Lesson 6 of 8 · All lessons in this module

Lesson 6 of 8 · 14 min

Required return, implied growth and the P/E ratio

A share price embeds a joint view on return and growth: in the Gordon model, r = dividend yield + g, so knowing one lets you back out the other.

In short

Implied (required) return: $r = D_1/P_0 + g$ , the expected dividend yield plus growth.
Implied growth: $g = r - D_1/P_0$ , or with only $D_0$ : $g = (rP_0 - D_0)/(P_0 + D_0)$ .
Divide the Gordon model by earnings: forward $P_0/E_1 = (D_1/E_1)/(r-g)$ , where $D/E$ is the payout ratio.
Forward P/E rises with the payout ratio and with g, and falls with r.
A price or P/E pins down only r − g. Compare implied growth with your own forecast to judge over- or undervaluation.

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