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Financial InstitutionsFinancial Institutions
and Marketsand MarketsFIN 304FIN 304
Dr. Andrew L. H. ParkesDr. Andrew L. H. Parkes
Day 8Day 8How do fnancial markets work?How do fnancial markets work?
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Ca!ter "0# $tocksCa!ter "0# $tocks
%e&e&'er te Di(idend )rowt%e&e&'er te Di(idend )rowtModel *)ordon )rowt Model+,Model *)ordon )rowt Model+,
Present -alue o a $tockPresent -alue o a $tock How to calculate teseHow to calculate tese /ats te (alue o stock i/ats te (alue o stock i
te co&!any 1oes 2ankru!t,te co&!any 1oes 2ankru!t,
/ALL $% 56$A
7%9997%999
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Di(idend 1rowt &odelDi(idend 1rowt &odel
6sin1 te &ulti!les o co&!ara'le6sin1 te &ulti!les o co&!ara'le
:r&s:r&s
Free cas ;ow &etod *co(ered in FinFree cas ;ow &etod *co(ered in Fin
"0
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=
ssss r
D
r
D
r
D
r
DP
1...
111
3
3
2
2
1
10
One whose dividends are expected togrow forever at a constant rate, g.
Stock Value = PV of Dividends
What is a constant growth stock?
Di(idendDi(idend 1rowt1rowt
&odel&odel
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As you know# or a constantAs you know# or a constant
1rowt stock=1rowt stock=
( )
( )
( ) t0t
202
101
g1DD
g1DD
g1DD
+=
+=
+=
gr
D
gr
gDP
ss
=
+
=
100
1
f g is constant, then!
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D D gtt
= +"#
t
tt
r
DPVD
+
=
1
!Pr,>g 0 IfP PVDt"=
$
".%&
'ears (t)"
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Dec. 24, 2009 Fin Institutions & Markets 7
/at a!!ens i 1 > r/at a!!ens i 1 > rss*k*kee+,+,
I rI rss? 1= 1et? 1= 1et ne1ati(ene1ati(e stock !rice= wic isstock !rice= wic isnonsense.nonsense.
/e cant use &odel unless *"+ 1
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Assu&eAssu&e'eta 'eta ".
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DD00was
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Dec. 24, 2009 Fin Institutions & Markets 0
/ats te stocks &arket (alue,/ats te stocks &arket (alue,
DD00
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/at is te stocks &arket (alue/at is te stocks &arket (alue
one year ro& now= Pone year ro& now= P"",,
DD""will a(e 'een !aid= so e@!ectedwill a(e 'een !aid= so e@!ected
di(idends are Ddi(idends are D
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Find te e@!ected di(idend yield andFind te e@!ected di(idend yield and
ca!ital 1ains yield durin1 te :rstca!ital 1ains yield durin1 te :rst
year.year.
Dividend
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otal return Di(idend yield otal return Di(idend yield
Ca!ital 1ains yield.Ca!ital 1ains yield.
otal return B G otal return B G "3."3.
otal return "3 rotal return "3 rss..
For constant 1rowt stock#For constant 1rowt stock# Ca!ital 1ains yield G 1Ca!ital 1ains yield G 1..
Find te total return durin1 te :rstFind te total return durin1 te :rst
year.year.
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*earrange /odel to rate of return for/!
.rto
0
1s
1
0 g
P
D
gr
DP
s
+
=
>hen, rs = $%.#%$2".%8 "."7= "."0 "."7 = #21.
;
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/at would P/at would P00'e i 1 0,'e i 1 0,
>he dividend strea/ would e aperpetuit
r
$%.""
".#2;
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I we a(e su!ernor&al 1rowt o 30I we a(e su!ernor&al 1rowt o 30
or 3 years= ten a lon15run constant 1or 3 years= ten a lon15run constant 1
G= wat is P G= wat is P00, r is still "3., r is still "3.
Can no lon1er use constant 1rowtCan no lon1er use constant 1rowt&odel.&odel.
Howe(er= 1rowt 'eco&esHowe(er= 1rowt 'eco&es constantconstantater 3 years.ater 3 years.
;
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@onconstant growth followed < constantgrowth!
