 percent.Step 2
Multiply the amount of systematic risk, also called the stock’s beta, by the price of systematic risk. Given a beta of 1.625, the amount paid for systematic risk is 1.625 times 4 percent equals 6.5 percent.Step 3
Add the risk free rate to the amount paid for systematic risk: 1 percent plus 6.5 percent equals 7.5 percent. This is the expected total return.
- Essentials of Investments; Zvi Bodie et al.
- The capital gains yield is numerically the same as the constant growth rate in dividends. When using the dividend discount model, if you know the constant growth rate for dividends use that for Step 1.
Kathryn Christopher has been writing about investments for more than 20 years. Her work has appeared in the "Journal of Alternative Investments" and numerous other academic and industry publications. She works at Wiggin Financial Planning, teaches for UMASSOnline from South Florida, and holds a PhD in finance from the University of Massachusetts.