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Unformatted text preview: Valuing Equity Chapter 6 Finance 357 Stock Value We can get the value of a stock by: 1. Discounting all future dividends 1. Discounting next periods dividend plus next period stock price 1. Discounting a growing dividend 2. Discounting the differential growth Examples w/ 5% discount rate 1. A stock is expected to pay a dividend of $0.50 next year and the same dividend each year forever. What should the stock be selling for today? Div / r $0.50 / .05 = $10 1. Next years dividend for a stock is expected to be $0.50. The stock is also projected to be selling for $10 next year. What should the stock be selling for today? ($0.50 + $10.00) / (1 + .05) = $10 Examples w/ 5% discount rate (cont) 1. A company will pay a $1 dividend next year, and the dividend is expected to grow by 5% per year forever. The discount rate is 15%. How much is the stock worth? Div / (r g) 1 / (.15  .05) = $10 Examples w/ 5% discount rate (cont) 1. One year from today, a company will pay a $1.10 dividend that will grow by 10% annually for 2 years afterward. After that growth, the dividend will grow at 5% per year, forever. The discount rate is 10%. How much is the stock worth today? $1.10 1.1 / (1.1) = 1 $1.21 1.21 / (1.1) 2 = 1 $1.33 1.33 / (1.1) 3 + [ 1.4 / (.1  .05) = $28 ] / (1.1) 3 = 1 + 21.04 = 1 + 1 + 1 + 21.04 = 24.04 Another Example A stock is expected to pay a $0.50 dividend a year from now and the dividend is expected to grow at 5% per year forever? If the discount rate is 10%, what should the stock be valued at today? Another Example A stock is expected to pay a $0.50 dividend a year from now and the dividend is expected to grow at 5% per year forever? If the discount rate is 10%, what should the stock be valued at today? Div / (r g) $0.50 / (.10  .05) = $0.50 / .05 = $10 Where does g come from? Until now, we have assumed that stocks dividends grow at rate g. But where does this number come from? Businesses grow by making investments in projects, equipment, etc. If the amount we invested was the same as our depreciation, then earnings would remain the same. This means that Net Investment will only be positive if some earnings are not paid out as dividends. Quick Note on EPS EPS can be retained by a company (reinvested) or it can be paid out to the shareholders as a dividend. EPS = Payout (Dividend) + Retained Earnings Retention Rate = 1 Payout Rate Payout Rate = 1 Retention Rate Earnings Growth How do earnings grow? Earnings Growth Example Our company reported earnings of $2,000,000 for the year just ended. We plan to retain 45% of the earnings and reinvest them into the firm. Throughout our history, we have averaged a 20% return on equity and we estimate that will continue. Based on this information, at what rate do we expect earnings to grow over the next year? Earnings Growth Example Our company reported earnings of $2,000,000 for the year just ended. We plan to retain 45% of the earnings and reinvest them into the firm. Throughout our...
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 Spring '06
 Hadaway
 Finance

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