FINA3010 Session3

FINA 3010: Financial Markets
Session 3: Stock Market 1

Chanik Jo
Assistant Professor of Finance
Stock Market 1 1/62

Overview of the course
I Session 1. Introduction of Financial Markets
I Session 2, Bond Market
I Session 3, 4 Stock Market
I Session 5. Mutual/Hedge Funds and ETFs
I Session 6. Midterm
I Session 7. Asset Allocation
I Session 8. Multi-factor models
I Session 9. Option Market
I Session 10. Market Efficiency
I Session 11. Green Finance
I Session 12. Final Exam
Stock Market 1 2/62

Review of the last session
I What is a return for bonds?

I Holding period return
I Yield to Maturity: Definition, relationship with price, and duration
I Term Structure
I Introduction
I Identification: How to observe the term structure?
I Data
I Why is this important?
I Term Spread
I Spot rate VS Forward rate
I Arbitrage opportunity
Stock Market 1 3/62

Overview of This session
I How to run a regression for optional presentations
I What is a stock?
I Definition
I Types of stocks: common vs preferred, size, book-to-market, and industries
I How to invest?
I Valuations
P1 Dt
I Pequity = t=1
(1 + re )t
I Discounted Cash Flow valuation: No growth, constant growth
I How to determine the discount rate and growth rate.
I Stock valuation using multiples.
I Applications of the valuation model
I Application 1. NPVGO model
I Application 2. Model-implied discount rate
I Application 3. Duration of stocks
Stock Market 1 4/62

What is a Stock?
I Before talking about the definition of stocks, do you remember stocks VS bonds?
I Definition: stocks (also known as equities) represent ownership interests in the firm
(although it is a tiny piece of the firm)
I Stocks have no specified maturity date (infinitely lived)
I If you buy a stock, you can receive cash in two ways

1. when the company pays dividends
2. when you sell your shares
Stock Market 1 5/62

What is a Stock? Types of stocks
1. Common stock
I Represents residual claim on the firm’s cash flows: common shareholders get paid
after everyone else is paid.
I Can receive dividends at management’s discretion
I Elect a board of directors, which chooses top management.
2. Preferred stock
I Receives fixed dividend payments before common stockholders.
I Dividends can be skipped but any skipped dividend must be paid in full in the future.
I Usually preferred stockholders have no voting rights.
I Somewhat similar to bonds.
Q: Why would invest in preferred stocks instead of common stocks?
Stock Market 1 6/62

List of Preferred stocks in the US
Stock Market 1 7/62

Example: Bank of China
Stock Market 1 8/62

What is a Stock? Types of stocks - size
Largest cap as of Jan. 19 2023
https://companiesmarketcap.com/usa/largest-companies-in-the-usa-by-market-cap/
Stock Market 1 9/62

Largest cap as of Jan. 18, 2022, HKSE market cap: 47T HKD
https://www.tradingview.com/markets/stocks-hong-kong/market-movers-large-cap/
Stock Market 1 10/62

US data from 1926

US data from 1988
Q: Between small and large stocks, can you tell which one is more volatile?

What is a Stock? Types of stocks - B/M
US data from 1926

What is a Stock? Types of stocks - B/M
US data from 1988

What is a Stock? Types of stocks - industries
US data from 1988
Rank by average returns

mean std SR
Electrical Equipment 1.29% 6.33% 20.39%
Personal and Business Services 1.27% 6.08% 20.84%
Business Equipment 1.25% 7.23% 17.22%
Tobacco 1.24% 6.52% 19.09%
Recreation 1.22% 6.77% 18.02%
Automobiles and Trucks 1.22% 8.29% 14.68%
Rank by Sharpe ratio

mean std SR
Healthcare 1.11% 4.37% 25.35%
Retail 1.21% 4.97% 24.37%
Food 0.97% 4.02% 24.17%
Beer & Liquor 1.15% 4.77% 24.16%
Consumer Goods 0.95% 4.11% 23.12%
Meals 1.13% 4.96% 22.73%

What is a Stock? Types of stocks - Cyclical VS Defensive
I Cyclical Stocks
I Businesses are sensitive to economic trends.
I Stock prices are very volatile.
I Example: automobile, travel and leisure, banks, furniture, high-end clothing
retailers.
I Defensive Stocks
I Businesses are stable over business cycles.
I Cash flow is very stable, and they tend to pay high dividends.
I Examples: utilities, food, beverages, drugs, and insurance sectors.
Q: When do you think cyclical stocks perform better than defensive stocks?

