Econ2035_Ch7

# s7mulated economy future dividends p0 6 the gordon

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Unformatted text preview: stock price can be calculated solely from the future dividend stream ∞ = =(+ ) •  Reality: Many stocks do not pay dividends Q: Why can those stocks have value? A: Buyers expect that the ﬁrm will pay dividends someday 5 The Generalized Dividend Valua7on Model •  Rela7on between a stock price and monetary policy ∞ = =(+ ) •  Expansionary monetary policy –  Lower interest rate ⇒ ↓required return (why?) –  S7mulated economy ⇒ ↑(future) dividends ⇒ ↑P0 6 The Gordon Growth Model •  Problems in the generalized dividend valua7on model: –  Values of dividend paid in the future (D1, D2, D3, …) are known with certainty –  It is not easy to calculate •  Simplifying assump7on: –  Dividends are expected to increase over 7me at a constant rate (g) –  Dt+1 = (1+g) Dt Dt+2 = (1+g) Dt+1 = (1+g) × (1+g) Dt = (1+g)2 Dt In general, Dt+j = (1+g)j Dt 7 The Gordon Growth Model •  With the assump7on, the current stock price can be expressed as: ×( + ) ×( + ) × ( + )∞ = + + ···+ (+ ) (+ ) ( + )∞ where D0 = the most recent dividend paid g = the expected constant growth rate in dividends ke = the required return on an investment in equity 8 The Gordon Growth Model •  With some algebra, it can be simpliﬁed to ×( + ) = = − − •  Underlying Assump7ons: a)  Dividend con7nues to grow at a constant rate (g) forever b)  g must be less than ke. Otherwise P0 becomes nega7ve. 9 The Gordon Growth Model = •  Implica7ons: ×( + ) − = − –  As g↑, P0↑(and vice versa) –  As ke↑, P0↓(and vice versa) –  Changes in D0 also posi7vely aﬀect P0 10 The Gordon Growth Model •  Understanding the shocks to the stock market •  Nega7ve shocks (e.g., the September 11 and Financial Crisis 2008) •  Increased uncertainty about the future economy –  Expec7ng lower growth rate of the economy ⇒ lower g –  Increasing risk ⇒ higher ke Stock price today (Po) ↓ 11 Theory of Expecta7on •  Expecta7on plays an important role in the stock price determina7on...
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## This note was uploaded on 06/11/2012 for the course ECON 2035 taught by Professor Stahl during the Spring '08 term at LSU.

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