Lec 7 - LECTURE 7 Equity Valuation AF3316 Investments...

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AF3316 Investments Shaojun (Shaun) Zhang, Ph.D. ASA School of Accounting and Finance The Hong Kong Polytechnic University LECTURE 7 LECTURE 7 Equity Valuation Equity Valuation
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7-2 AF3316 Lecture 7 Intrinsic Value and Market Price Intrinsic Value (IV) The present value of all cash payments to a share holder, including dividends as well as the proceeds from the ultimate sale of the share, discounted at the appropriate risk-adjusted interest rate Market Price (MP) The value that traders are willing to pay or accept Trading Signal IV > MP Buy IV < MP Sell or Short Sell IV = MP Hold or Fairly Priced
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7-3 AF3316 Lecture 7 Expected Holding Period Return The return on a stock investment comprises cash dividends and capital gains or losses Assuming a one-year holding period Let P 0 be current market price, P 1 be the market price and D 1 be the amount of cash dividend at the end of the year Expected HPR is the sum of the expected dividend yield and the capital gains yield (i.e. the expected rate of price appreciation).
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7-4 AF3316 Lecture 7 Required Return CAPM gives us required return: If the required return is lower than the expected return, the stock is under-priced and investors will buy. If the required return is higher than the expected return, the stock is over-priced and investors will sell. If the stock is fairly priced, the required return should equal expected return.
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7-5 AF3316 Lecture 7 Estimate of Intrinsic Value Estimate of intrinsic value (IV) Assuming a one-year holding period Let P 1 be the market price (MP) and D 1 be the amount of cash dividend at the end of the year Let k be the required return In market equilibrium, the current MP will reflect the IV estimates of all market participants. An individual investor whose IV estimate differs from MP in effect must disagree with some or all of the market consensus estimates of E(D1), E(P1), or k. The market consensus estimate of the required return is called the market capitalization rate k P E D E V + + = 1 ) ( ) ( 1 1 0
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7-6 AF3316 Lecture 7 General Dividend Discount Model V D k o t t t = + = ° ( ) 1 1 • V 0 = Value of Stock • D t = Dividend k = required return
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7-7 AF3316 Lecture 7 No Growth Model V D k o = Stocks that have earnings and dividends that are expected to remain constant – Preferred Stock
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7-8 AF3316 Lecture 7 No Growth Model: Example E 1 = D 1 = $5.00 k = .15 V 0 = $5.00 / .15 = $33.33 V D k o =
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7-9 AF3316 Lecture 7 Constant Growth Model Vo D g k g o = + - ( ) 1 g = constant perpetual growth rate
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7-10 AF3316 Lecture 7 Constant Growth Model: Example Vo D g k g o = + - ( ) 1 E 1 = $5.00 b = 40% k = 15% (1-b) = 60% D 1 = $3.00 g = 8% V 0 = 3.00 / (.15 - .08) = $42.86
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7-11 AF3316 Lecture 7 DDM • Example e.g. If D 1 = $4, r = 16%, g = 6%, what is the value of the stock today? In 4 years? Ans.: 0.06) - (0.16 4 g) - (r D P 1 o = = = $40. 1 . 0
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