"
%.2""8
%.750"
2."5&2
57.##2&
# % 2 5rs=#21
&5.#"70 = P"
g = 2"1 g = 2"1 g = 2"1 g = 71
D"= %."" %.7" 2.26 5.285 5.7&07
;&20#.77$
"7."#2."
7&07.5$PA
2 =
=
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/at is te e@!ected di(idend yield/at is te e@!ected di(idend yield
and ca!ital 1ains yield at t 0, Atand ca!ital 1ains yield at t 0, At
t 4,t 4,
Dividend
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Durin1 nonconstant 1rowt= di(idendDurin1 nonconstant 1rowt= di(idend
yield and ca!ital 1ains yield areyield and ca!ital 1ains yield are notnot
constantconstant.. I current 1rowt isI current 1rowt is1reater tan 11reater tan 1==
current ca!ital 1ains yield iscurrent ca!ital 1ains yield is 1reater1reater
tan 1tan 1..
Ater t 3= 1 constant G= so te tAter t 3= 1 constant G= so te t
4 ca!ital 1ains 1ains yield 4 ca!ital 1ains 1ains yield G.G.
2ecause r2ecause rss "3= te t 4 di(idend "3= te t 4 di(idendyield "3 5 G yield "3 5 G B.B.
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e current stock !rice ise current stock !rice is 4."".4."".
e P- o di(idends 'eyond year 3e P- o di(idends 'eyond year 3
isis 4G.""4G.""*P*P33 discounted 'ack to tdiscounted 'ack to t
0+. 0+.
e !ercenta1e o stock !rice duee !ercenta1e o stock !rice dueto lon15ter&J di(idends is#to lon15ter&J di(idends is#
!
= 6&.%1.$57.##
$&5.##
Is te stock !rice 'ased on sort5ter&Is te stock !rice 'ased on sort5ter&
1rowt,1rowt,
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$o&eti&es can1es in Euarterly$o&eti&es can1es in Euarterly
earnin1s are a si1nal o utureearnin1s are a si1nal o uture
can1es in cas ;ows. is wouldcan1es in cas ;ows. is would
aKect te current stock !rice.aKect te current stock !rice.
$o&eti&es &ana1ers a(e 'onuses$o&eti&es &ana1ers a(e 'onusestied to Euarterly earnin1s.tied to Euarterly earnin1s.
I &ost o a stocks (alue is due toI &ost o a stocks (alue is due to
lon15ter& cas ;ows= wy do solon15ter& cas ;ows= wy do so
&any &ana1ers ocus on Euarterly&any &ana1ers ocus on Euarterlyearnin1s,earnin1s,
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$u!!ose 1 0 or t " to 3= and$u!!ose 1 0 or t " to 3= and
ten 1 is a constant G. /at isten 1 is a constant G. /at is
PP00,,
"
#.0788#.&772#.267#
%".868&
# % 2 5
rs=#21
%&.0##6
g = "1 g = "1 g = "1 g = 71
%."" %."" %."" %.#%
%.#%
.P2 " "0
2".%6&0
;
...
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/at is di(idend yield and/at is di(idend yield and
ca!ital 1ains yield at t 0 andca!ital 1ains yield at t 0 and
at t 3,at t 3,
t = "!D#
P"
9' = #2."1 : 0.61 =&.%1.
%.""
$%&.0%0.61.
t = 2! @ow have constant growth
with g = capital gains
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I 1 I 1 5G5G= would anyone 'uy= would anyone 'uy
te stock, I so= at watte stock, I so= at wat
!rice,!rice,
+ir/ still has earnings and still pa
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/at are te annual/at are te annual
di(idenddi(idend
and ca!ital 1ains yield,and ca!ital 1ains yield,9apital gains
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Analysts oten use teAnalysts oten use te P &ulti!leP &ulti!le*te*te!rice !er sare di(ided 'y te earnin1s !er!rice !er sare di(ided 'y te earnin1s !ersare+ or tesare+ or te PCF &ulti!lePCF &ulti!le*!rice !er sare*!rice !er sare
di(ided 'y cas ;ow !er sare= wic is tedi(ided 'y cas ;ow !er sare= wic is teearnin1s !er sare !lus te di(idends !erearnin1s !er sare !lus te di(idends !ersare+ to (alue stocks.sare+ to (alue stocks.
