21Lecture21-revised

21Lecture21-revised - Economics 136 Financial Economics...

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Economics 136: Financial Economics Equities I – The Discounted Cash Flow Valuation Paradigm: The Gordon Growth Model & 2-Stage Dividend Discount Model November 19, 2012 Reading: BKM, Chapter 18, skim 19. Equities I: R. J. Hawkins Econ 136: Financial Economics 1/ 20
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The DDM for Constant Dividend Growth The Gordon Growth Model (Gordon & Shapiro, 1956) Growth In an earlier lecture we derived the Gordon Growth model: V 0 = D 0 (1 + g ) ( r s g ) = D 1 ( r s g ) where D 0 the latest dividend payment g the dividend growth rate r s the cost of equity capital D 1 the projected next dividend We can use the CAPM to calculate r s . What about g? Equities I: R. J. Hawkins Econ 136: Financial Economics 2/ 20
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Earnings and Dividend Growth General Observations Dividends are paid out of earnings. To understand dividend growth one needs to understand earnings growth. Three approaches to earnings growth: 1 Study the historical growth rate. 2 Rely on analysts. 3 Estimate from fundamentals. Equities I: R. J. Hawkins Econ 136: Financial Economics 3/ 20
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Earnings and Dividend Growth Study Historical growth rate An exercise in time-series analysis and forecasting of earnings per share (EPS). EPS t = c 0 + c 1 t + ... or ln (EPS t )= d 0 + d 1 t + or more complex econometrics (e.g. ARIMA). Time-series models outperform naive models. You only have quarterly observations of earnings (at best) for, typically, 10–15 years; 40 to 60 quarters of data. Equities I: R. J. Hawkins Econ 136: Financial Economics 4/ 20
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Earnings and Dividend Growth About Analysts Analysts can add value: 1 Firm-specifc in±ormation since last earnings report. 2 Macroeconomic in±ormation bearing on ±uture growth. 3 New competitor in±ormation. 4 Private in±ormation about the frm. 5 Public in±ormation other than earnings. e.g. earnings retention, proft margins, asset turnover, etc. However, “[t]he evidence indicates that this superiority in forecasting is surprisingly small for long-term [3-yr or 5-yr] forecasts and that past growth plays a signiFcant role in determining analysts forecasts.” Things to consider: 1 The amount o± recent frm-specifc in±ormation. 2 The number and quality o± analysts ±ollowing the stock. 3 The extent o± disagreement among analysts. Equities I: R. J. Hawkins Econ 136: Financial Economics 5/ 20
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Earnings and Dividend Growth Fundamental Analysis Growth: “The sustainable growth rate is the rate of earnings and dividend growth that can be sustained for a given level of
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21Lecture21-revised - Economics 136 Financial Economics...

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