FIN 2400 Chapter 7 - Key Concepts and Skills (Objectives)
LO1
LO2
LO3
Assess how stock prices depend on future dividends and dividend growth.
Identify the different ways corporate directors are elected to office.
Explain how the stock markets work.
Stocks
Stock Valuation
____________ Analysis – looks at financials, product, mgt., history, etc.
1. PE ratio – Price / E.P.S.
2. Zero-Growth Dividend (preferred stock)
3. Constant Growth Dividend (DCF)
4. Nonconstant Growth
___________ Analysis – uses charts to predict future prices
PE Ratio
Industry Average PE X Company’s EPS
If company EPS = $2.20 and industry average PE = 20, stock should sell around $_____.
Factors affected a company’s PE include:
1. ________
2. Expected ________ growth
3. Management
4. Dividends
Common vs. Preferred Stock
 Preferred has preference in claims to __________ and dividends – must be paid before common.
 Preferred dividends – ________
 Common dividends – __________
 Preferred usually have _________ voting rights
Zero-Growth Dividend (preferred stock)
If an investor expects a 10% return, how much are they willing to pay for the stock?
Dividends = 2.31 Price = ____________
Constant Growth Dividend Model (Discounted Cash Flow)
Cisco just paid $3.00 in dividends. If they expect to grow at a constant rate of 4% a year, what is the most an
investor would pay if they require a 10% return?
Gordon Growth Company is expected to pay a dividend of $4 next period and dividends are expected to
grow at 6% per year. The required return is 16%.
What is the current price?
What is the price expected to be in year 4?
Nonconstant or Supernormal Growth Model
1. Used with companies that have very high growth rates.
2. Calculate the PV of cash flows or dividends for the high growth period.
3. Solve for the PV of cash flows during the constant growth period that are a perpetuity.
4. The sum of these two is the stock price.
If Apple just paid a $2.00 dividend and estimates to have growth of 30% for 3 years, then a constant growth
(g) of 6%, what is P0? r is 13%
Can no longer only use constant growth model. However, growth becomes constant after 3 years.
Suppose g = 0 for t = 1 to 3, and then g is a constant 6%.
What is P0?
Terminal Value – the (present) value, at the horizon date, of all future dividends after that date.
Nonconstant growth followed by constant growth:
Samsung just paid $1.00 dividend. It expects 20% and 15% div growth the next two years and then assumes a
5% growth forever. If r=20% what is the most an investor should pay for the stock?
The Jones Company has decided to undertake a large project. Consequently, there is a need for additional
funds. The financial manager plans to issue preferred stock with a perpetual annual dividend of $5 per share.
If the required return on this stock is currently 20 percent, what should be the stock's market value?
A share of preferred stock pays a quarterly dividend of $2.50. If the price of this preferred stock is currently
$50, what is the nominal annual rate of return?
McKenna Motors is expected to pay a $1.00 per-share dividend at the end of the year (D1 = $1.00). The stock
sells for $20 per share and its required rate of return is 11 percent. The dividend is expected to grow at a
constant rate, g, forever. What is the growth rate, g, for this stock?
A share of common stock has just paid a dividend of $2.00. If the expected long-run growth rate for this stock is
15%, and if investors require a 19% rate of return, what is the price of the stock?
Suppose a firm is expected to increase dividends by 20% in one year and by 15% in two years. After that
dividends will increase at a rate of 5% per year indefinitely. If the last dividend was $1 and the required return
is 20%, what is the price of the stock?
Remember that we have to find the PV of all expected future dividends.
Nonconstant Growth – Solution
Compute the dividends until growth levels off
D1 = 1(1.2) = $1.20
D2 = 1.20(1.15) = $1.38
D3 = 1.38(1.05) = $1.449
Find the expected future price at the beginning of the constant growth period:
Find the present value of the expected future cash flows
Finding the Required Return Example
A firm’s stock is selling for $10.50. They just paid a $1 dividend and dividends are expected to grow at 5% per
year. What is the required return?
What is the dividend yield?
1(1.05) / 10.50 = 10%
What is the capital gains yield?
g = 5%
The Stock Markets
Primary vs. Secondary Markets
Primary = new-issue market
Secondary = existing shares traded among investors
Dealers vs. Brokers
Dealer: Maintains an inventor
Ready to buy or sell at any time
Think “Used car dealer”
Broker: Brings buyers and sellers together
Think “Real estate broker”
New York Stock Exchange (NYSE) merged with Euronext in 2007
NYSE Euronext merged with the American Stock Exchange in 2008
Members (Historically) - Buy a trading license (own a seat)
Designated market makers, DMMs (formerly known as “specialists”)
Each stock has one assigned DMM
All trading in that stock occurs at the “DMM’s post”
Trading takes place between customer orders placed with the DMMs and the “crowd”
“Crowd” = Floor brokers