What is a Stock? Types of stocks - Cyclical VS Defensive
Monthly industry returns volatility from 1988
Industry vol Industry vol

Utilities 3.91% Personal and Business 6.08%
Services
Food 4.02% Construction 6.13%
Consumer Goods 4.11% Oil 6.17%
Healthcare 4.37% Aircraft, ships, and 6.18%
railroad equipment
Wholesale 4.73% Apparel 6.25%
Beer & Liquor 4.77% Electrical Equipment 6.33%
Paper 4.86% Fabricated Products 6.44%
Meals 4.96% Tobacco 6.52%
Retail 4.97% Recreation 6.77%
Communication 5.01% Business Equipment 7.23%
Transportation 5.33% Mines 7.72%
Other 5.39% Textiles 8.15%
Finance 5.54% Steel 8.25%
Chemicals 5.64% Automobiles and Trucks 8.29%
Books 5.76% Coal 12.07%

What is a Stock?, Types of stocks
Other characteristics
I Value: Stocks that are considered to be undervalued by the market and are typically characterized
by a low price-to-earnings ratio, high dividend yield, and low price-to-book ratio.
I Growth: Stocks that have higher-than-average earnings and revenue growth, often at the expense
of current income.
I Momentum: Stocks that have had strong recent price performance and are expected to continue
to do well in the near future.
I Liquidity: Stocks that can be easily bought and sold without a↵ecting their price.
I Dividend Yield: A financial ratio that shows how much a company pays out in dividends each
year relative to its stock price.
I Beta: a measure of a stock’s volatility in relation to the overall market.
I Market capitalization: The total value of a company’s outstanding shares of stock.
I P/E ratio: The ratio of a company’s stock price to its earnings per share.
I Price-to-book ratio: The ratio of a company’s market capitalization to its book value.
I Return on equity: A measure of a company’s profitability that calculates how much profit a
company generates with the money shareholders have invested.

What is a Stock?, Stock index
S&P 500
I Value-weighted (eg. S&P 500) vs. price-weighted (eg. DJIA)
I Broad-based index vs sector indices.
I “Widely regarded as the best single gauge of the U.S. equities market, this world-renowned index
includes 500 leading companies in leading industries of the U.S. economy.” (Standard & Poors
website)”
I Represents approximately 75% of US market cap
I Important benchmark for portfolio managers
I Does not include dividends.

Dow Jones Industrial Average
I A stock market index that measures the performance of 30 large, publicly traded companies listed
on the stock exchange in the United States.
I It is one of the oldest (1896), and is often used as a benchmark for the overall performance of the
U.S. stock market.
I The DJIA is calculated by taking the sum of the prices of the 30 stocks and dividing it by a
divisor, which is adjusted to account for stock splits and other corporate actions.
I The DJIA is often reported in the media as a barometer of the stock market’s overall health.
I Does not include dividends.
Which index does make more economic sense?


What is a Stock?, How to buy?
I You can use brokerage companies: Interactive Brokers, HSBC, Charles Schwab, Webull
I Things to consider: commission fees, tax, auto-deposit feature, etc

Stock Valuation
I How to determine the value of a stock?

I Previously
P
I P= T CFt
t=1 (1+r )t
P C F
I Pbond = T t=1 +
(1 + rt )t (1 + rT )T
P
I Pstock = 1 Dt
t=1 (1+re )t
I How is it di↵erent from bonds?

