Finance (Material after prelim I) Flashcards
3 Reasons Common Stock is difficult to value.
- With common stock, not even the promised. ash flows are known in advanced.
- The life of the investment is forever because common stock has no maturity.
- There is no way to easily observe the rate of return that the market requires.
Cash Flows (simple problem):
Imagine that you are considering buying a share of stock today. You plan to sell the stock in one year. You somehow know that the stock will be worth $70 at that time. You predict that the stock will also pay a $10 per share dividend at the end of the year. If you require a 25 percent return on your investment, what is the most you would pay for the stock? In other words, what is the present value of the $10 dividend along with the $70 ending value at 25 percent?
If you buy the stock today and sell it at the end of the year, you will have a total of $80 in cash. At 25% :
Present Value = ($10+70)/ 1.25 = $64
$64 is the value you would assign to the stock today.
More generally:
- Let P0 be the current price of the stock
- Assign P1 to be the price in one period
- If D1 is the cash dividend paid at the end of the period: P0 = (D1+P1) / (1+R)
What are the 3 “special cases” where we can come up with a value for the stock?
- The dividend has a zero growth rate
- The dividend grows at a constant rate
- The dividend grows at a constant rate after some length of time
Special Case 1: Zero Growth Dividend
Implies that: D1= D2 = D3 = D = Constant
So, the value of the stock is:
P0 = D/ (1+R)^1 + D/ (1+R)^2 + D/ (1+R)^3 +…
Because the dividend is always the same, the stock can be viewed as an ordinary perpetuity with a cash flow equal to D every period.
With a Zero Growth Case, what is the per-share value?
P0= D/R
D: Dividend that is equal for every period
R: required return
Special Case: Constant Growth Dividend
The dividend for some company always grows at a steady rate = growth rate, than the price can be written as:
P0 = D1 / (R-g)
The result is called the dividend growth model.
Special Case: Non-constant Growth
If the dividend grows steadily after t periods, then the price can be written as:
P0 = D1 / (1+R)^1 + D2 / (1+R)^2 + ….
WHERE:
Pt= Dt * (1+g) / (R-g)
Two-Stage Growth
If the dividend grows at a rate g1 for t periods and then grows at rate g2 thereafter, then the price can be written as:
P0 = D1/ (R-g1) * [1- (1+g1/ 1+R)^t] + Pt/ (1+R)^t
Valuation Using Multiples
For stocks that don’t pay dividends (or have erratic dividend growth rates), we can value them using the PE ratio:
Pt = Benchmark PE ratio * EPSt
EPS: earnings-per-share
PE:
The Required Return
The required return, R, can be written as the sum of two things:
R= D1/ (P0+g)
D1/ P0 = the dividend yield
g = capital gains yield (the same thing as growth rate in dividends for the steady growth case)
What is common stock?
Equity without priority for dividends or in bankruptcy.
- usually applied to stock that has no special preference either in receiving dividends or in bankruptcy.
What are Dividends?
Payments by a corporation to shareholders, made in either cash or stock.
What are preferred stock?
Stock with dividend priority over common stock, normally with a fixed dividend rate, sometimes without voting rights.
-preferred stock is a form of equity from a legal and tax standpoint. It is important to note that holders of preferred stock sometimes have no voting privileges.
What is a Primary Market?
The market in which NEW securities are ORIGINALLY sold to investors.
-Companies sell securities to raise money
What is a Secondary Market?
The market in which PREVIOUSLY issued securities are TRADED among investors.
