chapter 7 Flashcards
what are the 2 expected cash flows from someone who owns a stock?
the dividends the firm pays out
the price of the sold share in the future
according to the law of one price, what does the current price of a stock reflect?
the expected future dividend and stock price
what is the “equity cost of capital”?
the expected return of other investments with equivalent risk
since it it difficult to estimate future dividends of a stock, what do we do to make it more simple?
we simplify the problem by assuming that dividends will grow at a constant rate ‘g’ forever
what are the 2 things a firm can do to maximize their share price?
the firm can increase the level of its dividend payments
they can increase their growth rate
what is the trade off that firms have when trying to maximize their share price?
investing in higher growth may mean using cash that could be used to pay dividends and this could negatively impact future growth
what is the dividend payout rate?
the fraction of earnings that the firm pays as dividends each year
what are the 3 ways a firm can increase its dividends?
increasing their earnings
increasing their dividend payout rate
reducing the number of shares outstanding (increasing EPS)
how can companies reduce the number of shares outstanding?
the firm can buy back existing shares from investors
what are the 2 ways a firm can use their earnings?
to pay dividends
retain and reinvest them
what is the retention rate?
the fraction of current earnings that the firm retains
what does the decision whether to retain more earnings and reduce the current dividend depend on?
depends on the profitability of the firms investment
when will cutting the firms dividend to increase investment raise the stock price?
it will only raise the stock price if the new investments have a positive NPV
what is share repurchase?
when a firm uses excess cash to buy back its own stock
why would the dividend discount model be adjusted?
because that model assumes that firms distribute all cash to shareholders through dividend payments
what is the total payout model?
a model that values all of the firms equity rather than just a single share and discounts the total dividends paid and shares repurchased
what is the method of comparables?
a way that estimates the value of the firm based on the values of similar firms or investments
what is a valuation multiple?
a ratio of the value to a measure of the firms size
what are the 2 most common valuation multiples?
P/E ratio
EV/ EBIT or EV/EBITDA
what are the estimates of stock prices made up of?
all of the different information of investors and the trading of a stock adds to the aggregate information of many investors
if your estimate is very different than the market price, what might you want to do?
you might want to reconsider how you arrived at your estimate
what is the efficient market hypothesis?
a theory that implies that all stock are fairly priced given all information that is currently available to investors
how does the efficient market hypothesis impact all positive-NPV opportunities?
it eliminates them
under the efficient market hypothesis, how does new information impact the price of a stock?
it will immediately change the price of the stock to reflect the new information through the buying and selling actions ion investors
is the efficient market hypothesis always correct?
no it is just an approximation that would hold in an ideal situation and not a perfect description of how stock markets work
