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Investment analysis, Prof. Peng
1
Ch12. Equity Valuation
¾
Value vs. Price: When is value
valuable
?
¾
Dividend Discount Model (DDM)
±
How does dividend discount model work?
±
Where does dividend growth come from?
¾
Earnings and P/E ratio (P/E)
Investment analysis, Prof. Peng
2
Intrinsic value vs. market price
±
What is Intrinsic value?
¾
The present value of expected net future cash flows,
discounted by the required rate of return
¾
Subjective: only as good as the
model
in which it is derived
and the
input
which goes into the model
±
What is Price?
¾
The average of the intrinsic value of all market participants
±
Can the Value and Price be Different?
¾
Absolutely!
±
Market inefficiency
±
Heterogeneous valuation
±
Asymmetric information
±
Show me the money
¾
Buy undervalued and sell overvalued stocks
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Investment analysis, Prof. Peng
3
How to find the
intrinsic value?
±
Dividend Discount Model
¾
the
intrinsic value
is the present value of future cash flows
¾
Two Critical Inputs:
±
Future cash flows
¾
Q
:. IBM is forecasted to pay $4 dividend at the year end, and have
12 month price target of $52. What is the stock value
today?
¾
A
: the value of the IBM stock is the present value of the future
cash flows, i.e.
±
k
: The market capitalization rate (cost of equity, required return)
¾
If
k
= 12%, stock value:
¾
k
in general depends on the riskness of the cash flows,
±
e.g.
CAPM
or
factor models
(later)
k
V
E
D
E
V
+
+
=
1
]
[
]
[
1
1
0
50
12
.
1
52
4
1
]
[
]
[
1
1
0
=
+
=
+
+
=
k
V
E
D
E
V
Investment analysis, Prof. Peng
4
Dividend Discount Model
±
More General Setup
¾
Convention: use exdividend value/price
()
2
2
2
2
1
0
1
]
[
1
]
[
1
]
[
k
V
E
k
D
E
k
D
E
V
+
+
+
+
+
=
k
V
E
D
E
V
E
+
+
=
1
]
[
]
[
]
[
3
3
2
k
V
E
D
E
V
E
+
+
=
1
]
[
]
[
]
[
2
2
1
k
V
E
k
D
E
k
V
E
D
E
V
+
+
+
=
+
+
=
1
]
[
1
]
[
1
]
[
]
[
1
1
1
1
0
D
1
V
0
2
3
4
∑
∞
=
∞
∞
+
=
+
+
+
+
+
+
=
1
2
2
1
1
0
)
1
(
)
(
)
1
(
)
(
...
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 Spring '08
 Huang

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