Chapter 9: Valuing Stocks

Question 1

What is the law of one price?

Answer 1

A law that implies that the price of a security should equal the present value of the expected cash flows an investor will recieve from owning it.

Question 2

P_t (_ = small t below P)

Answer 2

Stock price at the end of year t

Question 3

r_E (_ = small E below r)

Answer 3

Equity cost of capital

Question 4

N

Answer 4

Terminal date or forecast horizon

Question 5

g

Answer 5

Expected divident growth rate

Question 6

Div_t

Answer 6

Dividends paid in year t

Question 7

EPS_t

Answer 7

Earnings per share on date t

Question 8

PV

Answer 8

Present Value

Question 9

EBIT

Answer 9

Earnings before interest and taxes

Question 10

FCF_t

Answer 10

Free cash flow on date t

Question 11

V_t

Answer 11

Enterprise value on date t

Question 12

T_c

Answer 12

Corporate tax rate

Question 13

r_wacc

Answer 13

Weighted average cost of capital

Question 14

g_FCF

Answer 14

Expected free cash flow growth rate

Question 15

EBITDA

Answer 15

Earnings before interest, taxes, depreciation and amorization

Question 16

For an investor to be willing to sell a stock (equation)

Answer 16

P_0 < Div_1 + P_1/ 1 + r_E

Where: 
< = Less than or equal to
P_0 = Stock price at year 0
P_1 = Stock price at year 1
Div_1 = Dividends paid in year 1
r_E = Equity cost of capital

Question 17

Cash flows (to investor) from owning a stock

Answer 17

1. Dividends

2. Generating cash by selling the shares at a profit

Question 18

Investors will be willing to sell a stock if (equation)

Answer 18

P_0 > Div_1 + P_1/ 1 + r_E

Where: 
< = More than or equal to
P_0 = Stock price at year 0
P_1 = Stock price at year 1
Div_1 = Dividends paid in year 1
r_E = Equity cost of capital

Question 19

When buying and selling a stock this equation also has to be satisfied as for every stock bought or sold there must be a respective seller or buyer (who must be incentivised to sell)

Answer 19

P_0 = Div_1 +P_1/ 1 + r_E

Where:
P_0 = Stock price at year 0
P_1 = Stock price at year 1
Div_1 = Dividends paid in year 1
r_E = Equity cost of capital

Question 20

Total return equation

Answer 20

r_E = (Div_1 + P_1/ P_0) - 1 = (Div_1/ P_0) + (P_1 -P_0/ P_0)

Where: 
P_0 = Stock price at year 0
P_1 = Stock price at year 1
Div_1 = Dividends paid in year 1
r_E = Equity cost of capital

And
(Div_1/ P_0) = DIVIDEND YIELD
This is the expected annual dividend of the stock divided by its current price. It is the percentage return the investor expects to earn from the dividend paid by the stock.

(P_1 -P_0/ P_0) = CAPITAL GAIN RATE
This expresses the capital gain that the investor will earn on the stock - which is the difference between the expected sale and purchase price for the stock (P_1 - P_0). Capital gain is divided by the current stock price to express capital gain rate as a percentage return

Dividend yield + capital gain rate = total return

The equation also states that the stocks total return should equal the equity cost of capital SO the expected total return of the stock should equal the expected return of other investments available in the market with equivalent risk.