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Unformatted text preview: • Equity Valuation Models (cont.) • Efficient Markets Hypothesis (EMH) • Three Forms • Theoretical Foundations • Empirical Foundations • Empirical Challenges • Theoretical Challenges • Behavioral Finance • Theoretical Challenges to EMH • Categories of Investor Errors • Portfolio Construction • The Capital Allocation Decision • One Risky and One RiskFree Asset • Calculating the Standard Deviation of the Portfolio Return • The Capital Allocation Line (CAL) 1 2 1 2 ... (1 ) (1 ) (1 ) H H H D D D P V k k k + = + + + + + + P H = the expected sales price for the stock at time H H = the specified number of years the stock is expected to be held Specified Holding Period 1 (1 ) t o t t D V k ∞ = = + ∑ V = Value of Stock D t = Dividend k = required return Dividend Discount Models: General Model V D k o = • Stocks that have earnings and dividends that are expected to remain constant • Preferred Stock No Growth Model D = $5.00 k = .15 V = $5.00 /.15 = $33.33 V D k o = No Growth Model: Example (1 ) o o D g V k g + = g = constant perpetual growth rate Constant Growth Model (1 ) o o D g V k g + = g = constant perpetual growth rate k = required rate of return Constant Growth Model (1 ) o o D g V k g + = g = constant perpetual growth rate k = required rate of return D = dividend in year 0 Constant Growth Model Vo D g k g o = + ( ) 1 D = $3.00 k = 15% g = 8% V = 3.00 (1.08) / (.15  .08) = $46.29 Constant Growth Model: Example g ROE b = × g = growth rate in dividends ROE = Return on Equity for the firm b = plowback or retention percentage rate (1 dividend payout percentage rate) Estimating Dividend Growth Rates Dividend Growth for Two Earnings Reinvestment Policies Present Value of Growth Opportunities Continued • Price = Nogrowth value per share + PVGO (present value of growth opportunities) 1 E P PVGO k = + ROE = 20% d = 60% b = 40% E 1 = $5.00 D 1 = $3.00 k = 15% g = .20 x .40 = .08 or 8% Partitioning Value: Example V NGV PVGO o o = = = = = = 3 15 08 86 5 15 33 86 33 52 (. . ) $42. . $33. $42. $33. $9. V o = value with growth NGV o = no growth component value PVGO = Present Value of Growth Opportunities Partitioning Value: Example Continued Financial Ratios in Two Industries • P/E Ratios are a function of two factors • Required Rates of Return (k) • Expected growth in Dividends • Uses • Relative valuation • Extensive Use in industry Price Earnings Ratios P E k P E k 1 1 1 = = • E 1 expected earnings for next year • E 1 is equal to D 1 under no growth • k  required rate of return P/E Ratio: No Expected Growth 1 1 1 (1 ) ( ) 1 ( ) D E b P k g k b ROE P b E k b ROE = =  × = × b = retention ratio ROE = Return on Equity P/E Ratio: Constant Growth E = $2.50 g = 0 k = 12.5% P = D/k = $2.50/.125 = $20.00 PE = 1/ k = 1/.125 = 8 Numerical Example: No Growth b = 60% ROE = 15% (1 b ) = 40% E 1 = $2.50 (1 + (.6)(.15)) = $2.73 D 1 = $2.73 (1.6) = $1.09 k = 12.5% g = 9% P = 1.09/(.125.09) = $31.14 PE = 31.14/2.73 = 11.4 PE = (1  .60) / (.125  .09) = 11.4 Numerical Example: Growth P/E Ratios and Stock Risk...
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 Spring '10
 Ohly
 Economics, EMH, Capital Allocation Decision

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