Stock Valuation, Why Is It Important?
I Why do investors care about stock valuation?
I Investors want $$$.
I Why does a company care about its stock price and valuation?
I CEOs or firms own their own stocks (e.g, stock buyback).
I Companies don’t want to disappoint their investors.
I Stock is an important and often the largest component of an investment portfolio.
I Equity valuation allows you to determine if a stock is undervalued or overvalued and
thus invest your money smartly.
I We need a way to value stocks in order to:
I conduct a merger or acquisition.
I take your company to the public.
I Equity valuation is probably one of the most exciting and least certain areas of finance.

Stock Valuation, How Is the Price of a Stock Determined?
I You own a share of stock today that is worth P0 . What do you get for holding it for
one period? 0 1
I dividend: D1
I proceeds from selling it: P1 D1 + P 1
I Price today is the present value of expected future cash flows (it is unknown as of
today)
D1 + P 1
P0 =
1 + re
where re is the appropriate discount rate
I Is discount rate re larger or smaller than the one used for government bonds?
I Why did we not take D0 into account?
I re = D P1
P0 + P0
1
1: required returns = dividend yield + capital gain yield.

Stock Valuation, Discounted Cash Flow
I What is the price of the stock next period, P1 ?
D2 + P2
P1 =
1 + re
I Let’s substitute this equation for P1 into P0 formula

✓ ◆
D2 + P2
D1 +
1 + re D1 D2 P2
P0 = = + +
1 + re 1 + re (1 + re )2 (1 + re )2
I We can repeat this for P2 , then for P3 , etc. and get
X 1
D1 D2 D3 Dt
P0 = + 2
+ 3
+ ... =
1 + re (1 + re ) (1 + re ) t=1
(1 + re ) t

I So stock price = PV of expected dividend payments, and we can use the time value of
money techniques to value stocks that pay
I Dividends growing at a zero rate
I Dividends growing at a constant rate
I Dividends growing at di↵erent rates at di↵erent times
" ✓ ◆T #
C 1+g
I Recall ‘Growing Annuity’: PV = 1
r g 1+r
I Here, C = Dividend

Case 1: Zero Dividend Growth
I If you invest, you will get the same amount of dividend at the end of every year.
I That is, D1 = D2 = D3 = ...

D D D
P0 = + 2
+ + ...
1 + re (1 + re ) (1 + re )3
 ✓ ◆1
D 1+0 D
= 1 =
re 0 1 + re re

I Consider Coca-Cola Company (NYSE: KO):

I dividend per share: $1.64 in 2020
I Assume that the firm will keep paying the same dividend forever
I estimate that the appropriate discount rate is re = 6.23%
I CAPM R =rf + betaKo (E (Rm ) rf ) =0.0156 + 0.71 * 0.0658 = 0.0623
I What should the per-share price of the company be today?
1.64
P0 = = $26.32
0.0623
VS the actual price was $61.39 (as of Jan. 18, 2022)

I If we do the same for Lockheed Martin (NYSE: LMT) - $9.8, re = 7.68%, we would get
9.8
P0 = = $127.60
0.0768
VS the actual price was $372.62 (as of Jan. 18, 2022)
I Why are we so far o↵?

Coca-Cola and Lockheed Martin Dividends

Case 2: Constant Dividend Growth
I Almost all dividend-paying companies grow their dividends.
" ✓ ◆T #
C 1+g
r g 1+r
I If we assume that dividends will grow at a constant rate g forever, we can apply the growing
perpetuity formula
D0 (1 + g ) D1
P0 = =
re g re g

" ✓ ◆T #
C 1+g
r g 1+r
perpetuity formula
D0 (1 + g ) D1
P0 = =
re g re g
I This is known as the Gordon Growth Model

" ✓ ◆T #
C 1+g
r g 1+r
perpetuity formula
D0 (1 + g ) D1
P0 = =
re g re g
I This is known as the Gordon Growth Model
I It provides a great insight into why a stock price changes.

