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Valuation

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If you are willing to accept the idea that financial markets are efficient, the next question becomes one of how investors price common stocks. What do they consider important? What do they consider irrelevant? And how do they decide what is the required rate of return for their money?

The basic stock price valuation model is a discounted cash flow model in which the stock price is modeled as the present (discounted) value of the cash flows the investor expects to receive from owning the share.

For example, suppose the expected per share cash dividend for Ford Motor Company next year, D1, is $1.30; the investors’ required rate of return k on Ford’s common stock is 9.00 percent; and investors expect the annual growth rate g for Ford’s per share cash dividends to be 5.00 percent. With these expectations, we would estimate Ford’s stock price today to be $32.50 a share. The actual stock price may be more or less than $32.50, in which case, if you believe that markets are efficient, you have erred in estimating the dividend, the required rate of return, or the expected dividend growth rate.

As you can observe from the model, increases (decreases) in expected cash dividends and dividend growth rates cause an increase (decrease) in the stock price, as does a decrease (increase) in the investors’ required rate of return. Now we know how Ford managers can increase shareholder wealth: They can adopt policies that, other things being equal, lead to increases in cash dividends (either today or in the distant future) and/or lower the investors’ required rate of return. Let's start with cash dividends.
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Document Type: Research Article

Publication date: February 25, 2003

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