FIN 300 Chapter Notes - Chapter 8: Price–Earnings Ratio, Cash Flow, 0 (Year)
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FIN300 Wednesday, January 30, 2013
Chapter 8 Notes
A share of stock is a unit of ownership in a company. Shares and stocks are used interchangeably,
also equities and securities. Stockholders, shareholders, owners and stock investors are terms to
describe the person who earns the shares.
Labeled common stock on Liabilities/Owners Equity on a B/S. Dividends come to stock holders
too. They are a residual owner.
One restriction, they cannot use the company’s buildings or assets, only when there is liquidation
during bankruptcy and after the bond holders are paid off.
A Measure for the Stocks Market Analysis
Price Earnings (P/E) Ratio
The price of the stock divided by the earning per share (EPS). Key tool of stock market analysis
to determine ‘how well’ a company is doing.
P/E Ratio = Stock Price / EPS
Cash Flows for Shareholders
Cash can be received in two ways as a stockholder
-dividends cash payments taken from net income generated by the firm.
- sell your shares and make a capital gain/loss. You sell that either to an investor or back to
The price of the stock is the PV of these expected cash flows, as with bonds.
- the amount investors are WTP for the shares of the firm.
- not the book value, which is the net worth of the firm according to the B/S
- depending on the earning power of the existing assets and the expected profitability of fu-
ture investments. These determine the price.
Unrealistic ONE Period Ex:
Thinking of purchasing a stock in Moore Oil.
1) Expect it to pay a $2 dividend in one year (cashflow)
2) Believe you can sell it for $14 at that time (price, for this ex. FV)
3) Require a Rate of Return of 20% on investment (discount rate)
4) What is max. WTP? (PV, today)
- compute the PV of the expected cash flows
FIN300 Wednesday, January 30, 2013
-P/YR 1; PMT 2; FV=14; I/Y=20; N=1; CPT PV = -13.33
Realistically, you can’t know the stock sale price in future periods.
Stock is valued as the PV of all expected future cashflows (e.g. dividends)
To know the price in 5 years, we need the PV of all dividends paid from that point forwards.
Three Ways to Estimate Dividends
1) Constant dividend / zero growth
1) Pay a constant dividend forever (preferred stock)
2) Computed with the perpetuity formula
3) Certain percentages chosen is this, no matter if the actual cash flow increases, the per-
centage does not.
2) Constant dividend growth
1) Firm will increase the dividend by a constant percent every period
2) Computed using the dividend growth model
3) Supernormal growth
1) Dividend growth is not consistent initially but settles into a constant growth eventually
2) Formula is a combination of the dividend growth model and additional present value
CALCULATE PV of future expected dividends/cashflows! This is because FV cannot be known.
1) Zero Growth
Regular intervals forever, makes this a perpetuity.
P = D / R₀
P is the stock price at time 0, D is dividend, and R is the rate of required return₀
NOTE: D and R need to be on the same frequency basis- if the dividend is
paid annually, then the rate must be expressed annually
Ex: Suppose stock is expected to pay $0.50 dividend every quarter and the RRR is 10% with
quarterly compounding. What’s the price?
D = 0.50
R = 10% (THIS IS APR, EAR will have to be calculated if needed, APR will always be given)
P = D / (R/m) = 0.5 / (0.1 / 4 [quarterly compounding]) = 20₀
2) Dividend Growth Model (DGM)
DGM is used when dividends are expected to grow at a constant percent per period.