Topic 3 - Stock Prices Flashcards
Dividend Discount Model
A method of valuing a company’s stock price, based on the idea that a company is worth the sum of all future dividend payments, discounted back to present value.
Equity Cost of Capital ‘Re’
definition and formula
A percentage rate that represents the annual rate of return that investors can expect on their investment in a company.
Its the rate of return a company must offer to make investing in its stock worthwhile.
rE = div yield + cap gain rate
A stock
a share of ownership in a company
Limitations of DDM
- Very sensitive to change
- Management Discretion
- Dependence of Dividends - not all company’s pay regular dividends
- Assumption of Constant growth - which isn’t certain, so more risk compensation has to be included
Free Cash Flow Valuation model
A way to value a company by projecting its future free cash flows and discounting them back to their present value
I.e. the cash it has to put towards dividends or reinvesting in the company
WACC
weighted avg cost of capital - the avg rate of return that a company must pay to finance its operations through debt and equity.
It accounts for the weighted contributions of both in a company’s capital structure.
Comparable Method
A valuation method that uses the value of another very similar firm to create an estimate of a new firms value.
Limitations of Comparable Method
- hard to find similar company
- cannot determine if the entire industry is overvalued or undervalued
- other outlying factors need to be considered
EMH
the idea that in a competitive market prices react to all available information and its impossible to consistently beat the market
Methods to value stock
Dividend Discount Model
Discounted Free cash flow valuation model
Total Payout model
Comparable firms method
Dividend Yield
how much you get back per pound you put in
DY = D1/P0
Capital Gain Rate
The percentage increase in the value of an asset over its purchase price.
When you sell an asset for more than what you paid for it - the profit is capital gain
CGR = (selling price - purchase price) / purchase price
Capital gains tax
The tax you pay on the profit you make from selling an asset. It’s a way for the government to collect revenue on the appreciation of assets
constant dividend growth model
A special case of the dividend discount model
Price = D1/ (rE - g)
what determines the growth rate of dividends?
Earnings Growth
Payout Ratio
Economic conditions
