Stock Valuation and Markets Notes

Stock Valuation and Markets Notes - STOCK VALUATION AND...

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STOCK VALUATION AND MARKETS CHAPTER ORGANIZATION 8.1 Common Stock Valuation Cash Flows Some Special Cases Components of the Required Return 8.2 Some Features of Common and Preferred Stocks Common Stock Features Preferred Stock Features 8.3 The Stock Markets Dealers and Brokers Organization of the NYSE Nasdaq Operations Stock Market Reporting 8.4 Summary and Conclusions
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8.1. Common Stock Valuation .A Cash Flows Stock valuation is more difficult than bond valuation because the cash flows are uncertain, the life is forever and the required rate of return is unobservable. The cash flows to stockholders consist of dividends plus a future sale price. You can illustrate that the current stock price is ultimately the present value of all expected future dividends: P 0 = D 1 /(1+R) + D 2 /(1+R) 2 + D 3 /(1+R) 3 + … .B Some Special Cases Zero-growth – implies that D 0 = D 1 = D 2 … = D Since the cash flow is always the same, the PV is that for a perpetuity: P 0 = D / R Example: Suppose a stock is expected to pay a $2 dividend each period, forever, and the required return is 10%. What is the stock worth? P 0 = 2 / .1 = $20 Constant growth – Dividends are expected to grow at a constant percentage rate each period. D 1 = D 0 (1+g); D 2 = D 1 (1+g); in general D t = D 0 (1+g) t Note that this is really just a future value. Example: If the current dividend is $2 and the expected growth rate is 5%, what is D 1 ? D 5 ? D 1 = 2(1+.05) = $2.10 D 5 = 2(1+.05) 5 = $2.55 An amount that grows at a constant rate forever is called a growing perpetuity. The present value of all expected future dividends under this scenario can be expressed as follows: g - R D g - R g) 1 ( D P 1 0 0 = + =
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Example: Consider the stock given above. If the required return is 10%, what is the expected price today? In 4 years? P 0 = 2.10 / (.1 - .05) = $42 P 4 = 2.55 / (.1 - .05) = $51 Nonconstant (Supernormal) Growth Suppose a firm is expected to increase dividends by 20% in one year and by 15% in two years. After that dividends will increase at a rate of 5% per year indefinitely. If the last dividend was $1 and the required return is 20%, what is the price of the stock?
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