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One Period Valuation Model.To value a stock, you first find the present discounted value of the expected cash flows.
P0 = Div1/(1 + ke) + P1/(1 + ke) where
P0 = the current price of the stock
Div = the dividend paid at the end of year 1
ke = required return on equity investments
P1 = the price at the end of period one[ Q,'One Period Valuation ModelP0 = Div1/(1 + ke) + P1/(1 + ke)
Let ke = 0.12, Div = 0.16, and P1 = $60.
P0 = 0.16/1.12 + $60/1.12
P0 = $0.14285 + $53.57
P0 = $53.71
If the stock was selling for $53.71 or less, you would purchase it based on this analysis.
,%)F[[$Generalized Dividend Valuation Model%%(The one period model can be extended to any number of periods.
P0 = D1/(1+ke)1 + D2/(1+ke)2 +& + Dn/(1+ke)n + Pn/(1+ke)n
If Pn is far in the future, it will not affect P0
Therefore, the model can be rewritten as:
P0 = S Dt/(1 + ke)t?9\&?+*$Generalized Dividend Valuation Model%%(The model says that the price of a stock is determined only by the present value of the dividends.
If a stock does not currently pay dividends, it is assumed that it will someday after the rapid growth phase of its life cycle is over.
Computing the present value of an infinite stream of dividends can be difficult.
Simplified models have been developed to make the calculations easier.<cc The Gordon Growth ModelGordon Growth ModelAssumptions:
Dividends continue to grow at a constant rate for an extended period of time.
The growth rate is assumed to be less than the required return on equity, ke.
Gordon demonstrated that if this were not so, in the long run the firm would grow impossibly large.P
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d Gordon Model: ExampleFind the current price of Coca Cola stock assuming dividends grow at a constant rate of 10.95%, D0 = $1.00, and ke is 13%.
P0 = D0(1 + g)/ke g
P0 = $1.00(1.1095)/0.13 - 0.1095 =
P0 = $1.1095/0.0205 = $54.12{Xa "
Gordon Model: ConclusionsTheoretically, the best method of stock valuation is the dividend valuation approach.
But, if a firm is not paying dividends or has an erratic growth rate, the approach will not work.
Consequently, other methods are required.Price Earnings Valuation MethodThe price earning ratio (PE) is a widely watched measure of how much the market is willing to pay for $1 of earnings from a firm.
A high PE has two interpretations:
A higher than average PE may mean that the market expects earnings to rise in the future.
A high PE may indicate that the market thinks the firm s earnings are very low risk and is therefore willing to pay a premium for them.&Price Earnings Valuation Method<The PE ratio can be used to estimate the value of a firm s stock.
Firms in the same industry are expected to have similar PE ratios in the long run.
The value of a firm s stock can be found by multiplying the average industry PE times the expected earnings per share.
P/E x E = P
R
Price Earnings Model: ExampleThe average industry PE ratio for restaurants similar to Applebee s is 23. What is the current price of Applebee s if earnings per share are projected to be $1.13?
P0 = P/E x E
P0 + 23 x $1.13 = $26.R.Price Earnings Valuation MethodAdvantages:
Useful for valuing privately held firms and firms that do not pay dividends.
Disadvantages:
By using an industry average PE ratio, firm-specific factors that might contribute to a long-term PE ratio above or below the average are ignored.LMMSetting Security Prices(Stock prices are set by the buyer willing to pay the highest price.
The price is not necessarily the highest price that the stock could get, but it is incrementally greater than what any other buyer is willing to pay.
The market price is set by the buyer who can take best advantage of the asset.:DODOSetting Security PricesSuperior information about an asset can increase its value by reducing its risk.
The buyer who has the best information about future cash flows will discount them at a lower interest rate than a buyer who is uncertain.0QOErrors in Valuation-Problems with Estimating Growth
Growth can be estimated by computing historical growth rates in dividends, sales, or net profits.
But, this approach fails to consider any changes in the firm or economy that may affect the growth rate.
Competition, for example, will prevent high growth firms from being able to maintain their historical growth rate.
Nevertheless, stock prices of historically high growth firms tend to reflect a continuation of the high growth rate.
As a result, investors receive lower returns than they would by investing in mature firms.@ C CEstimating Growth: Table 1Errors in ValuationProblems with Estimating Risk
The dividend valuation model requires the analyst to estimate the required return for the firms equity.
However, a share of stock offering a $2 dividend and a 5% growth rate changes with different estimates of the required return.&Estimating Risk: Table 2Errors in ValuationProblems with Forecasting Dividends
Many factors can influence the dividend payout ratio. They include:
The firm s future growth opportunities a
Management s concern over future cash flows
Conclusion:
Analysts are seldom certain that the stock price projections are accurate.
This is why stock prices fluctuate widely on news reports.
