(90)---EQUITY CAPITALIZATION RATE

Equity Capitalization Rate

In our previous posts we discussed how the present value of a share can be calculated, after that we must know how to calculate expected dividends and required rate of return.

The required rate of return will depend upon the risk of the share. Then required rate of return will be equal to the risk free rate of interest plus the risk premium to account for the share’s risk.

In a well functioning capital market, the market price is the fair price of a share. We can use give below equation to estimate the capitalization or the required rate of return of the share,

Ke = (DIV1 / Po) + g

A blind faith in the formula can be misleading. One should be cautious in using the formula.

• Estimating errors.
• Unsustainable high current growth.
• Errors in forecasting dividends.

Linkages between Share price, Earnings and Dividends
Why do investors buy shares? Do they buy them for dividends or for capital gain?
Investors may choose between growth shares or income shares.

• Growth shares are those, which offer greater opportunities for capital gains.
• Dividend yield on such shares would generally be low since companies would follow a high retention policy in order to have a high growth rate.
• Income shares are pay higher rate of dividends, and offer low prospects for capital gains.

Because of the higher payout policy followed by companies their share prices tend to grow at a lower rate.