Chapter 7: Valuing Stocks

Question 1

Stock

Answer 1

a share in the ownership of a company’s assets and earnings

Question 2

The Dividend-Discount Model

Answer 2

• one-year investor
• potential cash flows (dividend and sale of stock)
• since the cash flows are risky, we must discount them at the equity cost of capital

Question 3

If stock price were less than this amount

Answer 3

expect investors to rush in and buy it, driving up the stock’s price

Question 4

If stock price exceeded this amount

Answer 4

selling it would cause the stock price to quickly fall

Question 5

Dividend Yield

Answer 5

• the expected annual dividend of a stock divided by its current price
• the dividend yield is the percentage return an investor expects to earn from the dividend paid by the stock

Question 6

Capital Gain

Answer 6

the amount by which the sale price of an asset exceeds its initial purchase price

Question 7

Capital Gain Rate

Answer 7

an expression of capital gain as a percentage of the initial price of the asset

Question 8

Total Return

Answer 8

• = 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

Question 9

Multi-Year Investor

Answer 9

the price of any stock is equal to the present value of the expected future dividends it will pay

Question 10

Constant Dividend Growth Model

Answer 10

• a model for valuing a stock by viewing its dividends as a constant growth perpetuity (forever)
• the simplest forecast for the firm’s future dividends states that they will grow at a constant rate, g, forever
• the value of the firm depends on the current dividend level, the cost of equity, and the growth rate