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**Unformatted text preview: **1 Stock Valuation Stock valuation General rule Dividend growth models Prof. Q. Ma HADM 2222: Stock Valuation 1 Stock characteristics Stock markets Cash Flows for Stockholders If you buy a share of stock, you can receive cash in two ways The company pays dividends You sell your shares, either to another investor in Prof. Q. Ma HADM 2222: Stock Valuation 2 the market or back to the company What is the price of stock if you know the expected cash flows? Present value of these expected cash flows One-Period Example Suppose you are thinking of purchasing the stock of Banfis Inc. and you expect it to pay a $2 dividend in one year and you believe that you can sell the stock for $14 at that time. It has just paid $2 dividend. If you require a Prof. Q. Ma HADM 2222: Stock Valuation 3 return of 20% on investments of this risk, what is the maximum you would be willing to pay? Two-Period Example Now what if you decide to hold the stock for two years? In addition to the dividend in one year, you expect a dividend of $2.10 and a stock price of $14.70 at the end of year 2. Now how much would you be willing to pay? Prof. Q. Ma HADM 2222: Stock Valuation 4 much would you be willing to pay? Three-Period Example Finally, what if you decide to hold the stock for three periods? In addition to the dividends at the end of years 1 and 2, you expect to receive a dividend of $2.205 at the end of year 3 and a stock price of $15.435. Now how Prof. Q. Ma HADM 2222: Stock Valuation 5 3 and a stock price of $15.435. Now how much would you be willing to pay? Developing The Model We could continue to push forward the time we would sell the stock The price of the stock is really just the present value of all expected future dividends Prof. Q. Ma HADM 2222: Stock Valuation 6 So, how can we estimate all future dividend payments? 2 Dividend Models Zero growth (constant dividend) The firm will pay a constant dividend forever Constant growth (dividend growth model) The firm will increase the dividend by a constant percent Prof. Q. Ma HADM 2222: Stock Valuation 7 every period Non-constant growth...

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