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Valuing Common Stocks: Fundamentals of Corporate Finance Finansiell Ekonomi Liu 2012
Valuing Common Stocks: Fundamentals of Corporate Finance Finansiell Ekonomi Liu 2012
Div1 P1
Price P0
1 r
The present value of future cash flows from a stock is also called
the Intrinsic value of the stock.
The DCF model: discounted cash flow
method (Dividend Discount Model)
Div1 P1 P0
Expected Return r
P0
Valuing Common Stocks
For a stock with no growth, and assuming the stock
will exist indefinitely, we can value the stock as a
PERPETUITY.
Div1 EPS1
Perpetuity P0
r r
5 110 100
Expected Return 0.15
100
How Common Stocks Are Valued
The price of any share of stock can be
thought of as the present value of the
futures cash flows. For a stock the future
cash flows are dividends and the
ultimate sales price of the stock.
Div1 P1
Price P0
1 r
Present value of one period return
How Common Stocks Are Valued
Example - continued: Blue Sky price can be thought
of as follows.
5 110
Price P0 100
1.15
Valuing Common Stocks
Constant Growth DDM - A version of the
dividend growth model in which dividends
grow at a constant rate (Gordon Growth
Model).
Div1
P0
rg
Given any combination of variables in the
equation, you can solve for the unknown
variable.
Example: valuing stocks
What is the value of the stock that expects to pay a
$3.00 dividend next year, and then increase the
dividend at a rate of 8% per year, indefinitely?
Assume a 12% expected return. (note: suppose that
Blue Sky invested 40% back to the company, the
dividend becomes 5*60%=3.)
Div1 $3.00
P0 $75.00
r g 0.12 0.08
Estimating the Cost of Equity Capital
H
Div t PH
P0
t 1 (1 r ) t
(1 r ) H
How Common Stocks Are Valued
Example
Blue Sky is forecasted to pay a $5.00 dividend at the end of year one and a
$5.50 dividend at the end of year two. At the end of the second year the
stock will be sold for $121. If the discount rate is 15%, what is the price of
the stock?
PV $100.00
How Common Stocks Are Valued
Example
Current forecasts are for Blue Sky to pay dividends of
$3, $3.24, and $3.50 over the next three years,
respectively. At the end of three years you anticipate
selling your stock at a market price of $94.48. What
is the price of the stock given a 12% expected return?
How Common Stocks Are Valued
Example
Current forecasts are for Blue Sky to pay dividends of $3, $3.24, and $3.50
over the next three years, respectively. At the end of three years you
anticipate selling your stock at a market price of $94.48. What is the price
of the stock given a 12% expected return?
PV $75.00
How Common Stocks Are Valued
Estimating the Cost of Equity Capital
Example – A stock was selling for $42.45 per
share at the start of 2012. Dividend payments
for the next year were expected to be $1.68 a
share. What is the dividend yield?
1.68
Dividend Yield
42.45
0.04
Estimating the Cost of Equity Capital
1.68
r 0.061
42.45
r 0.101
Estimating the Cost of Equity Capital
Required Return Measurements
Div 1
Dividend Yield
P0
Div1
Restated P0
rg
Div1
r g
P0
Estimating the Cost of Equity Capital
• Valuing Non-Constant Growth
9.13
Note here the
discount factor is
1/(1+0,1)3
Stock Price and Earnings Per Share
• If a firm chooses to pay a lower dividend, and
reinvest the funds, the stock price may increase
because future dividends may be higher.
8.33
P0 $55.56 g 0.25 0.40 0.10
0.15 5.00
P0 $100.00
0.15 0.10
With growth of the equity, the price of the share
worth more than before! 100-55,56=44,44
Stock Price and Earnings Per Share
Example - continued
If the company did not plowback some earnings, the
stock price would remain at $55.56. With the
plowback, the price rose to $100.00.
$100.43
Tails
$100.00
Heads
$100.43
$97.50
Tails
$95.06
Tails
Random Walk Theory
S&P 500 Five Year Trend?
or
5 yrs of the Coin Toss Game?
180
Level
130
80
Month
Random Walk Theory
S&P 500 Five Year Trend?
or
5 yrs of the Coin Toss Game?
230
Level
180
130
80
Month
Random Walk Theory
Market
Index
1,300
1,200
1,100
Cycles
disappear
once Last This Next
identified Month Month Month
Another Tool
Fundamental Analysts
Investors who attempt to find mispriced
securities by analyzing fundamental information,
such as accounting data and business prospects.
Research the value of stocks using NPV and other
measurements of cash flow
Efficient Market Theory
Efficient Market - Market in which prices reflect all
available information.
34
29
24
19
(%)
14
9
4
-1
-6
-11
-16
Days Relative to annoncement date
Market Anomalies
Existing Anomalies
•The Earnings Announcement Puzzle
•The New-Issue Puzzle
Old Anomalies
•The Small Firm Effect
•The January Effect
•The PE Effect
•The Neglected Firm Effect
•The Value Line Effect
Behavioral Finance
• Attitudes towards risk
• Beliefs about probabilities
Thank you!
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