ACCT820 Chapter 11 Risk Adjusted Expected Rates of Return and the Dividends Valuation Approach[1]

ACCT820 Chapter 11 Risk Adjusted Expected Rates of Return and the Dividends Valuation Approach[1]

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Unformatted text preview: Introduction and Overview • Economic theory teaches that the value of an investment equals the present value of the projected future payoffs from the investment discounted at a rate that reflects the time value of money & the risk inherent in those expected payoffs o A general model for the PV of a security at time t=0 (denoted as V ) w/an expected life of n future periods is as follows: V = Sum from t=1 to n of (Projected Future Payoffs t )/(1 + Discount Rate) t • In securities markets that are less than perfectly efficient, price does not necessarily equal value for every security at all times; therefore, it can be very fruitful to search for & analyze securities that may have prices that have deviated temporarily from their fundamental values o When buying a security, the investor pays the security’s price & receives the security’s value; when selling it, the investor receives the selling price & gives up the security’s value o Price is observable, but value is not; value must be estimated o Therefore, estimating the value of a security to make intelligent investment decisions is a common objective of financial statement analysis o Investors, analysts, investment bankers, corporate managers, & others engage in financial statement analysis & valuation to determine a reliable appraisal of the value of shares of common equity or the value of whole firms • Equity valuation models based on dividends, CFs, & earnings have been the topic of many theoretical & empirical research studies in recent years o These studies provide many insights into valuation, but 2 very compelling general conclusions emerge: 1. Share prices in the capital markets generally correlate closely w/share value, but 2. Share prices do not always equal share values, & temporary deviations of price from value occur • First, many studies demonstrate that dividends, CFs, & earnings-based valuation models generally provide significant explanatory power for share prices observed in the capital markets o The results show that share value estimates determined from these valuation models exhibit high positive correlations w/the stock prices observed in the capital markets o These correlations hold across different types of firms, during different periods of time, & across different countries o In the same vein, many empirical research studies also have shown that unexpected changes in earnings, dividends, & CFs correlate closely w/changes in stock prices • Second, a number of empirical research studies show that valuation models also help identify when share prices in the capital markets temporarily deviate from fundamental share values o Research results show that dividends, CFs, & earnings based valuation models help identify when shares are temporarily overpriced or underpriced, representing potentially profitable investment opportunities o Study by Frankel & Lee: sorted sample of firms each year into 5 portfolios based on quintiles of their estimate of value to share price; their findings show striking...
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This note was uploaded on 02/22/2012 for the course ACCT 820 taught by Professor Staff during the Fall '09 term at Texas State.

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ACCT820 Chapter 11 Risk Adjusted Expected Rates of Return and the Dividends Valuation Approach[1]

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