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ch 11

# ch 11 - Chapter 11 Stock Valuation And Risk Price-Earnings...

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Chapter 11 Stock Valuation And Risk

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Price-Earnings Method (PE) Apply the mean PE ratio of publicly traded competitors Use expected earnings rather than historical Valuation = Expected x Mean industry per share earnings PE ratio
Example Your firm is expected to generate \$5 per share next year. If the industry mean EPS is 20, what should your stock price be? Price=\$5(20)=\$100

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Price-Earnings Method (PE) Reasons for different valuations Different earnings forecasts Different PE multipliers Different comparison or benchmark firms Limitations of the PE method Errors in forecast or industry composite Based on PE, which some analysts question
Dividend Discount Model (DDM) The price of a stock reflects the present value of the stock's future expected dividends t = period D t = dividend in period t k = discount rate = + = 1 t t t k) (1 D Price

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Gordon Growth Model (GGM) Used when dividend payments are expected to change during the life of the firm g k Div P - = 1 0
Example What is the value of a stock that expects to pay a \$3.00 dividend next year, and then increase the dividend at a rate of 8% per year, indefinitely? Assume a 12% expected return. 00 . 75 \$ 08 . 12 . 00 . 3 \$ 1 0 = - = - = g k Div P

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Gordon Growth Model (GGM) The GGM formula can be rearranged to reveal the anticipated dividend yield and the growth rate rate Growth yield Div k g P Div k + = + = 0 1
Dividend Growth Rates Given the dividend in time t=0: Given other dividend payments: n n g Div Div ) 1 ( 0 + = ) 1 ( 1 g Div Div n n + = -

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Distinguishing between Div 0 and Div 1 : Div 0 Was paid Just paid Paid Yesterday Is Currently Being Paid Div 1 Will Pay Paying at the end of the Year Next Dividend
Limitations of DDM/GGM Potential errors in estimating dividends Potential errors in estimating growth rate Potential errors in estimating required return Not all firms pay dividends Technology firms Biomedical firms

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Adjusting the DDM/GGM Value of stock is determined by Present value of dividends over investment horizon Present value of selling price at the end
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