# How to assume ROE, dividend growth rate and cost of equity for stable stage

Dear All,

I practice using Damoradan two stage PE formulas. It need to assume some parameter for stable stage like: ROE (or payout ratio), dividend growth rate and cost of equity. Because our market is frontier so I think we don’t have any mature company so I don’t how these parameter should be in stable stage. Please kindly help me how to assume these parameter.

Many many thanks

I would just use historical and then make adjustments for ROE and payout ratio, so a really basic base case would be just use the LTM data. Growth will be a function of ROE and payout, equal to ROE (1-payout).

for cost of equity just use whatever your preferred method is to calculate cost of equity (probably CAPM)

example:

ROE 10%

payout 50%

book value 100

risk free rate 1%

ERP 6%

Beta 1.5

Calculated growth 5%

Calculated net income 10

calculated dividends 5

calculated discount rate 10%

Calculated value is 5/(10%-5%), or 100

also because cost of equity and return on equity are the same the market value is book value no matter the payout ratio (just in this special example, rare to really happen)

Damodaran once valued Twitter prior to IPO at around \$18 but post IPO it shot up to over \$40. So they asked him to explain. “I don’t know”, he said, “ask those who paid for the stock”.

To be fair, people that bought Twitter look dumb now it’s trading much closer to Damodaran’s estimate of \$18.

I was trying to illustrate how assumptions and academic models don’t mean anything: you are still gonna miss the market. Nobody wants to know the intrinsic value of an asset. In the long run we are all dead.

Agreed. The value of an asset is what you can convince the sap behind you to buy it for. The best use of models is to convince yourself you are correct and hold out for your calculated fair value.

I’m not a fan of the old “it’s worth what someone buys it for” platitude, you are almost always going to have to make some assumptions and try to determine a value. Unless you want to sit on the sideline and either index or just never invest you have to make a decision with a lot of uncertainties around you.

What do you think a PE ratio is? Essentially it’s the premium the market assigns to earnings. And considering it’s a multiple of earnings, it’s very important. Microsoft actually grew its bottom line like crazy during its “lost decade” but collapsing multiples led to lower stock prices.

Not saying you shouldn’t attempt to assign a value, but there’s no guarantee the person (or market, for that matter) will ever agree with you. And you know what Keynes said: “The market can remain irrational longer than you can remain solvent.”

I’m not saying you’ll be perfect, just that a lot of the quotes people throw around about the stock market have almost no value when you are actually doing analysis. Don’t get cocky and use a ton of leverage seems to be the one usable takeaway from most of them, but in terms of stock selection they are kinda worthless in my opinion.

Take the MSFT example, obviously that’s an interesting history and example of the importance of performance vs expectations instead of in absolute terms, but it doesn’t tell you anything about if the P/E today is too high or low, in that way that say, expected earnings growth does.

There’ll always be overvalued, fair-valued and undervalued stocks in the market. Specific examples don’t make or break a theory. If one has the right model, they’ll be able to pick the right stocks.

“If one has the right model, they’ll be able to pick the right stocks.”

No model is totally true and picks stocks correctly 100% of the time. Or even 80% of the time, to be honest. If you think that, you should find another field because you’re going to be disappointed in financial analysis. The market is both rational and irrational at the same time, and it’s hard to model human emotion.

The choice of model and accuracy % depends a lot on one’s investment timeframe.