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EC 545: Financial Economics Arindam Bandopadhyaya – Spring 2013 Meeting Notes - Set 5 – Stock Pricing Fundamentals and Assigned Problems from Chapter 8 in Readings Package      Stock price as a sum of discounted value of all dividend payments received by the stockholder until infinity Price of a preferred stock that pays constant dividend Price of a stock that pays a dividend that grows at a constant rate The required rate of return of a stock is the sum of dividend yield and capital gains yield; for a stock whose dividend grows at a constant rate the dividend growth rate is also the capital gains yield How to estimate the dividend growth; product of the retention ratio and the ROE

Example: Earnings of a corporation this year is $10 million. Retention ratio is 75% and the historical ROE is 12%. The number of shares outstanding is 1.25 million and the current price of the stock is $30. What is the stock’s required rate of return? Example – Non-constant dividend growth: A company just announced a dividend of $1.20 per share. Dividends are expected to grow annually at 3%, 4% and 5%, respectively, for the next 3 years. Then, the dividends are expected to grow at a constant rate of 6%, forever. If the stock’s required rate of return is 12% what is the current price of the stock? An alternative to the discounted dividend model The company is expected to continue to do what it does right now without any growth opportunities. In this case it earns its current earnings per share (EPS) in perpetuity. If the company does have additional growth opportunities, find the net present value of the growth opportunities (NPVGO) per share and add it to the present value of the perpetual EPS. Example: Company expects to earn $100 million in perpetuity if it does not undertake any new projects. The firm has an opportunity that requires an investment of $15 million today and $5

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