Lecture 2

# Lecture 2 - BUS 106 Spring 2011 Lecture 2 Common Stocks...

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BUS 106 Spring 2011 Lecture 2 Common Stocks

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Avinash Verma 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, which never expire, 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 3 Valuing Common Stocks We shall come across various formulas for valuing stocks. These different formulas give us different perspective on stock valuation. In other words, they provide different framework for valuation Different frameworks can also be useful from the point of view of the information that might affect stock prices today

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Avinash Verma 4 Valuing Common Stocks ( 2 ) Suppose you expect the price of AAPL to be \$450 in a year from now, and you don’t expect AAPL to pay any dividends.* You figure that given time and risk of the t =1 CF of \$450, 20% per year is a reasonable discount rate. From your perspective of holding AAPL only for a year, there is only one future CF, and, therefore, the value of AAPL should be \$450/1.2 =\$375. You find that AAPL sells for \$344.35. You will buy it because according to your framework, it is undervalued *AAPL hasn’t paid dividends since Nov 1995
Avinash Verma 5 Valuing Common Stocks ( 3 ) 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. If the expected dividend next period is D 1 , then: P 0 = E( P 1 + D 1 )/(1+ r ) Example: You expect the price of NYB next year to be \$20, and expect to receive a dividend of \$1 at t=1. If the “right” discount rate is 16%, P 0 = (\$20+\$1)/1.16 = \$18.10 *Expectations are denoted by E(.)

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Avinash Verma 6 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 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 are stated in expected terms, but E(.) is omitted here to prevent notational clutter .
Avinash Verma 7 Market Capitalization Rate ( 2 ) In words, the market capitalization rate is the sum of expected dividend yield, ( D 1 / P 0 ), and expected capital gain, [( P 1 P 0 )/ P 0 ] How the market capitalization rate is arrived at will be studied later in the course when we learn to measure and price risk

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Avinash Verma 8 Another Valuation Framework Most people have a longer investment horizon in mind when they buy a stock. Equity analysts specializing in a stock
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## This note was uploaded on 04/23/2011 for the course BUSINESS 106 taught by Professor Verma during the Spring '11 term at UC Riverside.

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Lecture 2 - BUS 106 Spring 2011 Lecture 2 Common Stocks...

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