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Unformatted text preview: 7/10/2009 1 STOCK MARKETS, PART II STOCK MARKETS, PART II INTRODUCTION TO MORTGAGES INTRODUCTION TO MORTGAGES JULY 10 TH , 2009 Lauren Heller Econ 423, Financial Markets The Plan for Today b Stock Valuation b The Gordon Growth Model b Price Earnings Valuation Model b Prices and Errors in Valuation b Introduction to Mortgages b Homework #5 Questions Recall from last time b We can value stocks by discounting the future cash flows we receive from them b Dividends and future sales of shares. b Weve discussed two methods of valuation so far: b One Period Valuation Model b Generalized Dividend Valuation Model b Well discuss two additional methods today. Recall from last time b Generalized Valuation Model: b A selling price far in the future is discounted heavily b As n , you could also write this as: b Problem Infinite sums dont always converge, and can be computationally taxing. ( 29 ( 29 ( 29 ( 29 n e n n e n e e k P k D k D k D P + + + + + + + + = 1 1 ... 1 1 2 2 1 1 ( 29 = + = n t t e t k D P 1 1 The Gordon Growth Model b Assumes that dividends grow at a constant rate each year b A goal for some firms. b With this assumption, we can rewrite the generalized valuation model as: b D = Most recent dividend paid b g = Expected growth rate in dividends (constant) ( 29 ( 29 ( 29 ( 29 ( 29 ( 29 + + + + + + + + + = e e e k g D k g D k g D P 1 1 ... 1 1 1 1 2 2 1 1 The Gordon Growth Model b With some algebra, the equation above can be shown to simplify to: b Lets see how ( 29 ( 29 ( 29 ( 29 ( 29 ( 29 + + + + + + + + + = e e e k g D k g D k g D P 1 1 ... 1 1 1 1 2 2 1 1 ( 29 ( 29 ( 29 g k D g k g D P e e = + = 1 1 7/10/2009 2 Deriving the Gordon Growth Model b Multiplying both sides of this equation by we obtain: b Subtracting Equation (1) from Equation (2): ( 29 ( 29 ( 29 ( 29 g k k g D k g D g k P e e e e + +...
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