Most investors in risky assets expect a positive return on their investments. Aggressive traders want a high return in a short time while conservative, long-term investors look for a return higher than a bank deposit or government bond.

Canadian Edge readers may have noticed we started publishing fair values for our Dividend Champions last October. We define fair value as the maximum price an investor could pay for the shares of a particular company and still receive a reasonable return in five years or more.

A reasonable return depends on the risk that an investor assumes by investing in a particular stock. The starting point is always the return on a risk-free asset (say, long-term government bonds) before adding a risk premium linked to the risk profile of the particular investment. No investor should buy a stock if there isn’t a realistic chance of getting this return.

Based on historical market precedent, we use a risk-free rate of 3% and a market risk premium of 6% for Canadian stocks. Risk premiums for individual stocks are then determined based on the risk of any stock relative to the overall market. This, in essence, is also the gist of the capital-asset-pricing model, the brainchild of Nobel prize winners in economics.

Without going into too much detail, here’s a simple example of how to estimate the required return for one of our Dividend Champions. BCE (TSX: BCE, NYSE: BCE) is a high-quality company with a sound balance sheet, good cash flow and a relatively stable income stream. Compared to the overall stock market, the risk of investing in BCE is considered lower—let’s say 70% of the total equity market risk.

The required annual return on BCE is therefore calculated as the risk-free rate for a long-term investment (3%) plus the required risk premium for the Canadian stock market (6%) adjusted for the relative risk of BCE compared to the overall market (0.7). The required return on BCE is:

Required Return = 3% + (6% * 0.7) = 7%

This is the first part of our fair value estimate.

The second part requires that we estimate future dividend payments for each company. Generally, we estimate dividend payments three years into the future and then make an assumption about the long-term growth rate. The dividends are then discounted back to their present value by using the required rate of return, also called the discount rate. This is our first estimate of fair value.

We use several other methods, including the Gordon growth model, to check how realistic that estimate is.

To show how our system works in practice, we’ve included several key figures for some of our top Dividend Champions in the table entitled “Coming Up With a Fair Value.” A few points about the table are worth noting:

The first column after each listed company indicates the return that investors should demand from the investment. Note that companies with lower-risk profiles, such as the utility Fortis (TSX: FTS, OTC: FRTSF) and the telecommunications company BCE, have lower required returns while the higher-risk companies, such as Potash Corp. (TSX: POT, NYSE: POT), have higher required returns.

The second column lists the expected annual dividend growth between 2015 and 2017. This is important information but not the only dividend growth estimate we use to calculate a fair value. We also estimate the long-term dividend growth for each company beyond 2017 to complete the calculations.

The last column shows the current stock price divided by the fair value expressed as a percentage. Where the ratio is above 100%, the stock is relatively expensive compared to our fair value estimate, as is the case with Canadian National Railways (TSX: CNR, NYSE: CNI) at 101%. With a ratio of 74%, Potash Corp., on the other hand, is relatively cheap compared to its fair value.

Fair value estimates are sensitive to changes in the assumptions made for the required return and dividend growth. Although we try to make conservative assumptions, we never base our decisions on valuation alone. Perhaps this is part of the art of investing because even if a valuation indicates a cheap stock, we still may not invest for no other reason than a gut feeling.