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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) Priceearnings 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) Dividendprice 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 dividendprice ratios and priceearnings ratios you see in nancial statements are almost always backward looking, unlike the denitions we are using here. Specically, pricedividend ratios are often calculated using the dividend in the past year, and similarly priceearnings 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
 SZEIDL
 Economics

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