Basic Stock Valuation: Dividend Growth Model The value of a share of common stock depends on the cash flows it is expected to provide, and those flows consist of the dividends the investor receive each year while holding the stock and the price the investor receives when the stock is sold. The final price includes the original price paid plus an expected capital gain. The actions of the marginal investor determine the equilibrium stock price. Market equilibrium occurs when the stock's price is Selectits intrinsic value. If the stock market is reasonably efficient, differences between the stock price and intrinsic value should not be very la and they should not persist for very long. When investing in common stocks, an investor's goal is to purchase stocks that are undervalued (the price is Selectthe stock's intrinsic value) and avoid stocks that are overvalued The value of a stock today can be calculated as the present value of -Select stream of dividends: Di (1r) t=1 This is the generalized stock valuation model. We will now look at 3 different situations where we can adapt this generalized model to each of these situations to determine a stock's intrinsic value: 1. Constant Growth Stocks 2. Zero Growth Stocks 3. Nonconstant Growth Stocks Constant Growth Stocks: For many companies it is reasonable to predict that dividends will grow at a constant rate, so we can rewrite the generalized model as follows: (1+1,)' ' (1+)2 1+r Ts-BL Ts-BL This is known as the constant growth model or Gordon model, named after Myron J. Gordon who developed and popularized it. There are several conditions that must exist before this equation can be used. First, the required rate of return, rs, must be greater than the long-run growth rate, g Second, the constant growth model is not appropriate unless a company's growth rate is expected to remain constant in the future. This condition almos never holds for -Select- firms, but it does exist for many -Select- companies Which of the following assumptions would cause the constant growth stock valuation model to be invalid? a. The growth rate is zero b. The growth rate is negative c. The required rate of return is greater than the growth rate d. The required rate of return is more than 50% e. None of the above assumptions would invalidate the model Select- Basic Stock Valuation: Dividend Growth Model The value of a share of common stock depends on the cash flows it is expected to provide, and those flows consist of the dividends the investor receive each year while holding the stock and the price the investor receives when the stock is sold. The final price includes the original price paid plus an expected capital gain. The actions of the marginal investor determine the equilibrium stock price. Market equilibrium occurs when the stock's price is Selectits intrinsic value. If the stock market is reasonably efficient, differences between the stock price and intrinsic value should not be very la and they should not persist for very long. When investing in common stocks, an investor's goal is to purchase stocks that are undervalued (the price is Selectthe stock's intrinsic value) and avoid stocks that are overvalued The value of a stock today can be calculated as the present value of -Select stream of dividends: Di (1r) t=1 This is the generalized stock valuation model. We will now look at 3 different situations where we can adapt this generalized model to each of these situations to determine a stock's intrinsic value: 1. Constant Growth Stocks 2. Zero Growth Stocks 3. Nonconstant Growth Stocks Constant Growth Stocks: For many companies it is reasonable to predict that dividends will grow at a constant rate, so we can rewrite the generalized model as follows: (1+1,)' ' (1+)2 1+r Ts-BL Ts-BL This is known as the constant growth model or Gordon model, named after Myron J. Gordon who developed and popularized it. There are several conditions that must exist before this equation can be used. First, the required rate of return, rs, must be greater than the long-run growth rate, g Second, the constant growth model is not appropriate unless a company's growth rate is expected to remain constant in the future. This condition almos never holds for -Select- firms, but it does exist for many -Select- companies Which of the following assumptions would cause the constant growth stock valuation model to be invalid? a. The growth rate is zero b. The growth rate is negative c. The required rate of return is greater than the growth rate d. The required rate of return is more than 50% e. None of the above assumptions would invalidate the model Select