Thus the expected return that an investor expects

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Unformatted text preview: las The price of a stock is equal to the present value of all future dividends. The intuition behind this insight is that the cash payoff to owners of the stock is equal to cash dividends plus capital gains or losses. Thus, the expected return that an investor expects from a investing in a stock over a set period of time is equal to: (14) Expected return on stock r dividend  capital gain investment Div1  P1  P0 P0 Where Divt and Pt denote the dividend and stock price in year t, respectively. Isolating the current stock price P0 in the expected return formula yields: (15) Div1  P1 1 r P0 The question then becomes "What determines next years stock price P1?". By changing the subscripts next year's price is equal to the discounted value of the sum of dividends and expected price in year 2: Div2  P2 1 r P 1 Inserting this into the formula for the current stock price P0 yields: Div1  P1 1 r P0 1 Div1  P1 1 § Div1  Div 2  P2 · ¸ ¨ 1 r 1 r © 1 r ¹ Div1 Div 2  P2  1 r (1  r ) 2 By recursive substitution the current stock price is equal to the sum of the present value of all...
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