Ch 7 - Stock Valuation (and Equity Markets)

Three reasons that common stock is difficult to value

1. Not even the promised cash flows are known in advance

2. Life of the investment is essentially forever because common stock has no maturity

3. There is no way to easily observe the rate of return that the market requires

What is a “Zero Growth” stock?

A share of common stock in a company with constant dividends, much like a share of preferred stock.

• Because the dividend is always the same, the stock can be viewed as an ordinary perpetuity.

Zero Growth: per-share value (formula)

P0 = D / R

What is a “Constant Growth” stock?

A share of stock that is always growing at a steady rate

Formula: next dividend of constant growth

Dt = D0*(1+g)^t

An asset with cash flows that grow at a constant rate forever is called …

a growing perpetuity

What is the model to calculate the price of a constant growth rate stock?

Dividend growth model

Formula: Dividend growth rate

Pt = (Dt+1)/(R-g)

What condition needs to be met in order for the dividend growth rate model to be applied?

R > g → required return rate must be > than the growth rate

What is the value of a stock?

The present value of all the future dividends

Dividend Yield formula

D1/P0

How to solve for require return rate:

Start with dividend growth model and rearrange to solve for R

• R = (D1/P0) + g

What is the dividend growth rate? What is another synonym?

the rate at which the stock price grows. It is also “capital gains yield” → rate @ which the value of the investment grows. “price appreciation” is also another term.

How does the growth model calculate total return as?

“Total return”:

• R = Dividend yield + Capital gains yield

• R = (D1/P0) + g

  • This will be a % or a decimal

Formula for stock price using PE ratio

Pt = Benchmark PE ratio * EPSt

What type of PE ratio is based on estimated future earnings?

forward PE ratio

Another term for forecast prices

target prices

What ratio to use when company is not profitable yet (negative earnings)?

Price-sales ratio

• Pt = P/S ratio * Sales per share

• OR:

  • Market Cap = P/S * Total Sales → Price per Share = Market Cap / Shares Outstanding

Common stock features

• no special rules either in paying dividends or bankruptcy

Shareholder rights

• shareholders elect directors who then hire management

• shareholders control corporation through the right to elect directors

How is dividend described?

In terms of $’s per share.

• Ex: $5 preferred = dividend yield of 5 percent of stated value

Two types of dividends payable on preferred stock

cumulative or noncumulative

• most are cumulative

What is it called when preferred dividends are cumulative and are not paid in a particular year?

“arrearage”