Ch 8 Stock Valuation Flashcards
Why is it hardder to value common stock than a bond?
3 reasons:
1. not even the promised cf are known in advance
2. the life of stock is forever (no maturity)
3. no way to observe the rate of return the market requires
Formula for present value of a stock
P0 = (D1 + P1)/ (1+r)
D1= cash dividend
P1= price in one period
r= requred market rate
What is the flaw with the Present value of stock formula?
you need to know the stock price in one period ahead
you can keep iterating forward and forward but this will only complicate things!
so what IS the point of iterating out the present value of the stock formula?
the price of a stock today is = to the present value of all the future dividends!!!!
Po = D1/ (1+r) + D2/ (1+r)^2 …..
what are 3 cases that we can use to determine the vlaue of a stock
- dividend has zero growth rate
- dividend grows at a constant rate
- dividend grows at a constant rate after some length of time
ZERO GROWTH RATE STOCK
- all dividends are the same, so this is a constant
- this is an ordinary perpetuity
Po = D/r
D: Dividend every period
r: the required return
CONSTANT GROWTH STOCK
dividend growth model
-when dividend is growing at a steady rate (g)
- a stock with dividends growing lik ethis is a GROWING PERPETUTITY
Po = Do x (1+g) / r-g = D/r-g
dividend aristocrats
companies like banks that have a policy of consitently increasing dividends every year!!! THEY MUST DO IT
how to use the dividend growth model to calculate the stock price in a future year?
- calgaulate the future value of the dividend by using:
Dt=PV(1+g)^t - Plug this into dividend growth model
Pt= Dt x (1+g) / r-g
Why does r> g always in the dividend growth rate model
bc if r=g or r<g then stock price is infinitely large (dividends get bigger and bigger so this is nonsense)
NOTE: g>r for some period of time, but not indefintiely
TRICKY PORTION OF DIVIDEND GROWTH RATE MODEL
IF YOU ARE GIVEN THE AMOUNT FOR THE NEXTTTTTT DIVIDEND!!!
do not use Do x (1+g)/r-g
USE D1/r-g!!!
Non constant growth
-sometimes there are supernormal growth rates over finite length of time
-we assume that the
dividends start growing at a constant rate sometime in the future
How to deal with non constant growth rates?
SCENARIO 1: WHEN DIVIDENDS ARE ZERO FOR THE FIRST SEVERAL YEARS
- you must find out what the stock will be worth once dividends are paid
use P0 = D1/ r-g
P0=FV
- calculate pv of the futureprice to get todays price
PV= FV/1+r ^t
NOTE: t is the last year where there are 0 dividends
How to deal with non constant growth rates?
SCENARIO 2: WHEN DIVIDENDS ARE NONZERO FOR THE FIRST SEVERAL YEARS
g= long run growth rate
G= short run growth rate
0) make a table,
year | expected div = div
0 total div (1+G) div0
1 div0(1+G) div1
2 div1(1+G) div2
3 div2(1+G) div3
1) start with calculatung the pv of all future dividends (use the dividend furthest out from today as D, so if 3 years= D3)
P3= D3 x (1+g)/ r-g
2) discount all cash dividends to present, add them, and add discount fof the P0 you just calculated as well
P0 = Div1/(1+r) + Div2/(1+r)^2 … + P3/(1+r)^t
2 criticisms of dividend growth model
First, in the late 1990s, the level of the market, and
especially tech stocks, was far higher than the present value of expected dividends. Second, market
prices are far more volatile than the present value of dividends
formula for the required return (r)
r= D1/P0 + g
D1/P0 is called dividend yield
g is the rate at which investmenet grows= CAPITAL GAINS YIELD
SO
r= dividend yield + capital gains yield
how do value stock of companies that dont pay dividends?
USE benchmark PE ratio * EPS to come up with a price
Price at time t = Pt
Pt= Benchmark PE x EPSt
what does benchmark PE ratio come from
similar companies, historical data,
note that the ratio can differ depending on industries
What if a company does not pay dividends and is very new and not yet profitable? (net earnings are negative)
how do we price it?
use price-sales ratio
Pt= benchmark price sales x sales per share
what is common stock
stock that has no special preference in dividends or in bankruptcy