*This post originally appeared on Dividend Growth Investing & Retirement.*

"Dividend Yield + Dividend Growth = Prospective Return" -

Josh Peters,The Ultimate Dividend Playbook(AL), Chapter 2

This formula is based on the Gordon Growth Model and is used to estimate the total return of a stock. It looks simple, but the Dividend Growth part of this formula can be tricky as it involves guessing a reasonable future dividend growth rate.

Fortunately, Josh Peters, CFA, a respected dividend growth investor, author of the popular book "The Ultimate Dividend Playbook", and former editor of the Morningstar DividendInvestor newsletter, created the Dividend Drill Return Model (DDRM) to help with this process.

Learn by example as I use the DDRM to estimate future dividend growth and total returns for **Bank of Nova Scotia ****(NYSE:BNS) [TSE:BNS]**. Once I've explained how the DDRM works, I'll share the Bank of Nova Scotia DDRM spreadsheet I used.

**The Dividend Drill Return Model (DDRM)**

To use the DDRM, you'll need 6 pieces of information (six inputs):

- Stock/share price
- Dividend rate
- Earnings per share (EPS)
- Return on equity (ROE)
- Core growth estimate
- Free growth estimate

The first three (Price, dividend, and EPS) are easy enough to figure out, but the last three (ROE, core growth, and free growth) are long-term future estimates which make them a bit harder.

First, let's look at Bank of Nova Scotia as an example and then I'll go deeper into the six inputs and the various elements of the DDRM.

Inserting the 6 inputs for Bank of Nova Scotia (highlighted in yellow below) into the DDRM below will give an estimate of dividend growth and total return (highlighted in green below).

**Stock/share price, Dividend rate, and EPS**

As of October 14, 2018, Bank of Nova Scotia's **share price was $71.71**.

Bank of Nova Scotia pays a quarterly dividend of $0.85, so the annual **dividend rate is $3.40** ($0.85 x 4).

EPS should be a forward estimate. I've used Value Line's Bank of Nova Scotia **2018 EPS estimate of $7.05**.

### **Return on equity ****(ROE)**** estimate**

If you are investing in companies with **sustainable** competitive advantages (economic moats), then past ROE can be helpful in estimating the projected return on equity.

"I usually wind up using either the most recent year's ROE or, if ROE has fluctuated widely in the past, a 5 or 10-year average." -

Josh Peters,The Ultimate Dividend Playbook(AL), Chapter 7

That said, if the current or historical ROE is more than 25% to 30%, then consider using a lower ROE as it is unrealistic for a company to maintain such a high ROE in the very long-term.

Another factor to consider is moat deterioration. If the moat is deteriorating, then you'll need to make an adjustment to lower the projected future ROE.

For Bank of Nova Scotia, I decided on a **projected ROE of 14%.** In 2018 Q3, Bank of Nova Scotia's ROE was 14.5% and its medium-term financial objectives include a 14%+ ROE.

*Source: Bank of Nova Scotia Investor Presentation Third Quarter 2018*

Looking back over the past decade, a 14% ROE looks reasonable if not a little conservative with 5- and 10-year averages of 15.1% and 16.5% respectively.

###
**Core growth estimate**

Core growth is the hardest to estimate, but Mr. Peters recommends starting with a building blocks approach with broader trends and being conservative as this estimate can have a large impact in the DDRM.

"I try to tie my expectations to broader trends - the growth of the U.S. population, inflation, regional economic growth, and so forth - whatever might be influencing the expansion potential for the business at hand." -

Josh Peters,The Ultimate Dividend Playbook(AL), Chapter 7

For Bank of Nova Scotia, I came up with a **core growth estimate of 5.0%**.

Canadian and US future economic growth is estimated to be around 1.5% to 2.5% (Future real gross domestic product (GDP) growth. *Sources:* *Knoema (Canada)** & **Knoema (US)**))*.

Add in 2% inflation and we are up to 3.5% to 4.5%.

And finally, I decided to bump it up to 5.0% because Bank of Nova Scotia has material operations in higher growth Pacific Alliance countries like Mexico, Peru, Chile, and Colombia.

*Source: Bank of Nova Scotia Investor Presentation Third Quarter 2018*

The 5% core growth estimate also happens to match Value Line's 3-5 year loans growth estimate.

*Source: August 10, 2018, Bank of Nova Scotia Value Line report*

Note that Value Line only gives 3-5 year estimates, and for our core growth estimate, we want to think longer term than this. If you thought growth was going to drop off after 5 years, then this 5% wouldn't be a good estimate and would need to be lowered.

**Free growth estimate**

Free growth is earnings growth that doesn't require reinvestment. This is pretty rare, so in most cases, this will be left at 0%. The example given in the book is a property-owning REIT that has contractual rent increases leading to 2% annual earnings gains without additional capital investment.

For Bank of Nova Scotia, I left the **free growth estimate at 0.0%**.

**Elements of the DDRM**

Now that we've gone over the six inputs, let's look at some of the elements of the DDRM (in red and black boxes below).

**Cost of growth**

The cost of growth calculation is an estimate of how much the company has to spend on a per share basis in order to continue to grow.

In Bank of Nova Scotia's case, roughly 36% (2.52/7.05) of EPS is needed to fund growth.

**Funding gap**

The funding gap calculation shows the amount of money left over after growth and the dividends are paid for.

It can be a positive or negative number. If the funding gap is positive, then there is money left over that could be used to buy back shares. If it is negative, then it implies that the company will have to issue more shares to fund growth.

**Share change**

The share change calculation shows how much of an impact the funding gap is going to have on dividend growth.

