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# Chapter 7 Common Stock Valuation.docx

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School
Department
Finance
Course
FIN 501
Professor
Edward Blinder
Semester
Summer

Description
FIN501 investment analysis I CHAPTER 7 COMMON STOCK VALUATION SECURITY ANALYSIS: BE CAREFUL OUT THERE  Fundamental analysis: examination of a firm’s accounting statements and other financial and economic information to assess the economic value of a company’s stock o Includes earnings per share, cash flow, book equity value, and sales  Cautionary note is there is good reason to believe that too-simple techniques that rely on widely available information are not likely to yield systematically superior investment results THE DIVIDEND DISCOUNT MODEL  The economic value of a security is properly measured by the sum of its future cash flows, where the cash flows are adjusted for risk and the time value of money  Dividend discount model (DDM): method of estimating the value of a share of stock as the present value of all expected future dividend payments, where dividends are adjusted for risk and the time value of money 2 3 T V(0) = D1/(1+k) + 2 /(1+k) + D3/(1+k) + ... + T /(1+k)  Constant growth rate model: a version of the dividend discount model that assumes a constant dividend growth rate T V(0) = [0 (1+g) / (k-g)] x [1 – (1+g / 1+k) ] ; where g ≠ k  Constant perpetual growth model: a version of the dividend discount model in which dividends grow forever at a constant rate, and the growth rate is strictly less than the discount rate o This method can only be applied to companies with a history of relatively stable earnings and dividend growth expected to continue into the distant future o The reason g or = k V(0) = [0 (1+g1) / (k1g )] x [1 – 11+g / 1+k) ] + 11+g / 1+k] x0[D (2+g ) /2(k-g )] o When the first stage growth rate is 1 = k, the formula reduces to: V(0) = D0x T + [0 (1+g2) / (k2g )] FIN501 investment analysis I EX. In five years, the company will pay a dividend for the first time at \$0.50 per share. You expect dividends to grow at a rate of 10% indefinitely and required return is 20%. V(4) = D4(1+g) / (k–g) = 5 / (0.20 – 0.10) = \$5 V(0) = \$5 / 1.20 = \$5 / 2.0736 = \$2.41 EX. Expected dividends for years 1, 2 and 3 are \$1.00, \$2.00, an \$2.50 respectively. After the third year, the dividend will grow at a constant rate of 5% per year. The required return is 10%. V(3) = D3x (1+g) / (k–g) = \$2.50 x 1.05/(0.10–0.05) = \$52.50 V(0) = [D1/ (1+k)] + [2 / (1+k) ] + [3 / (1+k) ] + 3V / (1+k) ] = [\$1/1.10] + [\$2/1.10 ] + [\$2.50/1.10 ] + [\$52.50/1.10 ] = \$0.91 + \$1.65 + \$1.88 + \$39.44 = \$43.88  The
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