Valuing Common Stocks
Growth can be derived from applying the return on equity to the percentage of
earnings plowed back into operations.
g = return on equity X plowback ratio
Our company forecasts to pay a $5.00 dividend next year, which represen
Inflation and Examples
You own a lease that will cost you $8,000 next year, increasing at 3% a year (the
forecasted inflation rate) for 3 additional years (4 years total). If discount rates are 10%
what is the present value cost of the lease?
Measuring Market Risk
Market Portfolio - Portfolio of all assets in the economy. In practice a broad stock
market index is used to represent the market.
Beta - Sensitivity of a stocks return to the return on the market portfolio.
(Technically, beta measur
Random Walk Theory
The movement of stock prices from day to day DO NOT reflect any pattern.
Statistically speaking, the movement of stock prices is random (skewed positive over
the long term because of the positive return required of stocks in general).
Diversification decreases variability from unique risk, but not from market risk.
The beta of your portfolio will be an average of the betas of the securities in the
If you owned all of the S&P Composite Index stocks, you would
Valuing Non-Dividend Stocks
What if a stock does not pay dividends and declares that it does not expect to?
Answer: Valuation is done by estimating cash flow and assuming that the
value of the firm is the discounted stream of cash that it generates. (Note
Stocks and Simple Models
Terminology of Stocks
Public Common Stock - Ownership shares in a publicly held corporation.
Primary Market - Place where the sale of new stock first occurs.
Secondary Market - market in which already issued securities are traded
Treatment of Inflation
Separate Investment & Financing Decisions
Calculating Cash Flows
Example: Blooper Industries
Cash Flow vs. Accounting Income
Discount actual cash flows
Using accounting income, rather than cash flow, could lead to erroneous decision
Proportionate Dividend Value
No Growth Perpetuity Model
If we forecast no growth, and plan to hold out stock indefinitely, we will then value
the stock as a perpetuity. (NOTE: First payment is dividend in time period 1 not 0)
Gordon Growth Model