long term growth estimates

CFA Level II Equities
#1

Given an equity risk premium of 3.5%, a forecasted dividend yield of 2.5% on the market index and a government bond yield of 4.5%, what is the consensus long-term earnings growth estimate?

Answer: 3.5% - 2.5% + 4.5% = 5.5%

Why do we subtract the forecasted dividend yield in this problem? I get why we’d start at the government bond yield as a baseline but don’t really understand why we take the excess of the equity risk premium over the forecasted divident yield and add it to the government bond yield? Wouldn’t a very large equity risk premium mean that particular market/industry is very risky? I guess I get why that implies long-term growth? Is it that simple? But I really don’t get why the dividend yield factors in…

#2

Total return is growth plus dividends. So growth is total return less dividends.

#3

Dividends paid hampers your growth, i.e. money is taken out of the company and that slows down growth. Think of Berkshire Hathaway stocks. They never paid any dividend and each stock is now trading in excess of $200,000!

#4

thanks!

#5

You’re welcome.