Lecture5 - Lecture 5 Stock Valuation RSM 332 Capital Market Theory Rotman School of Management University of Toronto Mike Simutin October 12/13

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Lecture 5: Stock Valuation RSM 332 Capital Market Theory Rotman School of Management University of Toronto Mike Simutin October 12/13, 2011 Stock Valuation RSM 332, 1/21
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Why Is This Important? I Stocks is an important and often the largest component of an investment portfolio I Equity valuation allows you to determine if a stock is undervalued or overvalued and thus invest your money smartly I To conduct a merger or acquisition, we need a way to value stocks I To take your company public, we need a way to value stocks I Equity markets seem to offer great riches if only you could understand how to value stocks I Equity valuation is probably one of the most exciting and least certain areas of finance Stock Valuation RSM 332, 2/21
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Stocks I Stocks (equities) represent ownership interests in the firm I If you buy a stock, you can receive cash in two ways 1. When the company pays dividends 2. When you sell your shares Two major types of stocks 1. Common stock I Represents residual claim on the firm’s cash flows: common shareholders get paid after everyone else is paid I Can receive dividends at management’s discretion I Elect board of directors, which chooses top management 2. Preferred stock I Receives fixed dividend payments before common stockholders I Dividends can be skipped but any skipped dividend must be paid in full in the future I Usually have no voting rights Stock Valuation RSM 332, 3/21
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How Is the Price of a Stock Determined? I You own a share of stock today that is worth P 0 . What do you get for holding it for one period? I Dividend, D 1 I Proceeds from selling it, P 1 I Price today is the present value of future cash flows P 0 = D 1 + P 1 1 + r where r is the appropriate discount rate I What is the price of the stock next period, P 1 ? P 1 = D 2 + P 2 1 + r Stock Valuation RSM 332, 4/21
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I Let’s substitute this equation for P 1 into P 0 formula P 0 = D 1 + ± D 2 + P 2 1 + r ² 1 + r = D 1 1 + r + D 2 (1 + r ) 2 + P 2 (1 + r ) 2 I We can repeat this for P 2 , then for P 3 , etc. and get P 0 = D 1 1 + r + D 2 (1 + r ) 2 + D 3 (1 + r ) 3 + ... = X t =1 D t (1 + r ) t I So stock price = PV of dividend payments, and we can use time value of money techniques to value stocks that pay I Dividends growing at a zero rate I Dividends growing at a constant rate I Dividends growing at different rates at different times I But Microsoft only started paying dividends in 2003, and Apple is still not paying any dividends I Does this mean that our approach is wrong? Stock Valuation
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This note was uploaded on 10/22/2011 for the course RSM 332 taught by Professor Raymondkan during the Spring '08 term at University of Toronto- Toronto.

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Lecture5 - Lecture 5 Stock Valuation RSM 332 Capital Market Theory Rotman School of Management University of Toronto Mike Simutin October 12/13

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