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Discounted Cash Flow Formula

From the constant-growth dividend discount model, we can infer the market capitalization rate, k, or the required rate of return, demanded by investors. Note that:

Capitalization Rate = Dividend Yield + Capital Gains Yield

If a stock is held for 1 year, and is bought and sold for its intrinsic value, then the following discounted cash flow formula calculates the market capitalization rate:

Discounted Cash Flow Formula
Capitalization Rate (k) =Dividend
Yield		+Capital Gains
Yield

k = Capitalization Rate

D1 = Next Year's Dividend

P0 = This Year's Stock Price

P1 = Next Year's Stock Price

g = Dividend Growth Rate

= D1
P0		+P1 - P0
P0
=D1
P0		+P0(1+g) - P0
P0
=D1
P0		+g

Often, this is how rates are determined for public utilities by the agencies responsible for setting public rates. Public utilities are generally allowed to charge rates that cover their costs plus a fair market return, with the fair market return being the market capitalization rate.

Example—Calculating the Market Capitalization Rate

If a stock, with an average risk, has a current market price of $40, pays a $1 quarterly dividend, and is growing 6% annually, then the market capitalization rate based on this information would be:

Market Capitalization Rate = $1 x 4 / $40 + 0.06 = 0.16 = 16%

Hence, we can infer that the market is demanding a required rate of return of 16% for compensating them for the risk of owning stock.