In a Dividend Discount Model (DDM), what is the basis for calculating dividends?

• A. Cumulative revenue growth
• B. Projected earnings per share (EPS)
• C. Total shareholder equity
• D. Net profit margin

Answer: (B)

In a Dividend Discount Model (DDM), the basis for calculating dividends relies primarily on projected earnings per share (EPS). This is because dividends are typically paid out of the company's earnings, and analysts look at expected future earnings to estimate how much of those earnings will be distributed to shareholders in the form of dividends.

Projected EPS provides insight into a company's profitability and its potential to generate cash flows available for distribution. By assessing the expected growth rate of EPS, one can derive an expectation for future dividends, as companies often have a policy of paying out a certain percentage of their earnings as dividends. This projection helps in determining not only the expected dividends but also their growth rate, which are essential components in a DDM valuation.

In contrast, cumulative revenue growth, total shareholder equity, and net profit margin are not direct indicators of dividend payments. Cumulative revenue growth relates to overall sales performance rather than cash flow available for dividends, total shareholder equity reflects the company's net assets rather than liquidity for payout, and net profit margin measures profitability per dollar of revenue, which may influence dividends but does not directly determine them. Thus, using projected EPS offers a more relevant and specific basis for calculating future dividends in the context of a DDM.