Stock Valuation
Dividend Discount Model
Terminology
i - the EFFECTIVE expected (or required) return
on the stock
Dt - the expected dividend per share paid in
period t
P0 - current share price (right after current
dividend Do has been paid)
P1 - the expected price per share 1 period from
now
g - the expected stock growth rate
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Stock Pricing Models
Price relationships:
• 1 period price model:
• dividend discount model:
• value of a no growth stock:
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Pricing Relationships continued
Constant growth dividend discount model:
• company pays dividends each period, and
dividends grow at a rate of g per year forever.
0 1 2 3 4
D0 D0(1+g) D0(1+g)2 D0(1+g)3 D0(1+g)4
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Pricing Relationships continued
expected growth is valuable!
The stock price is expected to grow grow
over time by the growth rate.
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Components of Expected Return
We can rewrite the stock pricing formula
as
The return expected by investors is
comprised of a dividend yield and a
capital gains yield
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Some Examples
Green Mountain Inc. (GMI) just paid a dividend of $3 per share
on its stock. The dividends are expected to grow at a
constant rate of 5% per share indefinitely. If investors
require a 12% return on GMI stock, what is its current price?
What will the price be in 3 years?
Torison Corp. stock currently sells for $108 per share. The
market requires a 15% return on the firm’s stock. If the
company maintains a constant 7% growth rate in dividends,
what was the most recent dividend per share?
Ancient Items Co is a mature manufacturing firm. The firm just
paid a $5 dividend, but management expects to reduce the
payout by 9% per year indefinitely. If you require a 12%
return on the stock, what will you pay for the stock today?
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Other Variations
Let it = effective annual rate in year t
Let i0,t = spot rate for discounting a
payment due at time t
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