2.2 Calculate the expected return on a share II
View the video to see the second in a series of three worked examples showing how to calculate the expected return on a share.
Transcript: Calculating expected return part 2
The growth rate of dividends in B plc is expected to keep pace with a future long-term inflation rate of 3.5 per cent and the historic real rate of growth of B plc, which has been 2 per cent.
B plc has just paid the current year’s total dividend of 1 euro and 40 cents and the current share price is 16.00 euros. Calculate the expected return for B plc’s shareholders.
To find the nominal growth rate, we will use the Fisher equation, where 1 plus the real rate, multiplied by 1 plus the expected inflation rate, equals 1 plus the nominal rate.
Let’s put the figures from the question in: 1.02 multiplied by 1.035 equals 1 plus the nominal rate.
Let’s now find the nominal rate: 1.0557 subtract 1 equals 0.0557. Therefore, the nominal growth rate is 5.57 per cent.
Let’s use the Gordon Growth variation of the dividend valuation model which is rearranged to find the expected return, whereby the expected return on a share (E(Ri)) is equal to the expected dividend next year (D1), divided by the current price of the share (Pi) plus the growth rate of dividends (g) from investing in the share.
To find the dividend next year we multiply 140 cents (if we work in cents) by 1.0557, divide this by 1,600 cents and then add the growth rate of 0.0557 or 5.57 per cent.
Work out the fractional term, which gives us 0.0924, and then add the growth rate of 5.57 per cent. This gives us an expected return for B plc’s shareholders of 0.1481 or 14.81 per cent.