Ch.8

• Past earnings and dividends

  Most important factors influencing a stock's current price
• Sales growth and net profit margin

  Key to the future financial success of a company
• Companies with high P/E ratios

  Tend to also have high dividend payout ratios
• A stock's value depends on future cash flows
• A company's estimated future earnings and its P/E ratio


  Can be used to estimate the stock's future price
• Estimated price of a stock in the future

  Includes the projected capital gain on the stock
• Key variables that affect the P/E ratio and the relationship between each variable and the P/E ratio:
• The first step in predicting a stock's future price is to forecast profits
• If net income rises, but the number of shares outstanding remains the same, EPS will rise
• Common-size income statement


  Expresses every item on the income statement as a percentage of sales
• A temporary decline in earnings per share

  Usually results in a temporary reduction of dividends
• A decline in earnings that investors expect to be temporary

  May actually increase a firm's P/E ratio
• The sales forecast depends on factors both internal and external to the firm
• Dividend payments


  Even if a company does not officially follow a fixed-dividend policy, they are fairly stable from one time period to another
• Major forces behind earnings per share

  Growth and the number of shares outstanding
• Over the last year, a firm's earnings per share increased, dividends per share increased, and share price increased


  The stock experienced an increase in its P/E ratio
• The efficient market hypothesis holds that a stock's intrinsic value and market value are essentially the same
• A stock will be an attractive investment if the required rate of return exceeds the expected rate of return
• There is no assurance that the actual rate of return on an asset will be similar to the projected rate of return
• The greater the perceived risk of an asset, the lower the expected rate of return
• Both beta and the expected return on the market portfolio incorporate risk into the Capital Asset Pricing Model
• Required rate of return

  The minimum rate of return an investor should expect
• Intrinsic value of an asset

  Equals the present value of all future cash flows at a given discount rate
• For Heather to identify stocks whose market prices are lower than their intrinsic values, she needs an accurate estimate of future earnings and dividends
• The intrinsic value of a stock is based on the current discounted value of all future dividends plus the discounted value of the sale price of the stock at a future point in time
• Rational


  (in classical economic theory) economic agents are able to consider the outcome of their choices and recognise the net benefits of each one
• Producers act rationally by


  Selling goods/services in a way that maximises their profits
• Workers act rationally by


  Balancing welfare at work with consideration of both pay and benefits
• Governments act rationally by


  Placing the interests of the people they serve first in order to maximise their welfare
• Rationality in classical economic theory is a flawed assumption as people usually don't act rationally
• A firm increases advertising


  Demand curve shifts right
• Demand curve shifting right

  Increases the equilibrium price and quantity
• Marginal utility


  The additional utility (satisfaction) gained from the consumption of an additional product
• If you add up marginal utility for each unit you get total utility
• Heather believes that by carefully examining a company's fundamentals and by applying the best valuation models she can identify stocks whose market prices are lower than their intrinsic values
• For Heather's belief to be true, some stocks must be incorrectly priced
• Time value of money concept

  The intrinsic value of a stock is based on the current discounted value of all future dividends plus the discounted value of the sale price of the stock at a future point in time
• The required rate of return estimated by the Capital Asset Pricing Model is not suitable for use in dividend valuation models
• Dividend valuation model (DVM)


  The value of a share of stock is a function of its future dividends
• If the annual dividend on a stock never changes, its price will never change