I Cash flow: a change in D leads to a change in P.
I Discount rate: a change in re leads to a change in P.
I Why do stock prices decline during the recession?

I Using the recent 3 years dividend growth rate

- Coca Cola: 2.32% per year
- Lockheed Martin: 0.97% per year
D1 1.64 · 1.0232
P0,Coca Cola = = = $42.92 (vs. $26.32 no growth, $61.39 in the real data)
re g 0.0623 0.0232
D1 9.8 · 1.0097
P0,Lockheed martin = = = $147.47 (vs. $127.6 no growth, $372.62 in the real data)
re g 0.0768 0.0097
I Is constant dividend growth assumption reasonable?

Coca-Cola and Boeing Dividend Growth

Firms’ life cycle

Case 3: Di↵erential Dividend Growth
I Dividends tend to grow at di↵erent rates depending on where the company is in its life cycle, the
economy, availability of positive NPV projects, cash flow uncertainty, etc.
I So it may be more realistic to use a di↵erential (rather than zero or constant) dividend growth
approach.
I Practically, we estimate dividends as precisely as possible in the foreseeable future, and assume a
constant growth rate thereafter:
D1 D2 DT DT (1 + g ) 1
P0 = + + ... + +
1 + re (1 + re )2 (1 + re )T re g (1 + re )T
| {z } | {z }
Precise valuation for short-term dividends Growing perpetuity

I Consider the following firm:
I current dividend: $2 per share
I dividend is expected to grow at 8% for 3 years, then it will grow at 4% in perpetuity
I Stocks of similar risk earn 12% e↵ective annual return
I Price is the sum of the present value of two cash flow streams: a growing annuity and a growing
perpetuity
0 1 2 3 4 5
.....
2 · 1.08 2 · 1.08 2
2 · 1.08 3 3
2 · 1.08 · 1.04 2 · 1.08 · 1.042
3
Dividend in 1 yr Dividend in 4 yrs

z }| { z }| {
✓ ◆3 !
$2 · 1.08 1.08 $2 · 1.083 · 1.04 1
P0 = 1 + = $28.89
0.12 0.08 1.12 0.12 0.04 1.123
| {z } | {z }
Value of perpetuity in 3 yrs
PV of 3-year annuity | {z }
Value of perpetuity today
Why did we not take the $2 dividend that the firm just paid into account?

I Your turn:
I the company paid a dividend of $4.00 to its stockholders
I the dividend will grow at 18% over the next 2 years
I after 2 years, the dividends will grow at 10% for 2 years
I after that, dividends will be constant (growth rate of 0%)
I assume a required rate of return of 10%
I What is the price of one share of this stock?
$ 64 .
13

Key Parameters
I Estimated price is very sensitive to small changes in our parameters: discount rate re
and dividend growth rate g
2.00
I For example, if D1 = 2.00, re = 10% and g = 5%, then P0 = = 40.00
0.10 0.05
I If re or g misestimated by just ±1%, the theoretical price could be:
2.00
I as low as P0 = = 28.57 or
0.11 0.04
2.00
I as high as P0 = = 66.67
0.09 0.06
I Where do re and g come from?

Estimating the Dividend Growth Rate
1. The simplest way to get g is to use the historical dividend growth rate
I e.g., average g over the last five years
2. The slightly less simple way is to estimate it as
g = Retention Ratio · ROE
where ROE is the return on equity.
Total Dividends
Retention Ratio = 1 Dividend Payout Ratio = 1
Net Income
Net Income
ROE =
Common Equity

Sales
-Cost of Goods sold (COGS)
Gross profit
-Operating expenses (SG&A)
Operating income (EBIT)
-Interest expenses
EBT
- Tax
Net income
I Net income is either paid out to shareholders as dividends or re-invested for the growth of a
company.
I EPS = Earnings Per share = Net income / # of shares outstanding.
I DPS = Dividend Per share = Net income ⇥ Dividend Payout ratio / # of shares outstanding.

g = Retention Ratio · ROE
I If Retention Ratio (RR) = 0, dividends cannot be bigger. For companies to grow, they
need money to invest (marketing, facilities, hiring, etc.)
I If ROE = 0, Net income = 0, there is no income left for a company to pay dividends.

