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Ryerson University
Information Technology Management
ITM 102
Louis Pike

CHAPTER 8 – STOCK VALUATION 8.1 Reasons for difficulty in evaluating a share: 1) Promised cash flows are not known in advance 2) Life of the investment is forever as common stock has no maturity 3) No way to observe the rate of return that the market requires Present Value of FCF (Future Cash Flows) to determine share of stock value: Po = (D1 + P1) / (1+r) D = cash dividend paid at the end of the period Po = Current price of the stock P1 = Price in one period R = required return in the market on the investment Current price of the stock can be written as the PV of the dividends beginning in one period and extending out forever: D1/(1+r)^1 + D2/(1+r)^2 + D3/(1+r)^3…. Price of the stock today is = to the present value of all the future dividends. Special Cases 1) Dividend has a zero growth rate D1=D2=D3=D=constant P0 = D1/(1+r)^1 + D2/(1+r)^2 + D3/(1+r)^3…. Because the dividend is always the same, the stock can be viewed as an ordinary perpetuity. P0 = D/r R = Required rate of return 2) Constant growth (The dividend grows at a constant rate) – growing perpetuity Dt = D0 x (1+g)^t T = periods in the future G= growth rate Only if the growth rate, g, is less than the discount rate, r, use the DIVIDENT GROWTH MODEL BELOW: P0 = D0 x (1+g)/r-g = D1/r-g To get the stock price at any point in time use: Pt = Dt x (1+g)/r-g = Dt+1/r-g 3) The dividend grows at a constant rate after some length of time If the company is not currently paying dividends and decides to in 4 years one can calculate the stock price today. We find out what it will be worth once dividends are paid. Then calculate the PV of that future price to get todays price. P4 = D5/r-g Ex. The stock will be worth 5$ in four years. To get the current value, discount this back four years. P0 = 5/ (1+r)^4 SPECIAL CASE: To calculate value of the stock today, do the following: Changing the Growth Rate r = (r-g) = D1/P0 r = D1/P0 + g Dividend Yield = D1/P0 The price a share of preferred stock is the dividend divided by the required return. Ex. Dividends will be paid 12$ per year beginning in 4 years. To find PV of preferred stock: Find P3, then P3/(1+r)^3 Rate at which the stock price grows = Capital gains yield Dividend growth model calculates total return as: r = Dividends yield + Capital gains yield Companies that don’t pay dividends: Find benchmark PE Ratio by stock’s price per share to its EPS over the previous year. PE Ratio = Stock price/share/Earnings per share (EPS) Price at time t = Pt = Benchmark PE Ratio x EPSt 8.2 Shareholders Rights Shareholders have the right to hire management/directors to
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