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CHAPTER 7 EQUITY MARKETS AND STOCK VALUATION CHAPTER ORGANIZATION 7.1 Common Stock Valuation - FinSim 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. Let P 0 be the current price of the stock, and assign P 1 to be the price in one period. If D 1 is the cash dividend paid at the end of the period, then: P 0 = (D 1 + P 1 ) / (1 + R) 1 However, the future sale price depends on the dividends paid after that point. Therefore, you can illustrate that the current stock price is ultimately the present value of all expected future dividends discounted at a rate ( R ) appropriate to the riskiness of the cash flows: Growth Stocks You might be wondering about shares of stock in companies such as eBay that currently pay no dividends. Small, growing companies frequently plow back everything and thus pay no dividends. Are such shares worth nothing? It depends. When we say that the value of the stock is equal to the present value of the future dividends, we don't rule out the possibility that some number of those dividends are zero. They just can't all be zero. Imagine a company that has a provision in its corporate charter that prohibits the paying of dividends now or ever. The corporation never borrows any money, never pays out any money to stockholders in any form whatsoever, and never sells any assets. Such a corporation couldn't really exist because the IRS wouldn't like it; and the stockholders could always vote to amend the charter if they wanted to. If it did exist, however, what would the stock be worth? The stock would be worth absolutely nothing. Such a company is a financial “black hole.” Money goes in, but nothing valuable ever comes out. Because nobody would ever get any return on this investment, the investment has no value. This example is a little absurd, but it illustrates that when we speak of companies that don't pay dividends, what we really mean is that they are not currently paying dividends. Some Special Cases - There are a few very useful special circumstances under which we can come up with a value for the stock. What we have to do is make some simplifying assumptions about the pattern of future dividends, that is, the forecasted growth rate for dividends. Zero Growth: A share of common stock in a company with a constant dividend is much like a share of preferred stock. The dividend on a share of preferred stock has zero growth and thus is constant through time. For a zero growth share of common stock, this implies that: D 0 = D 1 = D 2 … = D Therefore, the value of the stock is:
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Because the dividend is always the same, the stock can be viewed as an ordinary perpetuity with a cash flow equal to D every period. The per-share value is thus given by: P 0 = D / R where R is the required return.
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