Finance 8 - Part 2

Value of stock today

P0 - the PV of the dividend to be received in the first year (D1) plus the PV of the expected sales price in one year, P1

today's value =

PV of next year's dividend and price

PS pays

a constant dividend - Because the dividend does not change, the PS can be valued using the constant growth rate model with a zero growth rate expressed as P = D/I.

G2

a few years from now when we expect the firm to grow at a slower but more sustainable rate of growth

P/E model: relative value

a stock's pricey-ness measured relative to other stocks.

dividend discount model

a valuation approach based on future dividend income • Provides a useful theoretical basis because it illustrates the importance of dividends as a fundamental stock price determinant

constant-growth model

a valuation method based on constantly growing dividends. - Assumes that the growth rate is smaller than the discount rate. (Gordon growth model)

variable growth rate

a valuation technique used when a firm's current growth rate is expected to change some time in the future - combines PV cash flow and CGR model

PS prices thus tend to act like

bond prices. when interest rate rises, PS prices fall

growth stocks

companies expected to have above-average rates of growth in revenue, earnings and or dividends - People become too concerned with these, but they do not pay dividends and therefore are missing out on an important source of stable returns

CGR model does not work for

companies where g > 1

P/E ratio

current stock price divided by four quarters or earnings per share. - Represents the most common valuation yardstick in the investment industry.

expected return comes from

dividend yield and expected appreciation of the stock price (capital gain)

G1

first and higher growth rate which we expect to only last a few years

process

investor chooses two different growth rates for two stages of the analysis

difficult to apply this because

it requires that they estimate an infinite number of future dividends. • To use this model in practice, analysts make simplifying assumptions to make the model workable.

Dividend yield

last four quarters of dividend income expressed as a percentage of the current stock price. - higher for PS than CS because PS investors should expect a return from dividend payments only

using a longer holding period to estimate stock value

reduces some, but not all of the uncertainty - a 2 year holding period would be equal to today's stock value today's value = PV of next year's dividend, the second yrs dividend and the future price

focus on

stage 2 as long as G2 < 1, stage 2 can use the growth rate model in this case, change in dividend rate occurs in year 1 so we will use the value from year n

discount rate

used should reflect the investment risk level - high risk investments should be evaluated using higher interest rates

preferred stock

• A class of stock with fixed dividends. • Higher priority for receiving proceeds from bankruptcy proceedings than do common stockholders.

investors uses several methods to estimate a firm's growth rate for this model

They can project the dividend trend into the future and determine the implied growth rate - compute the past growth rate - or even consider a financial analyst's growth rate predictions.

we then

calculate each of the dividends

PS is largely

owned by other companies, rather than individual investors, because its dividends are mostly nontaxable income. - Don't have voting rights like CS, which prevents one company from controlling another through PS ownership

the zero growth rate version of the constant growth valuation model shows

that, since dividends are fixed, a PS price changes because of changes in the discount rate, i.

trailing P/E ratio

the P/E ratio computed using the past four quarters of earnings per share.

one way of determining what return stock investors require from a stock is to use

the constant growth rate model. - If the current stock price fairly reflects its value, then the discount rate should be the expected return for the stock.

one common assumption

the firm has a constant dividend growth rate, g. - If this is the case, next year's dividend is simply this year's dividend that grew one year at the growth rate.