While the equity asset class has a different risk and return profile than fixed-income securities, the principle of discounting expected future cash flows applies to both types of instruments. The periodic cash flows paid to equity owners are called dividends, with D₀ being the amount of the most recently paid dividend and D₁ representing the expected amount of the next dividend to be paid.

There are three basic ways that a stock's expected dividend payments can be structured.

Constant Dividend

It is like a perpetual bond. PV = D/r

Constant Dividend Growth Rate

The dividends grow at a constant rate: PV = D₁/(r - g)

Note the constant dividend formula is a special case of the constant growth rate formula with g = 0.

Changing Dividend Growth Rate

The dividends grow at a changing rate.

This is known as a two-stage dividend discount model.

Implied Return and Implied Growth

A stock's required return can be estimated given the stock's current price and assumptions about its expected future dividends and growth rates.

From PV = D₁/(r - g), we can get r = D₁/PV + g. The first component is dividend yield (D₁/PV), and the second is the dividend growth rate (capital appreciation component).

We can also re-arrange the equation by dividing each side by the next period's expected earnings per share:

PV/E₁ = (D₁ / E₁) /(r - g)

In this version, PV/E₁ is the forward price-to-earnings ratio, and D₁/E₁ is the dividend payout ratio.

Gross returns are useful in comparing managerial performance before the impact of fees, but net returns are more accurate measures of what investors have actually earned.