The Dividend Discount Model (DDM)

Investors of a stock have been receiving a 50% payout ratio, but management has announced an increase to 75% going forward. What is the _most likely_ effect on the estimated sustainable growth rate from this change?

Incorrect. The increase in the payout ratio reduces the retention rate. This will have a negative impact on the estimated growth rate.

Correct! The estimated sustainable growth rate is $$\displaystyle g = \left(1 - \frac{D}{EPS} \right) \times ROE $$. This is plainly stated as the retention rate multiplied by the return on equity. If the payout ratio increases from 50% to 75%, then the retention rate must decrease from 50% to 25%. Assuming no change in the return on equity, this will cut the estimated sustainable growth rate in half.

Incorrect. Consider that the payout ratio and the retention rate must sum to 1. The retention rate is a key component of the sustainable growth rate.

No change

One-half of the prior estimate

Two-thirds of the prior estimate