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Chapter 7

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Angela Trimarchi

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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