4. Equity Valuations Flashcards
What does Pn stand for in the Generalised Dividend Valuation Model?
- (Expected) sale price of the stock at time N.
What does Dt stand for in the Generalised Dividend Valuation Model?
(Expected) dividend paid at time t
What does ke stand for in the Generalised Dividend Valuation Model?
Required return on the equity
How is price of stock determined?
As the net present value of the future dividend stream.
What do we assume in the Gordon Growth Model?
Assume dividends are growing with a constant rate where g is less that Ke^t < (required rate of return)
What does D0 stand for in the Gordon Growth Model
Denotes the most recent dividend paid.
What does g stand for in the Gordon Growth Gordon model?
- Myron J. Gordon is the founder
- Constant growth rate
What are the challenges with the Gordon Growth Model?
- Dividend stream e.g. growth rates, other related measures - consider P/E ratio with the payout rate n such that nEt = Dt, in general
- Required return: starting with CAPM.
What Does P/E stand for?
Price to Earnings
What does E (ri) stand for in the Capital Asset Pricing Model (CAPM)?
Expected return of the asset i.
What does Rf stand for in the CAPM?
- Risk free return.
- Value of time.
What does E(rm) stand for in the CAPM?
Expected return on the market portfolio m
What does beta stand for in the CAPM?
- Sensitivity of asset i’s return to the market return.
Capital Asset Pricing Model
E(ri) = rf + Beta(i)[E(rm) - rf]
Beta and Security Market Line
Check notebook.
What is the security market line?
- Expected return of the stocks is a (linear) function of their beta with the market.
What does it mean if beta is 1.5?
- For every 1% increase in the market excess return, stock I’d return is expected to increase by 1.5% ceteris paribus.
Mean Variance analysis on portfolio selection problem
Assumes that the expected return and risk of a portfolio are measured respectively by the mean and variance (or standard deviation) of the portfolios return.
How can risk of a portfolio be reduced?
- By adding more assets.
What’s the efficient frontier?
Feasible portfolios with highest possible expected return and lowest level of volatility.
Two-Fund Separation Theorem
By introducing a risk-free asset, investors choose their optimal portfolio to combine the risk-free asset with an efficient risky portfolio.
Capital Market Line
Under CAPM, all investors optimally would hold some combination of the risk free security and the market (efficient) portfolio.
CAPM Restrictive Assumptions
- Investors choose portfolio based on the mean and variance of returns.
- Investors are rational and risk averse.
- Investors all invest for the same period of time.
- Investors have homogenous expectations.
- Investors can have unlimited short-sale positions on the risk-free assets.
- Markets are competitive and frictionless.
What does a share of a common stock allow stockholders to do?
- Receive dividends
- Vote
Value of Any Investment
Present value of all future net cash floes generated by the investment.
In GDVM, what does a stock’s value depend on?
- It’s future dividend payments and the required return on equity.
Elements of Gordon Growth Model?
- The expected constant growth of dividends (g)
- Stock’s most recent dividend paid.
- Required return on investments in equity.
Examples of Systematic Risk
- Risk that FED raises interest rates.
- Risk that oil prices rise, increasing production costs.
- Risk that economy slows, reducing demand for firm products.
What will happen to the volatility in a large portfolio?
Will decline as the size of the portfolio increases only the systematic risk remains.
How is risk premium of a security determined?
- By its systematic risk and does not depend on it diversifiable risk.
What happens when stocks are combined in a large portfolio?
- The firm-specific risks for each stock will average out and will be diversified.
Investors holding risky securities
Same proportion as the efficient portfolio, their combined portfolio will also reflect the same proportions as the efficient portfolio.
How is a portfolio risk premium and volatility determined?
- By the fraction that is invested in the market.
