FINA211 WK9-10 L18-19 Stock Valuation Flashcards
What is a stock?
A stock, also known as equity, is security that represents the ownership of a fraction of the issuing company
What is a financial security?
A security is a financial instrument that represents some type of financial value, usually in the form of a stock, bond, or option.
What is a share?
A share is a singular unit of a stock. A share entitles the owner to a proportion of the company’s assets and profits equal to how much stock they own.
What is a stock buyback?
Occurs when the issuing company pays shareholders the market value per share and re-absorbs that portion of its ownership.
Companies do this for various reasons, including company consolidation, equity value increase, and to look more financially attractive to investors.
However, they are typically financed with debt, which can cause a strain on cash flow.
What is a dividend?
A dividend is a distributio of a company’s earnings to its shareholders determined by the company’s shareholders.
Paying dividends sends a message about a company’s future prospects and performance.
The willinging and ability to pay steady dividends overtime provides a solid demonstration of financial strength.
A company that is still growing will not usually pay dividends because it wants to invest as much as possible into further growth.
Mature companies that believe that they can increase their values by reinvetsing their earninsg may choose not to pay dividends.
What determines whether a company pays dividends
A company will choose not to pay dividends when there are profitable projects available. NPV of projects > 0
A company will chooses to pay dividends when there are not any profitable projects available. NPV of projects < 0
What is the formula for the value of a share that pays a constant dividend and is held for a definite period of time?
P.0 = Div.1/(1+r)^1 + … + Div.t/(1+r)^t + P.t/(1+r)^t
where
P.0 = share price at t=0
Div = dividend
Div.1 = dividend in period 1
Div.t = dividend in period before share was sold
r = required return
t = period in which share is sold
P.t = price received when selling share
P.t = dividends after period t discounted to period t
What is the formula for the value of a share where dividends are paid in perpetuity?
P.0 = Div/r
What is the formula for the value of a share where the dividends grow at a constant rate and are paid at a constant rate?
P.0 = Div.1/r-g
What is the formula for net income in period t?
Net Income.t = Dividend.t + Retained Earnings.t
What is the formula for retained earnings in period t?
Retained Earnings.t = alphaNet Income.t
If retained earnings are a fixed proportion of net income.
Therefore alpha is a fixed proportion.
What is the formula for net income in period t+1?
Net Income.t+1 = Net Income.t + Retained Earnings.t * Return on Retained Earnings.t
Assuming a firm’s earnings grow every year because of re-investment of retained earnings.
The above formula can be simplified to:
NI.t+1 = NI.t + alphaNI.tROE
where
NI = net income
alpha = retention ratio
ROE = return on equity
How do you find the dividend growth rate using the formula for net income in period t+1?
NI.t+1 = NI.t + alphaNI.tROE
where
NI = net income
alpha = retention ratio
ROE = return on equity
g = alphaROE
To solve for alphaROE and therefore g:
Divide both sides by NI.t
NI.t+1/NI.t = 1 + alphaROE
Minus 1 from both sides
NI.t+1/NI.t - 1 = alphaROE
NI.t+1/NI.t - 1 = g
How do you solve for r using the dividend growth model?
P.0 = Div/(r-g)
P.0*(r-g) = Div
r-g = Div/P.0
r = Div/P.0 + g
