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FIN355_Chapter6

# FIN355_Chapter6 - Chapter 6 McGrawHill/Irwin Common Stock...

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Chapter McGraw-Hill/Irwin 6 Common Stock Valuation

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Learning Objectives Separate yourself from the commoners by having a good Understanding of these security valuation methods: 1. The basic dividend discount model. 2. The two-stage dividend growth model. 3. The residual income model. 4. Price ratio analysis. 6-2
6-3 Common Stock Valuation Our goal in this chapter is to examine the methods commonly used by financial analysts to assess the economic value of common stocks. These methods are grouped into three categories: Dividend discount models Residual Income model Free Cash Flow model Price ratio models

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6-4 Security Analysis: Be Careful Out There Fundamental analysis is a term for studying a company’s accounting statements and other financial and economic information to estimate the economic value of a company’s stock. The basic idea is to identify “undervalued” stocks to buy and “overvalued” stocks to sell.
6-5 The Dividend Discount Model The Dividend Discount Model (DDM) is a method to estimate the value of a share of stock by discounting all expected future dividend payments. The basic DDM equation is: In the DDM equation: P 0 = the present value of all future dividends D t = the dividend to be paid t years from now k = the appropriate risk-adjusted discount rate ( 29 ( 29 ( 29 ( 29 T T 3 3 2 2 1 0 k 1 D k 1 D k 1 D k 1 D P + + + + + + + =

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6-6 Example: The Dividend Discount Model – 1 Suppose that a stock will pay three annual dividends of \$200 per year, and the appropriate risk-adjusted discount rate, k, is 8%. In this case, what is the value of the stock today? ( 29 ( 29 ( 29 ( 29 ( 29 ( 29 \$515.42 0.08 1 \$200 0.08 1 \$200 0.08 1 \$200 P k 1 D k 1 D k 1 D P 3 2 0 3 3 2 2 1 0 = + + + + + = + + + + + =
6-7 Example: The Dividend Discount Model – 2 Suppose that a stock will pay three dividends of \$2, \$3, and \$4 per year (starting from the end of this year), and the appropriate risk-adjusted discount rate, k, is 8%, what is the value of the stock today? ( 29 ( 29 ( 29 ( 29 ( 29 ( 29 \$7.60 0.08 1 \$4 0.08 1 \$3 0.08 1 \$2 P k 1 D k 1 D k 1 D P 3 2 0 3 3 2 2 1 0 = + + + + + = + + + + + =

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6-8 The Dividend Discount Model: the Constant Growth Rate Model Assume that the dividends will grow at a constant growth rate g. The dividend next period (t + 1) is: For constant dividend growth for “T” years, the DDM formula becomes: ( 29 g) (1 g) (1 D g) (1 D D So, g 1 D D 0 1 2 t 1 t + × + × = + × = + × = + g k if D T P g k if k 1 g 1 1 g k g) (1 D P 0 0 T 0 0 = × = + + - - + =
6-9 Example: The Constant Growth Rate Model – 1 Suppose the current dividend is \$10, the dividend growth rate is 10%, there will be 20 yearly dividends, and the appropriate discount rate is 8%. What is the value of the stock, based on the constant growth rate model? ( 29 \$243.86 1.08 1.10 1 .10 .08 1.10 \$10 P k 1 g 1 1 g k g) (1 D P 20 0 T 0 0 = - - × = + + - - + =

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6-10 Example: The Constant Growth Rate Model – 2 Suppose the current dividend is \$10, the dividend growth rate is 8%, there will be 20 yearly dividends, and the appropriate discount rate is 10%.
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FIN355_Chapter6 - Chapter 6 McGrawHill/Irwin Common Stock...

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