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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 ¡ re¡ect 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 de¢nitions we are using here. Speci¢cally, 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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- Fall '08
- Economics, Dividend, Dividend yield, P/E ratio