What is ERR?
In the case of stocks, expected rate of return (ERR) is a formula used to forecast the future return on investment from a stock purchase -- which includes income from both equity and dividend growth.
How to Calculate Expected Return of a Stock
To calculate the ERR, you first add 1 to the decimal equivalent of the expected growth rate (R) and then multiply that result by the current dividend per share (DPS) to arrive at the future dividend per share. You then divide the future dividend by the current price per share (PPS) and then add the decimal equivalent of the expected growth rate to get the ERR.
For example, if a stock had a dividend of $1.50, a price per share of $60.00, and an expected growth rate of 10%, then the expected rate of return would be 12.75%, computed as follows:
ERR = ((1.50(1 + .10)) ÷ 60) + .10
ERR = ((1.50(1.10)) ÷ 60) + .10
ERR = (1.65 ÷ 60) + .10
ERR = .0275 + .10
ERR = .1275
ERR = 12.75%
Please note that the ERR formula is based on the dividend growth model, which assumes that dividends will be paid and that both the dividends and the company will grow at a constant rate. Of course, neither of these assumptions will likely hold true in the real world.
What is Expected Rate of Return Useful For?
Since ERR is based on assumptions that rarely hold true, most investors use ERR to compare the potential returns of one stock investment with another. After all, the growth rate figure used in the ERR formula does account for the actual historical growth of a company's earnings per share. Therefore, using ERR to compare potential returns of investing in one company over another makes more sense (at least to me) than using a high expected rate of return as the sole reason for buying shares in a particular stock.
The bottom line is, all methods of forecasting the potential return on investing in stocks are simply methods of making educated guesses. Sure, the better your educated guesses, the more you increase the odds that you will achieve a fair return for the risks you are taking. But there is no way to guarantee that some unforeseen event won't cause you to lose your principal in a short period of time.