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Lecture 2 - Common Stocks

# Lecture 2 - Common Stocks - UGBA 103 Lecture 2 Common...

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UGBA 103 Lecture 2 Common Stocks

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Avinash Verma UGBA103 2 Common Stocks A Common Stock is: A perpetual claim An ownership claim A residual claim A claim characterized by limited liability Holders of stock, a claim with no maturity date, own the firm, get paid from what is left over after all other stakeholders have been paid, and their liability is limited to what they paid for the stock
Avinash Verma UGBA103 3 Valuing Common Stocks We shall come across various formulas for valuing stocks. These formulas give us different perspectives on stock valuation. In other words, they provide different frameworks for valuation These different frameworks are also useful from the point of view of the information that might affect stock prices today

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Avinash Verma UGBA103 4 Valuing Common Stocks ( 2 ) Suppose you expect the price of Apple Computers (AAPL) to be \$250 in exactly a year from now, and you don’t expect AAPL to pay any dividends. * You estimate that given time and risk of the t =1 cash flow (CF) of \$250, 25% per year is a reasonable discount rate. *AAPL hasn’t paid dividends since Nov 1995
Avinash Verma UGBA103 5 Valuing Common Stocks ( 3 ) Your investment horizon is one year. Therefore, from your perspective of holding AAPL only for a year, there is only one future CF, and, therefore, the value of AAPL should be \$250/1.25 =\$200. You find that AAPL sells for \$138. You will buy it because according to your framework, it is undervalued

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Avinash Verma UGBA103 6 Valuing Common Stocks ( 4 ) Thus one possible framework of valuation is that the current value of a non-dividend paying stock is a risk-adjusted present value of its expected * price next period: P 0 = E( P 1 )/(1+ r ) Dividends can be readily introduced into this framework. If the expected dividend next period is D 1 , then: P 0 = E( P 1 + D 1 )/(1+ r ) *Expectations are denoted by E(.)
Avinash Verma UGBA103 7 Valuing Common Stocks ( 5 ) Example: You expect the price of New York Community Bancorp. (NYB) next year to be \$10.5, and expect to receive a dividend of \$1 at t=1. If the discount rate that takes the time and risk of the future price and dividend into account is 16%, then: P 0 = (\$10.5+\$1)/1.16 = \$9.91 Since NYB sells for \$10.35, it’s overvalued in your framework, and therefore, you won’t buy it.

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Avinash Verma UGBA103 8 Market Capitalization Rate ( 1 ) The “right” discount rate, or the rate that that takes time and risk characteristics of future cash flows from the stock into account, is also known as the market capitalization rate We can use the equation P 0 = E( P 1 + D 1 )/(1+ r ) to solve for the market capitalization rate (which we have been denoting by r ) as follows: * r = ( D 1 / P 0 ) + [( P 1 P 0 )/ P 0 ] *We know that future dividends and prices can only be stated in expected terms. However, E(.) is omitted here to avoid notational clutter .
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Lecture 2 - Common Stocks - UGBA 103 Lecture 2 Common...

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