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Unformatted text preview: ECON 136: Financial Economics Section 7 (Oct 16th) Xing Huang 1 Economics Department, UC Berkeley 1 Valuation Ratios 1.1 Review Recall the Gordon Growth Model: GGM assumes that dividends (and thus earnings) grow at a constant rate G = ROE & B; and that the discount rate remains constant R. Adding up the present value of all of the stock&s expected payments produces the formula for its price today: P t = D t +1 R & G = (1 & B ) E t +1 R & ROE B 1) Price-earnings ratio: P t E t +1 = 1 R (1+ PV GO E t +1 =R ) ; how many times larger the price today is than expected earnings per share in the next year reect growth oppourtunity ( PV GO E t +1 =R ) and stock risk ( R ) . 2) Dividend-price ratio n dividend yield: D t +1 P t = R G; the expected dividend payment per share next year as a percentage of price today. Historically, D/P only predicts prices, not dividends. 3) A note of caution for the real world: The dividend-price ratios and price-earnings ratios you see in nancial statements are almost always backward looking, unlike the denitions we are using here. Specically, price-dividend ratios are often calculated using the dividend in the past year, and similarly price-earnings ratios are often calculated using last year&s earnings. Dividends in reality and earnings in nancial statements may not be like what we assume in the GGM. (Some companies do not pay dividends; Earnings management) 1.2 Examples 1. A stock has a discount rate (expected return) of 7%, and its dividends are expected to grow at a constant 3% per year forever....
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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 University of California, Berkeley.
- Fall '08