Podcast
Questions and Answers
What is the primary goal of management in relation to stock price?
What is the primary goal of management in relation to stock price?
Intrinsic value and stock price are assumed to be equal in equilibrium.
Intrinsic value and stock price are assumed to be equal in equilibrium.
True
Name one approach for estimating the intrinsic value of a common stock.
Name one approach for estimating the intrinsic value of a common stock.
Discounted cash flow model
The ownership of common stock implies __________.
The ownership of common stock implies __________.
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Match the following methods of estimating stock value with their descriptions:
Match the following methods of estimating stock value with their descriptions:
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What is the formula for the price of a constant growth stock?
What is the formula for the price of a constant growth stock?
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The growth rate of a constant growth stock can be higher than the required rate of return.
The growth rate of a constant growth stock can be higher than the required rate of return.
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What is the expected growth rate if a firm has a 12% return on equity and pays out 25% of its earnings as dividends?
What is the expected growth rate if a firm has a 12% return on equity and pays out 25% of its earnings as dividends?
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In the constant growth model, $D_t$ is expressed as $D_0 (1 + g)^{______}$.
In the constant growth model, $D_t$ is expressed as $D_0 (1 + g)^{______}$.
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Match the following terms with their definitions:
Match the following terms with their definitions:
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Study Notes
Common Stock
- Represents ownership in a company, giving stockholders control.
- Stockholders elect the board of directors, who then select management.
- Management's objective is to maximize stock prices.
Intrinsic Value
- Estimated intrinsic value (P0) informs buy/sell decisions; price reflects true value in equilibrium.
- Stocks priced below intrinsic value are considered undervalued; those above are overvalued.
Valuation Approaches
- Discounted dividend model
- Discounted cash flow model
- Corporate valuation model
- Price-to-earnings (P/E) multiple approach
- Economic value added (EVA) approach
Dividend Discount Model
- Stock value derives from expected cash flows via dividends and sale price.
- Value formula accounts for present value of future cash flows.
Constant Growth Stocks
- Dividends grow at a constant rate (g) indefinitely.
- Pricing formula: P0 = D1 / (rs - g), where D1 represents next year's dividend.
Non-Constant Growth Stocks
- Exhibit supernormal growth before stabilizing at a constant growth rate.
- Requires estimation of future cash flows during high growth and a terminal valuation once growth stabilizes.
Discounted Cash Flow Model
- Suitable for companies with irregular dividend payments; assesses future cash flows.
- Profitability determined if DCF exceeds initial investment costs.
Corporate Valuation Model
- Assesses a firm’s market value through free cash flow (FCF).
- Uses weighted average cost of capital (WACC) for discounting future cash flows to compute intrinsic stock price.
Market Equilibrium
- Condition where current market price equals intrinsic value, meaning no incentive for buying or selling.
- Expected returns (determined by dividends and capital gains) must align with required returns (calculated using CAPM).
Preferred Stock
- Functions as a hybrid security, offering fixed dividends like bonds but with additional flexibility for the issuer.
- Preferred dividends must be paid before any distribute to common stockholders but can be omitted without bankruptcy risk.
Expected Returns on Preferred Stock
- Calculated as the annual dividend divided by the stock price, e.g., for a $5 dividend at a $50 price, the return is 10%.
Example Calculations
- Valuation of preferred stock with a $10 annual dividend and a required return of 10.3% yields a calculated value of approximately $97.09.
Key Considerations for Stock Valuation
- Required return must exceed growth rate for the constant growth model to be valid.
- Non-constant growth requires defining growth periods and terminal values to establish overall stock value.
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Description
This quiz covers the essential features of common and preferred stock, including how to determine their values. It also delves into the roles of stockholders and management in maximizing stock price. Test your understanding of stock valuation concepts and intrinsic value.
