ECON 435: Stock valuation

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ECON 435 > ECON 435: Stock valuation

Why stock valuation is more complicated than bonds

• Three aspects make stock valuation more complicated:
  • Uncertainty on future dividends;
    • We will see that we will be able to determined a stock price only under special assumptions:
      • (a) Constant dividends;
      • (b) Constant dividend growth.
  • Stocks are infinitely lived assets;
  • Difficult to estimate the required market return on stocks.

Calculating price of stock today

• Note: if dividends are not constant, they must be idscounted back to the present.
• GOOD EXAMPLE PROBLEM HERE: Quick quiz on page 18

Given constant dividends

• The price = the discounted value of all the dividends to infinity
• See slide here. Po is equal to the sum of the discounted dividend payments. - REMEMBER THIS EQUATION

Given constant growth of dividends

• Simplified: Price of stock = tomorrow's dividend / (R - g) when g < R
  • Note: price of stock grows over time at the same rate (g) of dividends
• Note: if R > g, price of stock is infinity
  • When g (dividend growth) is permantly higher than R (Required return maybe Nominal interest?), this is a company that is taking over the universe. It's permantly growing faster than the rest of the economy (R)
  • NEVER IN A TEST IN ECONOMICS REPORT A NEGATIVE PRICE (which is what the first equation would give you in the second example)
• See slide 6 here

Burton Malkiel's Rules

• 1. Supposed dividends (g) go up, therefore price of stock (Po) goes up.
• 2. If dividends today go up, given a constant g (growth rate), price should go up.
  • This is because tomorrows dividend = (1 + g)Do
• 3. If risk falls, price of stock goes up
• 4. If the risk free interest rate falls (for safe investments), you expect the stock price to go up.

Nominal rate of return (R) = risk free rate + p (risk premium)

Lecture slides

Chapter 8 slides