Textbook Notes (368,439)
Canada (161,878)
Finance (362)
FIN 501 (31)
Chapter 7

Chapter 7.docx

6 Pages
Unlock Document

FIN 501
Edward Blinder

Chapter 7: Common Stock Valuation  7.1 Security Analysis:  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  Numbers such as a company’s earnings per share, cash flow, book equity value, and sales are often called fundamentals because they describe, on a basic level, a specific firm’s operations and profits (or lack of profits)  7.2 The Dividend Discount Model:  A fundamental principle of finance holds that 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)  For example, suppose a company pays a dividend at the end of the year. - Let D(t) denote a dividend to be paid t years from now - Let V(0) represent the present value of the future dividend steam - Let k denote the appropriate risk-adjusted discount rate - Using the dividend discount mode, the present value of a share of this company’s stock is measured as this sum of discounted future dividends: ( ) ( ) ( ) ( ) ( ) ( ) ( ) ( ) ( ) - Assumes that the last dividend is paid T years from now, where the value of T depends on the specific valuation problem considered  Constant Dividend Growth Rate Model: a version of the dividend discount model that assumes a constant dividend growth rate - Letting a constant growth rate be denoted by g, then successive annual dividends are stated as: ( ) ( )( ) - If the number of dividends to be paid is large, calculating the present value of each dividend separately is tedious and possibly prone to error - Fortunately, if the growth rate is constant, some simplified expressions are available to handle certain special cases - The present value of the next T dividends, that is, D(1) through D(T), can be calculated using this: ( ) ( )( ) [ ( ( )) ] ( ) - Requires that the growth rate and the discount rate does not equal to each other ( ), since this requires division to be zero - When the growth rate is equal to the discount rate, that is, k=g, the effects of growth and discounting cancel exactly, and the present value V(0) is simply the number of payments T times the current dividend D(0): ( ) ( )  Constant Perpetual Growth: - Where a firm will pay dividends that grow at the constant rate g forever - 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 - Constant perpetual growth model: ( )( ) ( ) ( ) - Since D(0)(1+g)= D(1), we could also write the constant perpetual growth model as: ( ) ( ) ( )  Applications of the Constant Perpetual Growth Model: - The constant perpetual growth model can be usefully applied only to companies with a history of relatively stable earnings and dividend growth expected to continue into the distant future  Historical Growth Rates: - In the constant growth model, a company’s historical average dividend growth rate is frequently taken as an estimate of future’s dividend growth - There are two ways to calculate a historical growth rate yourself: 1. Geometric Average Dividend Growth Rate: a dividend growth rate based on a geometric average of historical dividends ( ) ⁄ [ ] ( ) D(0) is the earliest dividend and D(N) is the latest dividend to be used. 2. Arithmetic Average Dividend Growth Rate: a dividend growth rate based on an arithmetic average of historical dividends o We first calculate each year’s dividend growth rate separately and then calculate an arithmetic average of these annual growth rates o Example on page 195  The Sustainable Growth Rate: - It is necessary to come up with an estimate of g, the growth rate in dividends - In our previous discussions, we described two ways to do this: (1) using the company’s historic average growth rate or (2) using an industry median or average growth rate - We now describe a third way, know as the sustainable growth rate: a dividend growth rate that can be sustained by a company’s earnings - Retained Earnings: earnings retained within the firm to finance growth - Payout Ratio: proportion of earnings paid out as dividends - Retention Ratio: proportion of earnings retained for reinvestment - If we let D stand for dividends and EPS stand for earnings per share, then the payout ratio is: - The Retention Ratio: ( ) - Return on equity is commonly computed using an accounting-based performance measure and is calculated as a firm’s net income dividend by stockholders’ equity: ( ) - Common problems with sustainable growth rates is that they are sensitive to year-to-year fluctuations in earnings - Security analysts routinely adjust sustainable growth rate estimates to smooth out the effects of earning variations  7.3 The Two-Stage Dividend Growth Model:  Two-stage dividend growth model: dividend model that assumes a firm will temporarily grow at a rate different from its long-term growth rate  Assumes that a firm will initially grow at a rate during a first stage of growth lasting T years and thereafter grow at a rate during a perpetual second stage of growth  The present value formula for the two-stage dividend growth model is stated as follows: ( )( ) ( )( ) ( ) [ ( ) ] ( ) ( ) - The first term on the right-hand side measures the present value of the first T dividends and is the same expression we used earlier for the constant growth model - The second term then measures the present value of all subsequent dividends  The two-stage formula requires that the second-stage growth rate be strictly less than the discount rate, that is,  However, the first- stage growth rate can be greater, smaller, or equal to the discount rate  In the special case where the first-stage growth rate is equal to the discount rate, that is, , the two- stage formula reduces to this form: ( )( ) ( ) ( )  The last case we consider is non-constant growth in the first stage  Using the dividend growth model, we can say that the price in 4 years will be: ( ) ( ) ( ) ( ) ( ) ( ) ( )  We can now calculate the total value of the stock as the present value of the first three dividends plus the present value of the price at Time 3, V(3): total value of the stock today
More Less

Related notes for FIN 501

Log In


Join OneClass

Access over 10 million pages of study
documents for 1.3 million courses.

Sign up

Join to view


By registering, I agree to the Terms and Privacy Policies
Already have an account?
Just a few more details

So we can recommend you notes for your school.

Reset Password

Please enter below the email address you registered with and we will send you a link to reset your password.

Add your courses

Get notes from the top students in your class.