Stocks (Week 3) Flashcards
What is the equation for the annual rate of return for one share?
Formula used to estimate the price of a stock:
Estimate the value of a stock held for two years:
The value of a share is the present value of all expected future dividends per share.
What is the equation for this?
It’s often said that short-term invetsors don’t care about the value of the firm in the long run. Does that make sense?
No.
Short-horizon investors care about the price they sell, and the price they sell depends on expectations of future dividends, and so on.
If prices are ultimately detemrined by the PV relation, there is no distinction between short and long run.
What do you need to know in order to predict dividends?
Profits (aka as net income or earnings), as dividends are paid from profits.
How do you estimate an infinite stream of dividends?
We assume that dividends will remain constant forever.
Use the perpetuity formula to get:
In a more realistic model, dividends grow at a constant rate (g). What is the formula?
An analyst estimates the next-year expected dividend (D) and the expected growth rate (g). She then estimates the fundamental price as (image). If the actual price (Pa) is lower than the estimated price, what should she do?
She should buy if the actual price (Pa) is lower than the estimated price (Pe), and sell otherwise.
In the long run, the market corrects misvaluations, and prices return to their fundamental values.
What are five problems with trading recommendations?
- We need to estimate stuff we don’t know: dividends, discount rates, and growth rates. Estimates could be wrong.
- Constant growth model may be a poor approximation for the actual stream of dividends.
- Convergence to fundamental value may take a long time, and holding such positions may be risky.
- Analysts often disagree; how do you know you’re not overconfident?
- Too many people trying to do the same thing; surely there is no low-hanging fruit?
Where do discount rates come from?
Required rate of return (or discount rate) =
Compensation for time value of money + compensation for risk
Expected returns are high when risks are high
High expected returns are compensation for risk.
Suppose you want to value stock A, which you suspect is currently mispriced. There is another stock, B, which is in a very similar business to that of A. What can you do?
We say that B is a comparable stock. The trick is to estimate k by applying the CG model to B.
What is dividend yield?
The percentage of a company’s share price that it pays out in dividends each year.
If we are using stock B to calculate the value of stock A, what information (for stock B) do we need.
The dividend yield and growth rate.
How do we estimate the value of g? (growth rate)
g = Retention Ratio x Return on New Investment
What is the formula for Return on Equity?
