Chapter 7 Valuing Stocks Review for Exam Fina 3301

Lock in Twin

Common Stock

Equity security representing ownership in a corporation; holders have voting rights and potential for dividends.

Residual Claimants

Common stockholders who receive cash flows only after all other obligations (like debt payments) are met.

Stock Value Influences

– Company profitability
– Growth potential
– Current market interest rates
– Conditions in the overall stock market

Stock Market

A marketplace where shares of publicly traded companies are bought and sold.

Liquidity

The ability to quickly convert an asset into cash without significant value loss; stock exchanges provide liquidity.

Stock Index

A measurement of the value of a section of the stock market; used to track performance trends.

Dow Jones Industrial Average (DJIA)

A price-weighted index of 30 major U.S. companies, representing ~30% of U.S. stock market value.

S&P 500 Index

Market cap-weighted index of 500 large U.S. companies, covering ~80% of total U.S. stock market value.

Nasdaq Composite Index

Market cap-weighted index of all stocks listed on the Nasdaq exchange; heavily tech-weighted.

Bid Price (Stocks)

The price at which the market maker is willing to buy the stock.

Ask Price (Stocks)

The price at which the market maker is willing to sell the stock.

Bid-Ask Spread

The difference between the bid and ask prices; represents profit margin for the dealer.

Market Order

Order to buy or sell a stock immediately at the best available price.

Limit Order

Order to buy or sell a stock at a specific price or better.

Example (Limit vs. Market Order)

If Amazon's bid price is $37.79 and ask price is $37.85:
– Market buy order would execute at $37.85
– Limit sell order at $37.75 would not execute until price increases

Basic Stock Valuation Model

P0 = D1/(1+r) + (D2 + P2)/(1+r)^2

Dividend Discount Model (DDM)

Values a stock based on the present value of expected future dividends.

Constant Growth Model (Gordon Growth Model)

P0 = D1 / (r - g)(where D1 is next year's dividend, r is required return, g is constant growth rate)

Gordon Growth Model Assumptions

– Dividends grow at a constant rate forever
– Required return (r) > growth rate (g)

Example (Gordon Growth Model)

D0 = $4.00, g = 9%, r = 14%
D1 = D0 × (1+g) = $4.36
P0 = 4.36 / (0.14 - 0.09) = $87.20

Preferred Stock

A hybrid security with fixed dividend payments and no voting rights; behaves like perpetuity.

Preferred Stock Valuation

P0 = D / r
(for preferred stock with fixed dividend and no growth)

Example (Preferred Stock)

Dividend = $2.00, Required return = 6.5%
P0 = 2 / 0.065 = $30.77

Expected Return (Stocks)

r = (D1 / P0) + g
(dividend yield + capital gain yield)

Capital Gain

Increase in stock price; a portion of total return.

Dividend Yield

D1 / P0

Total Expected Return

Expected return = Dividend Yield + Capital Gain Yield

Variable (Nonconstant) Growth Model

Used when a firm grows at different rates in different periods (e.g., high growth first, then stable growth).

Example (Two-Stage Growth Model)

D0 = $5.00, g = 10% for 3 years, then 4% forever, r = 9%
Step 1: Calculate dividends for high-growth period
Step 2: Calculate P3 using Gordon Model
P3 = D4 / (r - g)
Step 3: Find P0 by discounting all cash flows

Nonconstant Growth Example Result

P0 = $122.17 (based on calculations in slides)

P/E Ratio (Price to Earnings)

P/E = Current Stock Price / Earnings Per Share (EPS)

High P/E Stock

Indicates expectation of high future growth; called "growth stock."

Low P/E Stock

Considered "value stock"; may be undervalued or slow growth.

Using P/E to Estimate Future Price

Pn = (P/E) × En
(where En = expected earnings in year n)

Example (P/E Valuation)

Caterpillar P/E = 12.98, EPS = $5.05, g = 12.8% for 5 years
Earnings to year 5 = 5.05 × (1.128)^5
P5 = (12.98) × E5