topic 7 Stock Valuation

# Topic 7 Stock - Stock Valuation Dividend Discount Model One year investor Cash flows may come from 2 potential sources The firm may pay out cash as

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Stock Valuation

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Dividend Discount Model One year investor Cash flows may come from 2 potential sources: The firm may pay out cash as dividend The investor might sell the shares at some future date When an investor buys stock, he will pay the current market price for a share, P0 . D1 is the total dividends paid per share during the year, assumed at the end of the year. At the end of the year, he’ll sell his share at the new market price, P1. We have the time line of investment: 0 1 -P0 D1+P1
Dividend Discount Model The future dividend payment and stock price are based on the investor’s expectations at the time of the stock is purchased. From these expectations, the investor will be willing to pay a price today up to the point that this transaction has a zero net present value (NPV), means Because these cash flows are risky, we cannot discount them by using the risk free interest rate, but use the equity cost of capital , instead, which is the expected return of other investments available in the market with ) ( 1 1 0 P D PV P + = , E r

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Dividend Discount Model Then, we can work out the stock price: If the current stock price less than P0, investor should buy this stock, otherwise he should sell it. E r P D P + + = 1 1 1 0
Dividend Yield, Capital Gains, and Total Return Total return: Total return = Dividend Yield + Capital Gain rate Dividend yield is the percentage return the investor expects to earn from the dividend paid by the stock. Capital gain is the earning from the difference between the expected sale price and the original purchase price of the stock. 0 0 1 0 1 0 0 1 0 1 0 1 1 rate gain Capital yield Dividend 1 P P P P D P P P P D P P D r E + = = - + = - + =

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Dividend Yield, Capital Gains, and Total Return Example: Suppose you expect LDS to pay annual dividend of %0.56 per share in the coming year and to trade for \$45.50 per share at the end of the year. If investments with equivalent risk to LDS’s stock have an expected return of 6.8%, what is the most you would pay today for LDS? What dividend yield and capital gain rate would you expect at this price?
Supposed that we plan to hold the stock for two years. Then we would receive dividends in both year 1 and year 2 before selling the stock, as below:

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## This note was uploaded on 12/17/2011 for the course B.A 13 taught by Professor Cr during the Spring '11 term at Haverford.

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Topic 7 Stock - Stock Valuation Dividend Discount Model One year investor Cash flows may come from 2 potential sources The firm may pay out cash as

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