Chapter 9: Valuing Stocks Flashcards
What is the law of one price?
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.
P_t (_ = small t below P)
Stock price at the end of year t
r_E (_ = small E below r)
Equity cost of capital
N
Terminal date or forecast horizon
g
Expected divident growth rate
Div_t
Dividends paid in year t
EPS_t
Earnings per share on date t
PV
Present Value
EBIT
Earnings before interest and taxes
FCF_t
Free cash flow on date t
V_t
Enterprise value on date t
T_c
Corporate tax rate
r_wacc
Weighted average cost of capital
g_FCF
Expected free cash flow growth rate
EBITDA
Earnings before interest, taxes, depreciation and amorization
For an investor to be willing to sell a stock (equation)
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
Cash flows (to investor) from owning a stock
- Dividends
2. Generating cash by selling the shares at a profit
Investors will be willing to sell a stock if (equation)
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
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)
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
Total return equation
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.