Estimating the Discount Rate
I Estimating the discount rate in practice is tricky...
I Several methods exist:

1. Average historical returns of matching companies (same industry, similar size,
similar risk, etc.)
Issues: usually quite noisy measures
2. Better alternatives: Capital Asset Pricing Model (CAPM), factor models, etc.
3. Using Gordon’s model
I We’ll talk about this after the midterm.

Stock Valuation, Dividends and Growth Opportunities
I The majority of companies pay no dividends yet in most cases, these firms have a positive value
(e.g. Alphabet)
- so, we need to find a way to value those firms.
I Questions:
1. why do some managers choose to pay dividends?
2. why do some managers choose instead to retain all earnings?
I In general:
- if the firm has better investment/growth opportunities than the shareholder, $1 in the firm is
more valuable than outside, so the firm should retain earnings.
- if instead, the firm makes a sub-optimal decision for the shareholder (agency problem - e.g.
keep the money to buy corporate jet), the firm destroys value and should instead pay out
dividends.
I What is a “better investment opportunity”?

Stock Valuation Application 1, The NPVGO Model
I The Net Present Value of Growth Opportunities (NPVGO) model allows us to measure the value
of a firm’s growth opportunities.
I In general, the value of a firm consists of the sum of
1. Its value for the case where the firm paid out 100% of its earnings as dividends, i.e., the value
of the firm does not invest in growth.
2. The net present value of the growth opportunities.
I How do we value each of these components?
1. What is the stock price of a firm that pays out all its earnings? D1 = EPS1 , g = RR ⇤ ROE = 0
EPS1
PE = ,
re
where EPS1 is the earning per share.

2. The NPVGO is simply the residual, i.e.,
EPS1 EPS1
P0 = NPVGO + , NPVGO = P0
re re
where P0 is the price of the stock.

Stock Valuation Application 1, The NPVGO Model
Example
I Consider a firm with EPS1 = $5 at the end of the first year, a dividend-payout ratio of 30%, a
discount rate of 16%, and a return on equity of 20%
I Dividend in one year will be D1 = $5 · 0.30 = $1.50 per share
I Retention ratio is 1 0.30 = 0.70, so g = 0.70 · 20% = 14%
I From the dividend growth model, the share price is
D1 1.50
P0 = = = $75.00
re g 0.16 0.14
I From the NPVGO model, the share price is
EPS1 5.00
P0 = + NPVGO = + NPVGO ) NPVGO = 75.00 31.25 = $43.75
re 0.16
I The growth prospect accounts for 58.3% (=43.75/75) of the stock value.

Stock Valuation Application 2, Discount rate
Estimating the Discount Rate - Gordon model
I Can we estimate re using the Gordon model?
I We know that price today is
E (D1 ) + E (P1 )
P0 =
1 + re
I E (D1 ) and E (P1 ) are expected next period’s dividend and price and are not known with certainty
today
I We can rearrange this equation to get a model-implied discount rate:
E (D1 ) E (P1 ) P0
re = +
P P0
| {z0 } | {z }
Expected Dividend Yield Expected Capital Gain
I In the constant dividend growth model, we can write
D1 D1
P0 = , which implies that re = +g
re g P0

Estimating the Discount Rate - Gordon model
I In the constant dividend growth model, we can write
D1 D1
P0 = , which implies that re = +g
re g P0
I For P0 , you enter the real price.

I We reverse-engineer the discount rate so that the resulting predictive price is the same as the
market price.
I This is the model-implied required rate of returns for equity.
I By imposing the model into the data, we back out the required rate of returns.

