Section 6

# Section 6 - ECON 136: Financial Economics Section 6 (Oct...

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Unformatted text preview: ECON 136: Financial Economics Section 6 (Oct 9th) Xing Huang Economics Department, UC Berkeley 1 Equity Valuation 1.1 Review & Dividend Discount Model This says that the price of a stock today is the present value of its future dividend payments. Similar to price of bond P t = 1 X i =1 E t [ D t + i ] (1 + R ) i & Gordon growth model Assumes that dividends grow at a constant rate G and the discount rate remains constant R. Thus, E t [ D t + i ] = (1 + G ) i & 1 D , and with this assumption the dividend discount model reduces to: P t = D R ¡ G & Dividends grow because part of the company&s earnings are re-invested into productive activ- ities. 1) Return on equity (ROE): amount of money earned on each dollar invested in the ¡rm. 2) Plowback/retention ratio (B): amount of money reinvested in the company for each dollar earned. 3) Earnings (E): total amount of money earned on the total amount of money invested in the ¡rm.- D t +1 = (1 ¡ B ) ¢ E t +1- E t +1 = K t ¢ ROE- K t +1 = K t + E t +1 ¢ B = K t ¢ (1 + ROE ¢ B )- K t , D t , E t has growth rate of G = ROE ¢ B in steady state Plugging these de¡nitions into the Gordon Growth Model produces the more detailed formula P t = D t +1 R ¡ G = (1 ¡ B ) ¢ E t +1 R ¡ ROE ¢ B & Present value of growth opportunities PV GO = D t +1 R ¡ G ¡ E t +1 R = (1 ¡ B ) ¢ E t +1 R ¡ ROE ¢ B ¡ E t +1 R 1 PVGO tells us how much value the company&s management is creating by reinvesting some of its earnings as opposed to paying more out as dividends. When ROE > R, PVGO > 0. When ROE=R, PVGO = 0. When ROE < R, PVGO < 0. 1.2 Example 1. Consider company ABC whose stock pays an initial dividend per share next year of \$100 and has expected dividend growth rate of 6% per year when the discount rate is 8% per year....
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## This note was uploaded on 01/25/2010 for the course ECON 136 taught by Professor Szeidl during the Fall '08 term at Berkeley.

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Section 6 - ECON 136: Financial Economics Section 6 (Oct...

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