Chapter 7: Valuing stocks Flashcards
What information is included in stock trading reports, and how can stock- price information about other firms be used to help you value a particular firm? (LO7-1)
Large companies usually arrange for their stocks to be traded on a stock exchange. The stock listings report the stock’s price, price change, volume, dividend yield, and price- earnings (P/E) ratio.
To value a stock, financial analysts often start by identifying similar firms and looking at how much investors in these companies are prepared to pay for each dollar of earnings or book assets.
How can one calculate the present value of a stock given forecasts of future dividends and future stock price, and how do a company’s growth opportunities show up in its stock price and price- earnings ratio? (LO7-2)
Stockholders generally expect to receive (1) cash dividends and (2) capital gains or losses. The rate of return that they expect over the next year is defined as the expected dividend per share DIV1 plus the expected increase in price P1 − P0, all divided by the price at the start of the year P0.
Unlike the fixed interest payments that the firm promises to bondholders, the divi- dends that are paid to stockholders depend on the fortunes of the firm. That’s why a company’s common stock is riskier than its debt. The return that investors expect on any one stock is also the return that they demand on all stocks subject to the same degree of risk.
The present value of a share is equal to the stream of expected dividends per share up to some horizon date plus the expected price at this date, all discounted at the return that investors require. If the horizon date is far away, we simply say that stock price equals the present value of all future dividends per share. This is the dividend discount model.
If forecast dividends grow at a constant rate, g, then the value of a stock is P0 = DIV1/(r − g). This is the constant-growth dividend discount model. Sometimes, it is feasible to discount forecasted dividends for the next few years and then to discount the expected price at the end of this period. The expected price is often estimated using the constant-growth model.
You can think of a share’s value as the sum of two parts—the value of the assets in place and the present value of growth opportunities, that is, of future opportunities for the firm to invest in high-return projects. The price-earnings (P/E) ratio reflects the market’s assess- ment of the firm’s growth opportunities.
How can these stock valuation formulas be used to infer the value of an entire business? (LO7-3)
Similar valuation methods can be used to estimate the value of an entire business. In this case, you need to forecast and discount the free cash flows provided by the business. These are the cash flows that are not plowed back into the business but can be used to pay dividends or repurchase stock.
How does competition among investors lead to efficient markets? (LO7-4)
Competition between investors will tend to produce an efficient market—that is, a market in which prices rapidly reflect new information and investors have difficulty making con- sistently superior returns. Of course, we all hope to beat the market, but if the market is efficient, all we can rationally expect is a return that is sufficient on average to compensate for the time value of money and for the risks we bear.
The evidence for market efficiency is voluminous, and there is little doubt that skilled professional investors find it difficult to win consistently. Nevertheless, there remain some puzzling instances where markets do not seem to be efficient. Some financial economists attribute these apparent anomalies to behavioral foibles.
