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# 4504c10 - Common Stock Valuation Chapter 10 Fundamental...

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Common Stock Valuation Chapter 10 Fundamental Analysis Approaches Present value approach Capitalization of expected income Intrinsic value based on the discounted value of the expected stream of cash flows Multiple of earnings (P/E) approach Stock worth some multiple of its future earnings Present Value Approach (Capitalization of Income) Intrinsic value of a security is ) K + (1 D t = P t e t o 1 = K e = appropriate discount rate In using model, to estimate the intrinsic value of the security must: Discount rate (Capitalization Rate, Required Rate of Return) Required rate of return: minimum expected rate to induce purchase given the level of risk The opportunity cost of dollars used for investment Expected cash flows and timing of cash flows Stream of dividends or other cash payouts over the life of the investment Dividends paid out of earnings and received by investors Earnings important in valuing stocks Retained earnings enhance future earnings and ultimately dividends If use dividends in PV analysis, don’t use retained earnings in the model Retained earnings imply growth and future dividends Compared computed price to actual price

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Dividend Discount Model Current value of a share of stock is the discounted value of all future dividends Problems: Need infinite stream of dividends Dividends received 40-50 years in the future are worth very little in present value with the discount rate is sufficiently high (12%, 14%, 16%) Dividend stream is uncertain Dividends not guaranteed Declared by Board of Directors Must estimate future dividends Dividends may be expected to grow over time Must model expected growth rate of dividends and the growth rate need not be constant Dividend Discount Model-Zero Growth Assume no growth in dividends Fixed dollar amount of dividends reduces the security to a perpetuity p K o D o P = K p = appropriate discount rate Similar to preferred stock because dividend remains unchanged Dividend Discount Model-Constant Growth-Gordon Model Assumes a constant growth in dividends Dividends expected to grow at a constant rate, g, over time where g: growth rate k e : required return K e > g D 1 is the expected dividend at end of the first period D 1 =D 0 (1+g) g) + (1 D = D g - K D = P o 1 e 1 o
Implications of constant growth Stock prices grow at the same rate as the dividends (g) Problem: what if higher growth in price than dividends or visa versa Stock total returns grow at the required rate of return Growth rate in price plus growth rate in dividends equals k, the required rate of return A lower required return or a higher expected growth in dividends raises prices Reasons for Different Values of Same Stock Each investor may use their individual k

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