FIN 105 LT2 Reviewer

Finding the expected stock price t years

- Chapter 10: Stocks and their Valuation
from today

- Chapter 11: Cost of Capital

Step 1: Solve for any missing values

Chapter 10: Stocks and their Valuation
- To solve for g, use the formula for P0

Notes: - P0 = D1 /(rs − g)

- For the marginal investor, P0 must equal P Step 2: Solve for the expected stock price
- Option 1: Use the constant growth model

hat 0

- The growth rate in dividends, g should • Ph att = D0(1 + g)t ÷ (rs − g)

also equal the growth rate in earnings and

- Option 2: Use the future value formula

the stock’s price

• Ph att = P0(1 + g)t

- A stock should be sold if the expected

rate of return is less than the required rate Find the present value of a non constant
of return
growth stock today

Denotations in word problems Step 1: Solve for the dividends of the

- The last dividend that was paid is denoted nonconstant growth stocks
as D0 and is known with certainty
- D1 = D0(1 + g)

- The dividends expected to be paid at the Step 2: Find the present value of the
end of year t is denoted as Dt
nonconstant growth stocks
- The current market price of a stock is - PVD1 = D1 /(1 + rs )1

denoted as P0
Step 3: Solve for the present value for the
- The expected price of a stock at the end constant growth rate
of the year is denoted as P hat 1
- Example: Ph at3 = D4 ÷ (rs − g)

Step 4: Find the present value of the

Formulas constant growth stocks
1. Dividend yield = D1 /P0
- PVPh at3 = D4 ÷ (rs + g)3

2. Capital gains yield = (P1 − P0 )/P0

Step 5: Add all of the dividends to find the
3. Expected total return = D1 /P0 + value of the stock today
(P1 − P0)/P0
- P0 = PVD + PVPh at
4. Final price of a stock =
P0 + (P1 − P0)/P0