InvestmentPlanningWeek7_2_2 - FSU Certificate in Financial...

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FSU Certificate in Financial Planning Investment Planning © Florida State University Page 1 Lecture Title: Week 7: Valuation Methods, Efficient Market Hypothesis, Measures of Stock Performance Week 7: Common Stock Valuations and Returns Introd uctio n In week 3 we worked a great number of problems with the financial calculator to become comfortable with the concept of the time value of money. In weeks 4 and 5 we studied risk, returns, probabilities, and modern portfolio theory. This week we will build on the knowledge gained in those three weeks as we focus on investing in common stock. Objectives At the end of this week you should have a working knowledge of the following: Required rate of return Determinants of a stock's price Calculation of a stock's value Use of ratios in evaluating stocks Efficient market hypothesis Various methods of computing and stating the return of a stock Concepts of dollar cost averaging and averaging down Lecture Presentation Chapter 9 We've previously spent some time examining expected and total returns. It should be obvious that for different investors one of the two components of return, income and growth, may be preferable to the other.
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FSU Certificate in Financial Planning Investment Planning © Florida State University Page 2 Dividend Growth Valuation Model Determining the intrinsic value of any asset involves bringing future cash inflows back to the present at the appropriate discount factor. Almost always, that discount factor is the investor's required rate of return. One can think of the required rate consisting of: 1. the risk free rate and 2. a risk premium associated with the investment. Once a valuation is obtained it is compared to the current asset's price to determine if it is underpriced or overpriced in the marketplace. Cash flows from stocks are, of course, dividends. A model based on stock cash flows, such as the dividend growth model, considers only dividends and their growth. You should be saying at this point something to the effect of how impractical that is since many stocks don't pay dividends, dividends are subject to change, their growth can be hard to predict, etc. As you become aware of the components of the model, you may also question the reliability of other data that must be inputted, such as risk free rate, growth rate, return on the market, etc. Thomas Henry Huxley once said, "Alas, the great tragedy of science, the slaying of a beautiful theory by an ugly fact." As discussed before, many of the models and formulas used in investment planning are flawed. After all, this academic area is still in its infancy and, in effect, we're trying to predict the future. Those
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FSU Certificate in Financial Planning Investment Planning © Florida State University Page 3 of us who are pragmatists get a little heartburn over all the vagueness, but let's keep an open mind and learn it all.
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