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Growth(%) Price
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12 30.00
13 26.25
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'A x(xʦ""")))UUUMMMBBB999|PP3f3333f333ff3fffff3f3f̙f3333f3333333333f3333333f3f33ff3f3f3f3333f3333333f3̙33333f333ff3ffffff3f33f3ff3f3f3ffff3fffffffff3fffffff3f̙ffff3ff333f3ff33fff33f3ff̙3f3f3333f333ff3fffff̙̙3̙f̙̙̙3f̙3f3f3333f333ff3fffff3f3f̙3ffffffffff!___wwwmmmmCCCommmmmmmmmm!mmmmCCyCmmmmּּCּּּܼmmmmCCyyCommmmmC!CmmmmCCCRCCnmmCܼCCCܼܼܼmmmmmCCyyCCommm!C!!C!mmmmmCCQyQCCnmmmּCCCּCCCּּmmmmmCCyRyCCmmmmmCC!CCC!CCmmmmCCyQCCnmmmmܼCCCCCCoS,ܼܼCmCCyCCmmmm!C!C!to,,,,CCCQyCnmmּܼSCCB+E%S,E,ּܼC_CCyCCmCm,B,+$+,,,CCCCCCCCmCCmnܮ,S,E+E,S,ܼܼcc The Gordon Growth ModelGordon Growth ModelAssumptions:
Dividends continue to grow at a constant rate for an extended period of time.
The growth rate is assumed to be less than the required return on equity, ke.
Gordon demonstrated that if this were not so, in the long run the firm would grow impossibly large.P
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P0 = D0(1 + g)/ke g
P0 = $1.00(1.1095)/0.13 - 0.1095 =
P0 = $1.1095/0.0205 = $54.12{Xa "
Gordon Model: ConclusionsTheoretically, the best method of stock valuation is the dividend valuation approach.
But, if a firm is not paying dividends or has an erratic growth rate, the approach will not work.
Consequently, other methods are required.Price Earnings Valuation MethodThe price earning ratio (PE) is a widely watched measure of how much the market is willing to pay for $1 of earnings from a firm.
A high PE has two interpretations:
A higher than average PE may mean that the market expects earnings to rise in the future.
A high PE may indicate that the market thinks the firm s earnings are very low risk and is therefore willing to pay a premium for them.&Price Earnings Valuation Method<The PE ratio can be used to estimate the value of a firm s stock.
Firms in the same industry are expected to have similar PE ratios in the long run.
The value of a firm s stock can be found by multiplying the average industry PE times the expected earnings per share.
P/E x E = P
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Price Earnings Model: ExampleThe average industry PE ratio for restaurants similar to Applebee s is 23. What is the current price of Applebee s if earnings per share are projected to be $1.13?
P0 = P/E x E
P0 + 23 x $1.13 = $26.R.Price Earnings
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One Period Valuation Model.To value a stock, you first find the present discounted value of the expected cash flows.
P0 = Div1/(1 + ke) + P1/(1 + ke) where
P0 = the current price of the stock
Div = the dividend paid at the end of year 1
ke = required return on equity investments
P1 = the price at the end of period one[ Q,'One Period Valuation ModelP0 = Div1/(1 + ke) + P1/(1 + ke)
Let ke = 0.12, Div = 0.16, and P1 = $60.
P0 = 0.16/1.12 + $60/1.12
P0 = $0.14285 + $53.57
P0 = $53.71
If the stock was selling for $53.71 or less, you would purchase it based on this analysis.
,%)F[[$Generalized Dividend Valuation Model%%(The one period model can be extended to any number of periods.
P0 = D1/(1+ke)1 + D2/(1+ke)2 +& + Dn/(1+ke)n + Pn/(1+ke)n
If Pn is far in the future, it will not affect P0
Therefore, the model can be rewritten as:
P0 = S Dt/(1 + ke)t?9\&?+*$Generalized Dividend Valuation Model%%(The model says that the price of a stock is determined only by the present value of the dividends.
If a stock does not currently pay dividends, it is assumed that it will someday after the rapid growth phase of its life cycle is over.
Computing the present value of an infinite stream of dividends can be difficult.
Simplified models have been developed to make the calculations easier.>cc The Gordon Growth ModelGordon Growth ModelAssumptions:
Dividends continue to grow at a constant rate for an extended period of time.
The growth rate is assumed to be less than the required return on equity, ke.
Gordon demonstrated that if this were not so, in the long run the firm would grow impossibly large.P
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P0 = D0(1 + g)/ke g
P0 = $1.00(1.1095)/0.13 - 0.1095 =
P0 = $1.1095/0.0205 = $54.12{Xa "
Gordon Model: ConclusionsTheoretically, the best method of stock valuation is the dividend valuation approach.
But, if a firm is not paying dividends or has an erratic growth rate, the approach will not work.
Consequently, other methods are required.Price Earnings Valuation MethodThe price earning ratio (PE) is a widely watched measure of how much the market is willing to pay for $1 of earnings from a firm.
A high PE has two interpretations:
A higher than average PE may mean that the market expects earnings to rise in the future.
