Dividend Yield and Expected Capital Gains Yields on Stocks

As we saw with bond Yield to Maturity (YTMs) in the last chapter, stocks' required rates of return have two parts:

r = dividend yield + expected capital gains yield

The dividend yield is directly analogous to the bonds' current yield:

and the expected capital gains yield is also computed the same way:

Now, we can use this formula to directly estimate the expected capital gains yield, but it's usually easier to calculate the dividend yield and then "back out" the expected capital gains yield by subtracting dividend yield from r.

For example, if we continue the problem from the previous section, we already have P0 = $16.80. We could value the stock at time 1 by dropping I)] (because in pricing the stock at time 1, we assume that 1\ will stay with the seller) and move all the remaining cash flows one period closer to us before finding their present value:

With this, we can calculate the expected capital gains yield as:

However, since we already had P0, it would have been easier to first calculate dividend yield:

and then calculate the expected capital gains yield as:

Expected capital gains yield = r - dividend yield

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