finNotesEquityValuation

finNotesEquityValuation - EQUITY VALUATION The Dividend...

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EQUITY VALUATION The Dividend Valuation Model Normal Growth Stocks "Super" Growth Stocks The Dividend Valuation Model When you buy a share of common stock you expect it to be "profitable" -- you expect to earn a return made up of one or two parts: the dividends you receive from the company and/or the capital gain you earn by being able to sell the stock in the future at a price higher than the price you paid. But as we'll see, the only part that matters is the expected dividend stream starting from when you buy the stock all the way through infinity. The only thing that gives the stock certificate value is the stream of cash payments from the company to the owners of the certificate. But what about the capital gain or price appreciation? Very simply, the price that another investor will pay you for the stock at some point in the future depends on the portion of that infinite dividend stream that the second investor will receive plus his or her capital gain. But that capital gain will depend on what a third investor will pay and that's dependent on their share of the dividend stream plus their expected capital gain. Each time the stock is sold, theoretically the buyer is looking to the future and computing the present value of their expected dividend stream plus the present value of their capital gain. But the capital gain is always dependent on the dividend stream from that point through infinity. Let's assume that you decide to buy a share of common stock and that you anticipate holding the stock for an arbitrary three years. We'll assume that yesterday the company paid a dividend per share of D 0 . Does this mean that you were dumb for waiting one day too many to buy the stock? No! If you had bought the stock yesterday morning, you would have had to have paid an additional D 0 for the stock. The date of record for the dividend payment and the amount of the dividend are both known well before it is paid. There are not very many surprises. OK, so you decide to buy a share and hold if for three years before selling it. Yesterday the stock paid a dividend per share of D 0 . Let's assume that the market requires a rate of return on a common stock of this risk class of k e %. Where the heck did that come from?? Lots of different ways to arrive at an estimate of k e . k e can be gotten from our "beta model". You remember that, right! k e = i + Β * ( k m - i ), where i is the risk-free rate of interest, Β is the stock's beta coefficient and k m is the expected return of the stock market. Conceptually, a good way to estimate k e is to find out the rates of return on other similar firms. If you're buying a share of Exxon, find out what the return has been on Chevron, Sunoco, Shell, etc. In any case, we'll use a required return of k e . You plan to buy the stock, hold if for three years and then sell it at the prevailing market price at the end of
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finNotesEquityValuation - EQUITY VALUATION The Dividend...

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