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OEM 2009 Program
Stocks and Their Valuation
Page
1
CHAPTER 8
Stocks and Their Valuation
Common Stock: Terminology
±
Voting rights
±
Preemptive rights
±
Classified stock
±
Initial public offering (IPO)
±
Par value
±
Dividends
±
Stock splits
Control
±
Stock represents ownership
±
Ownership implies control
±
Stockholders elect directors
±
Directors hire management
±
Management’s goal:
Maximize the stock price
Common Stock Symbols
D
t
=
Expected dividend at period t
P
0
=
Current price
P
=
Expected price at period t
^
t
g
=
Expected growth rate
BR =
Sustainable growth rate
B
=
Retention rate
=
(1  DPR)
R
=
Return on equity
Common Stock Symbols
r
S
=
Required rate of return
r
S
=
Expected rate of return
= Actual rate of return
^
__
r
S
=
Actual rate of return
=
Expected dividend yield
=
Expected capital gains yield
^
D
1
P
0
P
1
P
0
P
0
Stock Valuation
²
Assume that you plan to buy a
share of stock today. You expect
to hold this stock for 1 year,
receive a dividend payment at
the end of the year, then
immediately sell the stock in the
market.
How much should you
pay for the stock today?
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Stocks and Their Valuation
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Stock Valuation
P
0
=
[D
1
+ P
1
]
But what is the value of P
1
1+r
S
1
^
^
________
But, what is the value of P
1
P
1
=
[D
2
+ P
2
]
1
1+r
S
1
^
^
________
Stock Valuation
P
0
=
[D
1
]
+
[D
2
+ P
2
]
1
1+r
S
1
1
1+r
S
2
^
________
________
P
0
=
[D
1
]
+
[D
2
]
+ .
..
+
[D
∞
+ P
∞
]
1
1+r
S
1
1
1+r
S
2
1
1+r
S
∞
^
________
________
________
Stock Valuation
0
1
2
∞
P
0
=D
1
D
2
D
∞
r
S
Assume present value of P
∞
will be zero:
P
0
=
+
+ … +
D
1
D
2
D
∞
(1+r
S
)
1
(1+r
S
)
2
(1+r
S
)
∞
Stock Valuation
±
Our only problem now is to
determine the dividend in each
period and the correct discount
rate (investor’s required rate of
return) to use.
Discount Rate
±
Assume that this stock has a
beta of 1.25, the riskfree rate is
5%, and the expected return on
the market is 13%.
We can use
the CAPM to then determine r
S
as follows:
r
S
=
.05
+
[.13 .05][1.25]
=
15%
Dividends
±
Assume that the firm just paid a
dividend of $1.50 (you won’t get
this). Future dividends will depend
on growth rate assumptions:
z
Zero (or no) growth
z
Constant growth
z
Nonconstant growth (followed
by constant growth)
OEM 2009 Program
Stocks and Their Valuation
Page
3
Zero Growth
P
0
=
Σ
[D
t
]
∞
t =1
1
(1+r
S
)
t
__________
Assume D
t
=
D for all t, since g = 0
P
0
=
[D]
Σ
=
D
r
S
1
(1+r
S
)
t
∞
t =1
___________
Zero Growth
At a zero growth rate, the dividend
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This note was uploaded on 05/12/2010 for the course FIN 5405 taught by Professor Tapley during the Summer '08 term at University of Florida.
 Summer '08
 Tapley
 Valuation

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