###
**Dividend growth**

The share change is added to the free and core growth estimates to estimate future dividend growth.

Using our six inputs has resulted in a **future dividend growth estimate of 6.6% for Bank of Nova Scotia**.

**Total return**

Going back to the equation "Dividend Yield + Dividend Growth = Prospective Return", we can see that the **total return estimate for Bank of Nova Scotia is 11.3%**.

And that's how the DDRM works!

### Excel DDRM Spreadsheet

I've included my DDRM spreadsheet for download here: Dividend Drill Return Model (DDRM).

I left the Bank of Nova Scotia figures used in this article in the spreadsheet, so just remember to adjust the inputs to the company you are assessing.

**DDRM Limitations**

Now that you understand how the DDRM works, let's talk about some of its limitations.

The **first limitation** is that the DDRM is based on the Gordon Growth Model.

"The Gordon Growth Model doesn't work particularly well for companies with low dividend yields (less than 2 percent), high dividend growth rates (greater than 7 percent), or firms with a wide range of potential growth rates. But for mature businesses with safe, decent yields and predictable growth, this formula can work very well indeed." -

Josh Peters,The Ultimate Dividend Playbook(AL), Chapter 8

The **second limitation** is its reliance on high-quality estimates. Four of the six inputs (EPS, ROE, core growth, and free growth) are estimates. Make a mistake here and you could end up with unreasonable dividend growth and total return expectations.

The **third limitation** is that the "dividend yield + dividend growth = total returns" formula assumes that a single reasonable dividend growth rate is used in perpetuity.

"To work, one must presume that the current dividend is sound and the dividend growth rate will remain stable into the indefinite future. However, if the stock price rises at roughly the rate of the dividend over time, we can use this approach to forecast total returns over time horizons shorter than forever. I generally use a five-year view." -

Josh Peters,The Ultimate Dividend Playbook(AL), Chapter 7

This requirement to find a single dividend growth rate suitable for a 5-year or more period is also why the DDRM is...

..."not particularly well suited to deeply cyclical firms, whose earnings power and even dividend rates will vary widely from year to year. It's also not suited for emerging-growth stories. But for the ranks of relatively consistent, mature, moat-protected stocks […] we can use the dividend as a critical selection tool." -

Source:Morningstar Investing Classroom - The Dividend Drill(If you want to learn a bit more about the DDRM, this link is worth checking out).

**How to mitigate DDRM limitations**

For the first and third limitations, it comes down to awareness. So long as you are aware that the DDRM won't be as reliable for stocks with volatile earnings, yields under 2% or dividend growth rates above 7% and you avoid or limit your use of the DDRM in these scenarios, you should be OK.

The second limitation is harder to mitigate as no one can predict the future.

Estimates will always be flawed, but by running the DDRM for multiple scenarios, you can at least get a better overall picture with a range of expectations.

I ran the DDRM again using core growth and ROE estimates that were plus or minus 2% of my original 5% core growth and 14% ROE estimates. Depending on how reliable you think your estimates are, you would adjust the +/- 2% up or down. The less reliable your estimates, the wider range of expectations you should have.

In our example, we are left with a **dividend growth range of 5.6% to 7.8%** and **total returns ranging from 10.4% to 12.5%** for Bank of Nova Scotia.

While the DDRM has its limitations, I still think **it can be a useful tool for assessing higher yield, high quality, relatively consistent, and mature dividend growth stocks.**

It also works well as a comparison tool when trying to figure out which of two or more stocks you want to invest in.

**Observation: Quality matters**

High-quality companies that have sustainable competitive advantages usually have higher ROEs. We learned from our DDRM Bank of Nova Scotia example that a higher ROE translates into higher dividend growth and total returns. This is just another reason why it is important to focus on quality companies when investing for the long-term.

"All else being equal, a corporation with a high ROE is going to do a better job of increasing its dividend than one with a low ROE, so evaluating and monitoring a company's competitive position (economic moat) is essential." -

Josh Peters,The Ultimate Dividend Playbook(AL), Chapter 3

**Summary**

"Dividend Yield + Dividend Growth = Prospective Return" -

Josh Peters,The Ultimate Dividend Playbook(AL)

While this formula looks simple, the Dividend Growth part can be tricky. Guessing a reasonable future dividend growth rate is hard, but the Dividend Drill Return Model (DDRM) can help with this process.

With six inputs (Price, dividend, EPS, ROE, core growth, and free growth), you can use the DDRM to estimate dividend growth and total returns.

We estimated dividend growth of 6.6% and total returns of 11.3% with our Bank of Nova Scotia example.

Because of its reliance on estimates, it is recommended to run the DDRM for multiple scenarios to get a better overall picture with a range of expectations. For Bank of Nova Scotia, we came up with a **dividend growth range of 5.6% to 7.8%** and **total returns ranging from 10.4% to 12.5%.**

Having a range of estimates is better, but there are still some DDRM limitations. This is why it is better to limit your use of this tool to assessing higher yield, high quality, relatively consistent, and mature dividend growth stocks.

No one can predict the future, so it is important to take these DDRM estimates exactly as they are, as **ESTIMATES**. While estimates may not accurately predict the future, they can help with decision making and creating a framework to help pick investments that meet your needs.

I see the DDRM as a useful tool when comparing multiple dividend growth stocks in order to determine which one is best suited to your needs.

Despite its limitations, *"for mature businesses with safe, decent yields and predictable growth, this formula can work very well indeed." - Josh Peters*

*Disclosure: I own shares of Bank of Nova Scotia. You can see my portfolio **here**.*