A high PE may indicate that the market thinks the firm s earnings are very low risk and is therefore willing to pay a premium for them.&Price Earnings Valuation Method<The PE ratio can be used to estimate the value of a firm s stock.
Firms in the same industry are expected to have similar PE ratios in the long run.
The value of a firm s stock can be found by multiplying the average industry PE times the expected earnings per share.
P/E x E = P
`
Price Earnings Model: ExampleThe average industry PE ratio for restaurants similar to Applebee s is 23. What is the current price of Applebee s if earnings per share are projected to be $1.13?
P0 = P/E x E
P0 + 23 x $1.13 = $26.R.Price Earnings Valuation MethodAdvantages:
Useful for valuing privately held firms and firms that do not pay dividends.
Disadvantages:
By using an industry average PE ratio, firm-specific factors that might contribute to a long-term PE ratio above or below the average are ignored.LMMSetting Security Prices(Stock prices are set by the buyer willing to pay the highest price.
The price is not necessarily the highest price that the stock could get, but it is incrementally greater than what any other buyer is willing to pay.
The market price is set by the buyer who can take best advantage of the asset.6DODOSetting Security PricesSuperior information about an asset can increase its value by reducing its risk.
The buyer who has the best information about future cash flows will discount them at a lower interest rate than a buyer who is uncertain.&QQErrors in Valuation-Problems with Estimating Growth
Growth can be estimated by computing historical growth rates in dividends, sales, or net profits.
But, this approach fails to consider any changes in the firm or economy that may affect the growth rate.
Competition, for example, will prevent high growth firms from being able to maintain their historical growth rate.
Nevertheless, stock prices of historically high growth firms tend to reflect a continuation of the high growth rate.
As a result, investors receive lower returns than they would by investing in mature firms.@ C CEstimating Growth: Table 1Errors in ValuationProblems with Estimating Risk
The dividend valuation model requires the analyst to estimate the required return for the firms equity.
However, a share of stock offering a $2 dividend and a 5% growth rate changes with different estimates of the required return.&Estimating Risk: Table 2Errors in ValuationProblems with Forecasting Dividends
Many factors can influence the dividend payout ratio. They include:
The firm s future growth opportunities a
Management s concern over future cash flows
Conclusion:
Analysts are seldom certain that the stock price projections are accurate.
This is why stock prices fluctuate widely on news reports.
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3 17.17
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10 44.00
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$On-screen Show Kennesaw State University3 Times New RomanSymbolDefault DesignStock ValuationOne Period Valuation ModelOne Period Valuation Model%Generalized Dividend Valuation Model%Generalized Dividend Valuation ModelThe Gordon Growth ModelGordon Growth ModelGordon Model: ExampleGordon Model: Conclusions Price Earnings Valuation Method Price Earnings Valuation MethodPrice Earnings Model: Example Price Earnings Valuation MethodSetting Security PricesSetting Security PricesErrors in ValuationEstimating Growth: Table 1Errors in ValuationEstimating Risk: Table 2Errors in ValuationFonts UsedDesign Template
Slide Titles _3mbumgarnmbumgarn Valuation MethodAdvantages:
Useful for valuing privately held firms and firms that do not pay dividends.
Disadvantages:
By using an industry average PE ratio, firm-specific factors that might contribute to a long-term PE ratio above or below the average are ignored.LMMSetting Security Prices(Stock prices are set by the buyer willing to pay the highest price.
The price is not necessarily the highest price that the stock could get, but it is incrementally greater than what any other buyer is willing to pay.
The market price is set by the buyer who can take best advantage of the asset.6DODOSetting Security PricesSuperior information about an asset can increase its value by reducing its risk.
The buyer who has the best information about future cash flows will discount them at a lower interest rate than a buyer who is uncertain.&QQErrors in Valuation-Problems with Estimating Growth
Growth can be estimated by computing historical growth rates in dividends, sales, or net profits.
But, this approach fails to consider any changes in the firm or economy that may affect the growth rate.
Competition, for example, will prevent high growth firms from being able to maintain their historical growth rate.
Nevertheless, stock prices of historically high growth firms tend to reflect a continuation of the high growth rate.
As a result, investors receive lower returns than they would by investing in mature firms.@ C CEstimating Growth: Table 1Errors in ValuationProblems with Estimating Risk
The dividend valuation model requires the analyst to estimate the required return for the firms equity.
However, a share of stock offering a $2 dividend and a 5% growth rate changes with different estimates of the required return.&Estimating Risk: Table 2Errors in ValuationProblems with Forecasting Dividends
Many factors can influence the dividend payout ratio. They include:
The firm s future growth opportunities a
Management s concern over future cash flows
Conclusion:
Analysts are seldom certain that the stock price projections are accurate.
This is why stock prices fluctuate widely on news reports.
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D0 = the most recent dividend paid
g = the expected growth rate in dividends
ke = the required return on equity investments
The model can be simplified algebraically to read:
P0 = D0(1 + g) D1
(ke - g) (ke g)~@
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