Stocks and valuation

Question 1

what is the most important issue in stock valuation?

Answer 1

what a stock will do in the future
–> depends upon its future returns from dividends and capital gains / losses
–> historical data gives insights into the future direction of a company and its profitability
–> BUT: past results are not a guarantee of future results

Question 2

dividend-discount model (one year)

Answer 2

potential cash flows (dividend and the sale of the stock) have to be discounted at the equity cost of capital
P0 = (Div1 + P1) / (1 + rE)
–> if current stock price is smaller, investors buy the stock, driving up the price
–> if current price is bigger, investors sell the stock, causing price to drop

Question 3

dividend-discount model (multi-year)

Answer 3

potential cashflows (several dividends and later sale of the stock) have to be discounted at the equity cost of capital

P0 = (Div1)/(1 + rE) + (Div2)/(1+rE)^2 + … + (Divn + Pn)/(1+rE)^n

–> price of the stock = present value of all expected future dividends and cash flow from the sale in year N

Question 4

dividend-discount model with constant dividend growth (Gordon’s formula)

Answer 4

dividends will grow at a constant rate (g) forever

P0 = D1/(r - g) = D0*(1+g) / (r-g)

Question 5

how can firms increase their dividend?

Answer 5

• incresing earnings
• increasing dividend payout rate
• decreasing number of shares outstanding

Question 6

dividend-discount model with variable growth

Answer 6

normal dividend-discount model and then gordon’s formula once the growth stabilizes (remember to discount with n!!!)

P0 = D1/(1+r)^1 + D2/(1+r)^2 + … + Dn/(1+r)^n + Dn(1+g)/(r-g) x 1/(1+r)^n

Question 7

sources of errors in valuation using the pricing models

Answer 7

• problems with estimating growth (growth rate)
• problems with estimating risk (perceived risk is reflected in discount rate / required returns)
• problems with forecasting dividends