Example
I For example, Hang Seng bank paid a $5.5 dividend over the last year
I ROE = 15.987/172.036 = 0.0929
I RR = 1-5.5/8.16 = 0.326
I g = ROE*RR = 0.0303
I The current price of Hang Seng is $155.5, so the discount rate is
D1 5.5 · 1.0303
re = +g = + 0.0303 = 6.674%
P0 155.5
I This is more conditional expected return, not long-term equilibrium return.

Stock Valuation Application 3, Duration of stocks
I Duration ⇡ dp
dr
I Sensitivity of a security price with respect to a discount rate.
I How quickly can I recover my investment (e↵ective maturity)?
I These two statements are closely related. A price is sensitive to a discount rate because cash
flows are mostly generated in the long future.
PT P
I Macaulay Duration: CFt t
t=1 (1+r )t ⇥ P where P = T CFt
t=1 (1+r )t
I Previous example 6% annual payment, Three years to maturity, YTM 8%, and 1,000 of par.
I Coupon payment = 1,000 ⇥ 0.06 = 60, Bond price = 60 + 60 2 + 1,0603 = 948.46
1.08 1.08 1.08
I Macaulay Duration = 60 1
+ 60 2
+ 1,060 3
= 2.82
1.08 948.46 1.082 948.46 1.083 948.46
I w1 = 60 1
: Importance of CF in year 1
1.08 948.46
I w2 = 60 1
: Importance of CF in year 2
1.082 948.46
I w3 = 1,060 1
: Importance of CF in year 3,
w1 + w2 + w3 = 1
1.083 948.46
I Macaulay Duration = 1 ⇥ w1 + 2 ⇥ w2 + 3 ⇥ w3

I Duration ⇡ dp
dr
I Sensitivity of a security price with respect to the discount rate.
I How quickly can I recover my investment (e↵ective maturity)?
I These two statements are closely related. A price is sensitive to a discount rate because cash
flows are mostly generated in the long future.
PT PT
I Macaulay Duration: CFt
t=1 (1+r )t ⇥ t
P where P = CFt
t=1 (1+r )t
I In Gordon’s model, P = D1
re g = D0 (1+g )
re g
I Duration of stock =
T
X 1
X D0 (1 + g )t t
CFt t
t
⇥ =
t=1
(1 + r ) P t=1
(1 + re )t P

I Duration of stock =
X1 X1 X1
D0 (1 + g )t t D0 (1 + g )t (re g )t (1 + g )t 1
(re g )t 1 + re
t
= t
= =
t=1
(1 + re ) P t=1
(1 + re ) D0 (1 + g ) t=1
(1 + re )t 1 1 + re re g
1 + re
=
D1 /P0
P1
I The second last equality comes from t=1 xn 1
n= 1
(1 x)2 for 0 < x < 1
I If a firm does not pay dividends, the duration is high, meaning that it takes a longer time
to recover your investment.

Example
I Duration of stock = 1+re

re g
I Hang Seng bank: Duration = 1+0.0674

= 28.77
0.0674 0.0303
I Tencent
I ROE = 179.619 / 1110.2267 = 0.1618
I RR = 1- 1.6/23.67 = 0.9324
I g = 0.1618 * 0.9324 = 0.1509
I re = D1 + g = 1.6⇤1.1509 + 0.1509 = 0.155.
P 0 452.4
I Duration = 1+0.1550 = 283.75!
0.155 0.1509
I Tech stocks are growth stocks. Their CF will be generated in the future. They don’t pay
dividends. Of course, duration is high ! Very sensitive to the interest rate.
I Does it mean that it takes 283.75 years to get your money back, so you shouldn’t invest in
Tencent?

Example
CNBC article on Jan. 18, 2022

Example
VUG: Vanguard growth index fund, VTV: Vanguard value index fund

Stock Valuation, Using Multiples
I An alternative to discounted cash flow models is to value a company using some

‘multiple’, or ratio.
I The idea is that comparable companies (e.g., those in the same industry) should have
similar multiples.
I The commonly used multiple is the price-earnings (P/E) ratios: price per share divided
by earnings per share.

