stocks

one period model

investor plans to purchase a common stock and hold it for one period

finite holding period: multiple periods

in multiple period setting, investors will seek to estimate all the cash flows that the stock will generate

weakness of finite model

1. IMPOSSIBLE to predict future selling price

2. dividends are hard to estimate

infinite holding periods

assume that the stock price is to be valued as a prepared stream of dividends… no future selling price is ot be considered in the pricing formula

why might this be reasonable?

• corporations have unlimited life

• stock price = PV of all future dividends

issues with infinite model

1. dividends don’t grow at a constant rate

2. price is very sensitive to g (growth rate)

3. how do we value a firm that does not pay dividends?

3 basic types of stock market transactions

1. primary market: when an existing public firm issues new shares of stock

2. secondary market: when existing shares of public firms are traded

3. ipo market: initial public offering

   1. when a private firm goes public

   2. selling shares (ownership)

   3. ipo’s are more frequent in BULL markets

      1. stock prices increase for extended period of time

      2. bear markets - stock prices decreasing

two phase growth model (non-constant growth model)

pros:

1. don’t assume future selling price

2. Dividends don’t grow constantly forever

cons:

1. still hard to estimate dividends

2. price is still very sensitive to the growth rate

3. how do you value a firm that pays no dividends?

increase in net income for the firm

income > expected

model: NI increases —> dividends increase —> share price increase

increase in sales

sales > expected

model: sales increase —> NI increase —> dividends increase —> share price increases

risk associated with a stock increases

increase risk —> decrease stock price

model: risk increases —> r increases —> share price decreases