Investments Lesson 4 Flashcards
Dividend discount model
Values company’s stock by discounting future stream of cash flows
If required rate of return decreases, stock price will __?
If dividend is expected to increase stock price will __?
Increase
Increase
Example Exam Question:
Current annual dividend $2/share. 5 years ago was $1.36/share. Expect dividends to grow at same rate. Required rate of return is 12%. Expected return on market is 14%. What is the value of a share of common stock using constant dividend growth model?
A. $11 B. $17 C. $25 D. $36 E. $54
E
Dividend discount model can be used for simple perpetual dividend growth or more complicated variable dividend growth
For variable, must start with last rate & work backwards
Example Exam Question:
Expects company will increase dividends by 7% for next 3 years, 5% for 2 years, 3% on. Recent financial statements show earnings per share of $12 & retention ratio of 60%. If require at least 8% return on investment, what is value?
A. $112.97
B. $114.04
C. $115.63
D. $116.22
B
Disadvantages of dividend discount model
Requires constant perpetual growth rate of dividends
Cannot estimate stocks without dividends
Growth rate cannot be greater than expected return
Security price becomes very sensitive to expected return when nearing growth rate
Price/Earnings Ratio
How much investor is willing to pay for each dollar of earnings
P/E = price per share/eps
Price per share = p/e x eps
Price/Earning to Growth
PEG= P/E ratio / 3-5 year growth rate in earnings
Used to determine if stock’s P/E ratio keep pace with firm’s growth rate
Equal to 1- fairly valued
Greater than 1 fully valued or overvalued
Book Value
Amount of stockholder’s equity in the firm/ how much shareholders would receive if firm liquidated
Useful to compare to firm’s stock price
Dividend Payout Ratio
DPR = Common Stock Dividend / EPS
(Formula NOT provided-memorize!)
Higher DPR, more mature company
High DPR: possibility of dividend being reduced
Low DPR: dividend may be raised thereby increasing stock price
Return on Equity (ROE)
ROE = EPS/stockholder’s equity per share
Measured overall profitability of company
Direct relationship between ROE, earnings, & dividend growth
Example Exam Question: What is ROE? EPS: $2 C/S dividend: $1 P/S dividend: $.50 Sales: $5,000,000 Shares outstanding: 1,000,000 Total equity: $7,000,000
A. 15%
B. 20%
C. 25%
D. 28.5%
D
Dividend Yield Formula:
Dividend Yield = dividend/stock price
Annual dividend as percentage of stock price
Example Exam Question; Which most likely to increase dividend? 1: div yield 10%, stock price $20, eps $2 2: 5%, $50, $2.50 3: 8%, $30, $2.40 4: 12%, $40, $5
A. 1 B. 2 C. 3 D. 4 E. None
D
Dollar Cost Averaging
Same dollar amount each month
Fundamental Analysis:
Ratio analysis on financial statements
Liquidity, activity, profitability, c/s measurements, economic data, inflation, interest rates, GDP, unemployment
Believe price driven by financial performance
Assumes:
Investors can determine reliable estimates of stock’s future price behavior
Some securities may be priced & fundamental analysis determines which ones
Technical Analysis
Charting & plotting trading volume & price movements
Will predict future direction of stock prices long before fundamental
Believe supply & demand drive price
Resistance (top level)-sell
Support (bottom level)-signal new demand
Charting
Plotting historical stock prices to determine trading pattern
50,100,200 day moving average
Market Volume
Investor sentiment
If mv is high & market goes up: positive indicator
If mv high & market goes down: negative indicator
If mv low & market up: negative
If mv low & market down: positive