6th letter to friends of Brunei [Stock Valuation (part 3]

In calculating intrinsic value of a stock, we need to know the dividend "growth rate" (g), or sometimes known as sustainable growth rate. This growth rate can be calculated as follows:

g = Return on Equity (ROE) x Retention Ratio.

Let me explain the easier term, which is ROE. It is the net income of a company divided by common stockholders' equity, mathematically it is:

ROE = Net Income / Equity.

Retention ratio is the proportion of earning retained after dividends are being paid out. This sounds complicated, let me illustrate in a comical way. Let's assume dividend as the amount a man need to give his wife from his income (i.e. earnings). For every $1000 this man earns, he gives $800 to his wife, then the Dividend Payout Ratio (DPR) is $800/$1,000 = 0.8. How much has this man "retained" the earning for himself? The answer is $200, the retention ratio is 1-0.8 = 0.2.

Retention ratio is therefore expressed as 1 - DPR (or dividend payout ratio)

Example: ABC Co's return on equity is 12%. Earnings per stock was $4, and a per stock dividend of $1 was paid out. What is ABC Co's retention ratio and its sustainable growth rate?

Dividend Payout Ratio(DPR) = $1 / $4 = 0.25

Retention Ratio(RR) = 1 - DPR = 1- 0.25 = 0.75

Sustainable Growth Rate (g) = ROE x RR = 0.12 x 0.75 = 0.09 (or 9%)