Example
I You want to find the stock price of firm ‘A’ that has projected earnings of $3 next
period.
I Suppose you have this information about a similar firm ‘B’:
I Dividend retention ratio is 50%, ROE = 20%
I Appropriate discount is 15%
I First we compute the PE of the similar firm ‘B’:
DB,1 EB,1 ·(1 retention ratio)
PB,0 re g re retention ratio·ROE
PEB = = =
EB,1 EB,1 EB,1
(1 retention ratio)
=
r retention ratio · ROE
(1 0.5)
= = 10
0.15 0.5 · 0.2
I Now we can find the stock price of firm ‘A’:
PEA = PEB ! PA,0 = EA,1 ⇥ PEB = 3 · 10 = $30

I If the price is di↵erent from $30, is there an arbitrage?
P/E as comparable
If you remember nothing else about P/E ratios, remember to avoid stocks with excessively high
ones. A company with a high P/E must have incredible earnings growth to justify its high price.
–Peter Lynch
I Rearranging the NPVGO formula:
P0 1 NPVGO
= +
EPS1 re EPS
|{z} | {z 1 }
cost of capital Growth opportunities per unit of profit
I Thus a firm with a high PE ratio has either:

I Low cost of capital, i.e. a safe firm, or
I Lots of growth opportunities
I Examples of the e↵ects of growth opportunities. PEs of major HK companies:
I Tencent: 20, Alibaba: 19.24, JD.com: 30.05
I HSBC: 13, Bank of China: 3.75

Performance of Portfolios Formed on P/E Ratio
20
19
18
Annual Return, Percent

17
16
15
14
13
12
11
10
9
Low P/E 2 3 4 5 6 7 8 9 High P/E
Portfolios Sorted by Price-Earnings Ratio

Other Multiples
I Book-to-market ratio: book equity value per share/market price per share
I Price-to-sales ratio
I Price-to-cash flow ratio
I Ratio of market value to earnings before interest and taxes
I EV/EBITDA
I EV = Market value of equity plus debt.
I EBITDA = EBIT + Depreciation + Amortization
I Many others.
These valuation multiples are only shortcuts for more fundamental discounted cash flow
valuation.

Let’s criticize what we’ve done.
I What are the problems of the models that we talked about?

A Few Closing Thoughts

Summary
I Basic principle: the value of a stock is the present value of all future cash flows.
I Present value of all future dividends
I Dividend Discount Model
I Zero growth
I Constant growth
I Multi-stage growth
I Estimating r and g
I Net Present Value of Growth Opportunities (NPVGO) Model
I Estimating discount rate using the model
I Duration of stocks
I Using multiples: the P/E ratio

FINA3010 Session3

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FINA3010 Session3

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FINA 3010: Financial Markets

Session 3: Stock Market 1

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I What is a return for bonds?

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I If you buy a stock, you can receive cash in two ways

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Q: Why would invest in preferred stocks instead of common stocks?

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Rank by average returns

Rank by Sharpe ratio

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Industry vol Industry vol

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I Value-weighted (eg. S&P 500) vs. price-weighted (eg. DJIA)

I Broad-based index vs sector indices.

I Represents approximately 75% of US market cap

I Important benchmark for portfolio managers

I Does not include dividends.

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I Does not include dividends.

Which index does make more economic sense?

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I How to determine the value of a stock?

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I Let’s substitute this equation for P1 into P0 formula

I We can repeat this for P2 , then for P3 , etc. and get

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I That is, D1 = D2 = D3 = ...

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I Consider Coca-Cola Company (NYSE: KO):

I What should the per-share price of the company be today?

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I Why are we so far o↵?

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I This is known as the Gordon Growth Model

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I This is known as the Gordon Growth Model

I It provides a great insight into why a stock price changes.

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I Using the recent 3 years dividend growth rate

I Is constant dividend growth assumption reasonable?

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