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**Date Submitted:** 09/20/2012 10:06 PM

FINM2401

Valuing Stocks

Valuing Stocks

2

Dividend-discount

model Total payout model Free cash flow valuation Comparable firms

P/E ratio EBITDA multiple

Information

and stock prices

Lecture 7

The Dividend Discount Model

3

Timeline

for One-Year Investor

0 –P0 1 Div1 + P1

Since the cash flows are risky, we must discount them at the equity cost of capital (rE).

Lecture 7

The Dividend Discount Model

4

A

One-Year Investor

If the current stock price were less than this amount, expect investors to rush in and buy it, driving up the stock’s price. If the stock price exceeded this amount, selling it would cause the stock price to quickly fall.

Lecture 7

Income from Shares

5

Dividends

(Div) Capital Gain (P)

Total

return = dividend yield + capital gain rate The expected total return of the stock should equal the expected return of other investments available in the market with equivalent risk.

Lecture 7

Try it out…

3M (MMM) is expected to pay dividends of

$1.92 per share in the coming year. You expect the stock price to be $85 per share at the end of the year. Investments with equivalent risk have an expected return of 11%.

What is the most you would pay today for

3M stock? What dividend yield and capital gain rate would you expect at this price?

Lecture 7

6

Solution

Total Return = 2.45% + 8.54% = 10.99% ≈ 11%

Lecture 7

7

A Multi-Year Investor

8

What

is the price if we plan on holding the stock for two years?

0 –P0 1 Div1 2 Div2 + P2

Lecture 7

The Dividend-Discount Model Equation

9

What

is the price if we plan on holding the stock for N years?

This

holds for any horizon N.

Thus all investors (with the same beliefs) will attach the same value to the stock, independent of their investment horizons.

Lecture 7

The Dividend-Discount Model Equation

10

The

price of any stock...