@a&!le#@a&!le#
sti&ate te a(era1e P ratio o co&!ara'lesti&ate te a(era1e P ratio o co&!ara'le:r&s. is is te:r&s. is is te P &ulti!leP &ulti!le..
Multi!ly tisMulti!ly tis a(era1e P ratioa(era1e P ratio'y te'y te e@!ectede@!ectedearnin1s o te co&!anyearnin1s o te co&!anyto esti&ate its stockto esti&ate its stock!rice.!rice.
s n1 e oc r ceMulti!les to sti&ate $tockMulti!les to sti&ate $tock
PricePrice
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e entity (alue *-+ is#e entity (alue *-+ is# te &arket (alue o eEuity * sares o stockte &arket (alue o eEuity * sares o stock
&ulti!lied 'y te !rice !er sare+&ulti!lied 'y te !rice !er sare+
!lus te (alue o de't.!lus te (alue o de't. Pick a &easure= suc as 2IDA= $ales=Pick a &easure= suc as 2IDA= $ales=
Custo&ers= ye'alls= etc.Custo&ers= ye'alls= etc. Calculate te a(era1e entity ratio or aCalculate te a(era1e entity ratio or a
sa&!le o co&!ara'le :r&s. Forsa&!le o co&!ara'le :r&s. Fore@a&!le=e@a&!le= -2IDA-2IDA
-Custo&ers-Custo&ers
6sin1 ntity Multi!les6sin1 ntity Multi!les
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Find te entity (alue o te :r& inFind te entity (alue o te :r& inEuestion. For e@a&!le=Euestion. For e@a&!le= Multi!ly te :r&s sales 'y te -$alesMulti!ly te :r&s sales 'y te -$ales
&ulti!le.&ulti!le. Multi!ly te :r&s o custo&ers 'y teMulti!ly te :r&s o custo&ers 'y te-Custo&ers ratio-Custo&ers ratio
e result is te total (alue o te :r&.e result is te total (alue o te :r&.
$u'tract te :r&s de't to 1et te total$u'tract te :r&s de't to 1et te total(alue o eEuity.(alue o eEuity. Di(ide 'y te nu&'er o sares to 1et teDi(ide 'y te nu&'er o sares to 1et te
!rice !er sare.!rice !er sare.
6sin1 ntity Multi!les6sin1 ntity Multi!les
*Continued+*Continued+
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It is oten ard to :ndIt is oten ard to :nd co&!ara'leco&!ara'le:r&s.:r&s.
e a(era1e ratio or te sa&!le oe a(era1e ratio or te sa&!le o
co&!ara'le :r&s oten as a wide ran1e.co&!ara'le :r&s oten as a wide ran1e. For e@a&!le= te a(era1e P ratio &i1t 'e
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/y are stock !rices/y are stock !rices
(olatile,(olatile,
grD
"P
s
#
=
rs
= r*+
(*P-
)i
could change.
nflation expectations*isk aversion9o/pan< risk
g could change.
;
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/at is &arket eEuili'riu&,/at is &arket eEuili'riu&,
;
n eFuiliriu/, stock prices are stale.>here is no general tendenc< for
people to u< versus to sell.
>he expected price, P, /ust eFual theactual price, P. n other words, thefunda/ental value/ust e the sa/e asthe price.
(-oreC)
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n eFuiliriu/, expected returns /usteFual reFuired returns!
rs= D#P" g = rs= r*+ (r-: r*+).;
H i ili' iH i ili' i
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How is eEuili'riu&How is eEuili'riu&
esta'lised,esta'lised,
f rs= g rs, then P"is Gtoo low.H
f the price is lower than thefunda/ental value, then the stock is aGargain.H
Eu< orders will exceed sell orders, the
price will e id up, and D#P"falls until
D#P" g = rs= rs.
;
;
D#P"
;
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Now take a look at O6%$9Now take a look at O6%$9
'ou will want to egin looking for a9hinese co/pan< to value as wellI
want