EC223 Chapter 7 – Stocks, Rational Expectations, and the Efficient Market Hypothesis Week 7
Computing the Price of a Common Stock
-Common stock if the principal way that corporations raise equity capital
-This ownership interest gives shareholders a bundle of rights
-Dividends are payments made periodically, usually every quarter, to stockholders
The One-Period Valuation Model
-To value the stock today, you need to find the present discounted value of the expected cash flows
P0= Div 1 + P1_____
(1+k e (1 +ke)
P0= the current price of the stock
Div1= the dividend paid at the end of the year
ke= the required return on investments in equity
P1= the price at the end of the first period; the assumed sales price of the stock
The Generalized Dividend Valuation Model
-The one-period valuation model can be extended to any number of periods
-The generalized dividend model is as follows:
P0 = Sum of D n__
(1 +ke)t
-Buyers of the stock expect that the firm will pay dividends someday
-Most of the time a firm institutes dividends as soon as it has completed the rapid growth phase of its
life cycle
-The generalized dividend valuation model requires that we compute the present value of an infinite
stream of dividends, a process that could be difficult
The Gordon Growth Model
-Assumes constant dividend growth
P0= D 0 (1 + g) = D 1_
(ke– g) (ke– g)
D 0 the most recent dividend paid
g = the expected constant growth in dividends
ke= the required return on an investment in equity
-This model is useful for finding the value of stock given a few assumptions:
1. Dividends are assumed to continue growing at a constant rate forever
2. The growth rate is assumed to be less than the required return on equity, k e
Price Earnings Valuation Method
-Awidely watched measure of how much the market is willing to pay for $1 earnings from a firm
-A high PE has two interpretations:
1. A higher than average PE may mean that the market expects earnings to rise in the future.
This would return the PE to a more normal level
2. A high PE may alternatively indicate that the market feels the firm’s earnings are very low risk
and is therefore willing to pay a premium for them
P x E = P
E
-Firms in the same industry are expected to

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