FINANC 3000 1st Edition Lecture 13 Outline of Last Lecture I. Stock MarketsII. Trading StocksIII. Basic Stock ValuationOutline of Current Lecture I. Dividend Discount ModelII. Estimating Growth RateIII. Preferred StockIV. Variable Growth TechniqueV. P.E. ModelCurrent LectureDividend Discount Model- If investors receive all the future cash flows from the stock as future dividends, the stock’s value to the investor is PV of all future dividendso- Difficult to estimate infinite number of future dividendso Use simplifying assumptions to make the model workableo One assumption: the company and constant dividend growth rate,g o To find the dividend in one year D1 = D0 x (1+g)- Constant growth model where g(growth rate) is smaller than i(discount rate)These notes represent a detailed interpretation of the professor’s lecture. GradeBuddy is best used as a supplement to your own notes, not as a substitute.oEstimating Growth Rate- Assumes the same rate of growth to infinityoo Normally the company might grow very quickly for several years, but experience slower growth after that (Apple)o Stock valuation model dynamics make clear that lower discount rates lead to higher (power of compounding)o Stock valuation model dynamics make clear that higher growth rates lead to higher valuation- Several ways to predict growth rate:o Project dividend trend into the futureo Consider financial analyst’s growth rate- Ex.o Financial analysts forecast Limited Brands (LTD) growth rate for the future to be 12.5 percent. LTD’s recent dividend was $0.60. What is the value of Limited Brands stock when the required return is 14.5 percent?- Ex.o Financial analysts forecast Limited Brands (LTD) growth rate for the future to be 12.5 percent. LTD’s recent dividend was $0.60. What is the value of Limited Brands stock when the required return is 14.5 percent?Preferred Stock- Has priority over common stock in bankruptcy- Doesn’t have voting rights- Pays a constant dividend- Valued using constant-growth model with g=0o Formula: P0=D/i- Preferred stocks come from finance, energy and real estate companies- Dividend yieldo Last four quarters of dividend income expressed as a percentage of the current stock price MCD pays $0.77 of dividends per quarter, closing prices is $94.36 Dividend yield = (0.77*4)/94.36 = 3.26% Dividend yield is higher from preferred stocks, investors do not expect anycapital appreciation, since there is now growth in dividend expected- Price of preferred shares are only affected by changes in prevailing market rate or i- Preferred stock price movements are similar to bond price movements- Interest rate increases, preferred stock prices decrease- Interest rate decreases, preferred stock prices increaseExpected Return- Determining i requires looking at the risk of stocko Investors will demand higher i for stocks with higher risk- If stock is valued fairly discount rate i will equal expected return from stock- Can rearrange constant growth model to solve for io Expected rate of returno- Ex.o Ecolap Inc. (ECL) recently paid a $0.46 dividend. The dividend is expected to growat a 14.5 percent rate. The current stock price is $44.12. What is the return shareholders are expecting?  Step 1: First convert D0 to D1- $0.46 x (1 +0.145) = $0.5267 Step 2:Variable Growth Technique- Some companies grow at very high rates for short periods of timeo Example for Appleo Can’t use constant growth models, since it assumes the same rate of growth into infinityo If g is higher than i then constant growth model doesn’t work- To value high growth companies we can use variable growth rate techniqueo Used when growth rate is expected to change in the futureo Need to figure out how long the super growth period will last- Step 1:o Need to determine high growth rate (g1) and number of periods it will continue and future constant growth (g2) after that- Step 2:o Need to determine dividend in each of the years of high growth Use formula D1=D0 x (1+g1), D2=D0 x (1+g1)^2, etc..- Step 3:o Calculate price using constant growth formula, after the super growth period is overP/E Model- P/E model allows to compare relative valuation of different firms- P/E gives you price per dollar of earnings- Which company is better?o Company 1: earnings $5 a share, share price $100o Company 2: earnings $2 a share, share price $50- Let’s compareo Company 1: P/E is 100/5=20, a cost of $20 per $1 of earningo Company 2: P/E is 50/2=25, a cost of $25 per $1 of earning- P/E the most common valuation metric in investingo- P/E that uses earnings for the last 12 months is called trailing P/E- Companies that have higher growth will have higher P/E ratio, because they expect that earnings will grow much faster in the future- Facebook vs. Ford- When earnings are negative can’t find P/E (Amazon)- P/E that uses estimate of future earnings is called forward P/Eo Incorporates investor’s expectations to future earningso Forward P/E is more difficult to estimate- Companies with high P/E and high growth are appropriately priced- Companies with low P/E and low growth are appropriately priced- If a company has low P/E and high expected growth, are referred to as value stockso Value stocks – companies considered temporary undervalued- Ex.o Pfizer, Inc. (PFE) has earnings per share of $2.09 and a P/E ratio of 11.02. What is the stock price? Need to solve for P in P/E-