Stocks and their valuation

A stock whose dividends are expected to grow forever at a constant rate, g. D1 = D0 (1 g)1. 21. Exam type question. Which of the following statements is. PowerPoint PPT presentation

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Title: Stocks and their valuation

1

• Stocks and their valuation
• (chapter 9)

Facts about common stock

• Represents ownership
• Ownership implies control
• Stockholders elect directors
• Directors elect management
• Managements goal Maximize the stock price

Intrinsic Value and Stock Price

• Outside investors, corporate insiders, and

  analysts use a variety of approaches to estimate

  a stocks intrinsic value (P0).

• In equilibrium we assume that a stocks price

  undervalued

• Buy or Sell?
• Stocks with a price above its intrinsic value are

  overvalued

• Buy or Sell?

Dividend growth model

• Value of a stock is the present value of the

  future dividends expected to be generated by the

  stock.

• r s is the required rate of return (think the

  one from CAPM)

Constant growth stock

• A stock whose dividends are expected to grow

  forever at a constant rate, g.

• D1 D0 (1g)1
• D2 D0 (1g)2
• Dt D0 (1g)t
• If g is constant, the dividend growth formula

  converges to

What happens if g rs?

• If g rs, the constant growth formula leads to a

  negative stock price, which does not make sense.

• The constant growth model can only be used if
• rs g
• g is expected to be constant forever

If rRF 7, rM 12, and ß 1.2, what is the

required rate of return on the firms stock?

• Use the SML to calculate the required rate of

  return (rs)

• rs rRF (rM rRF)ß
• 7 (12 — 7)1.2
• 13

If D0 2 and g is a constant 6, What is the

stocks market value?

• Using the constant growth model

What is the expected dividend yield, capital

gains yield, and total return during the first

year?

• Dividend yield
• D1 / P0 2.12 / 30.29 7.0
• Capital gains yield
• (P1 P0) / P0
• (32.10 — 30.29) / 30.29 6.0
• Total return (rs)
• Dividend Yield Capital Gains Yield
• 7.0 6.0 13.0