Malkiel’s model = should be willing to pay more for a stock the higher is the growth rate
& longer it is expected to last –key to his rules hold if other things remain equal
if any new investment simply earns rate k, then growth is purely at the expense of
dividends & does nothing for the shareholder – whether firm invests the funds for
shareholder at rate k or shareholder gets dividends & invests elsewhere at rate k should
have no impact on value
insights = excess profits add to value & growth adds to value only if accompanied by
excess profits – model = limited in its assumption of a constant growth rate & constant
profit rate – real world = expect high growth opps. are at some point exhausted & high
profits might well be whittled away by entry
Malkiel’s four rules = security’s FF value & its PE multiple will be higher: the larger the
companies growth rate & longer its duration; the larger the dividend payout ratio for the
firm; the less risky the company’s stock; & the lower the general level of interest rates
risk is part of discount rate k, where k = risk free rate (rf) + equity premium €
=> good evidence that most investors are risk averse & would be willing to pay more for
a less risky security, other things being equal
general level of interest rates also in k in rf – to some extent bonds & stocks = substitutes
– if interest rate on bonds is lower, bonds less desirable & ppl willing to pay more for
stocks
stocks & PE risk falling – bid up & high returns & high PEs – future = no g, lower div.
yield & anticipated lower returns in fut.
maturity = # of years to the end of the bond, to the point where principle is to be repaid
duration = weighted avg. of years t until maturity, w/ weights being equal to the present
value of the cash flows to be paid in each period – elasticity of bond to interest rate
modified duration = D’=D/(1+r) = used by bond traders to express impact on value of a
change in interest rates of 100 basis points – higher MD = higher sensitivity
% change in value turns out to be slightly less than modified duration due to convexity
of the bond – bond’s value falls w/ r at a decreasing rate, the impact of the finite change is
a bit less than that implied by the derivative taken at the initial values
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 Spring '11
 Petersen
 Interest Rates, Interest, Risk premium

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