CH10Answers - Chapter 10: Common Stock Valuation CHAPTER...

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Chapter 10: Common Stock Valuation CHAPTER OVERVIEW The coverage of common stocks is divided into two chapters. Chapter 10 covers the valuation of stocks, while Chapter 11 focuses on the analysis and management of stocks. In addition, the chapter on efficient markets concludes Part III because the concept is almost entirely concerned with stocks as far as students in a beginning Investments course are concerned. Chapter 10 is one of the most important chapters in the text. It covers the valuation of common stocks in detail, including both the discounted cash flow approach and the P/E ratio approach. Clearly, students should know how to find the intrinsic value of a stock using the capitalization of income approach--that is, they should know how to use the Dividend Discount Model--as well as be familiar with how the P/E ratio is used in common stock valuation. The chapter opens by explaining the present value approach to valuation. This capitalization of income method seeks to determine the value of a security (its intrinsic value) by discounting all expected future cash flows using a required rate of return. This discussion also includes a brief consideration of the required rate of return and the expected cash flows. The chapter centers around Discounted Cash Flow (DCF) techniques, which underlie a true understanding of common stock valuation. The traditional Dividend Discount Model (DDM) includes the three growth rate cases: zero growth, constant growth, and multiple growth. Numerous examples are provided throughout. The purpose of this analysis is to provide students with the necessary insight into how stock valuation often relies on discounting expected cash flows. Students will be able to apply this knowledge to sove valuation problems, which are found at the end of the chapter. NOTE: While the DDM has its limitations, and may in many cases not be used by practicing security analysts and investors, it is essential that students understand this model as the basis for valuation. It is the classic, time-honored approach, and should be the beginning point when learning common stock valuation techniques. Furthermore, major providers of stock information and recommendations, such as , regularly calculate an intrinsic value for a stock and talk about this intrinsic value. Morningstar also does this when it talks about “fair value estimates.” Therefore, the DDM cannot simply be dismissed as being not very useful in the real world. The essential points about the Dividend Discount Model are discussed, including dividends vs. price in the model and the concept of intrinsic value itself. A detailed analysis of the constant growth model is highlighted in the Appendix by an example showing the present value of the first 60 years of dividends, year by year. The multiple growth model is fully described, with examples.
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DCFs techniques involving both free cash flow to equity and free cash flow to the firm are discussed. Differences between the two are considered. Relative valuation techniques and target prices are considered as an alternative approach
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This note was uploaded on 02/13/2012 for the course FINA 3480 taught by Professor Moore during the Spring '11 term at Toledo.

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CH10Answers - Chapter 10: Common Stock Valuation CHAPTER...

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