Financial Markets and Institutions (2-downloads)

Investor

Discount Rate

Stock Price

You

15%

$16.67

Jennifer

12%

$22.22

Bud

7%

$50.00

You are willing to pay $16.67 for the stock. Jennifer would pay up to $22.22,

and Bud would pay $50. The investor with the lowest perceived risk is willing to

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Chapter 13 The Stock Market

313

pay the most for the stock. If there were no other traders, the market price would

be just above $22.22. If you already held the stock, you would sell it to Bud.

The point of this section is that the players in the market, bidding against each

other, establish the market price. When new information is released about a firm, expec-

tations change, and with them, prices change. New information can cause changes in

expectations about the level of future dividends or the risk of those dividends. Since

market participants are constantly receiving new information and constantly revising

their expectations, it is reasonable that stock prices are constantly changing as well.

Errors in Valuation

In this chapter we learned about several asset valuation models. An interesting exer-

cise is to apply these models to real firms. Students who do this find that computed

stock prices do not match market prices much of the time. Students often question

whether the models are wrong or incomplete or whether they are simply being used

incorrectly. There are many opportunities for errors in applying the models. These

include problems estimating growth, estimating risk, and forecasting dividends.

Problems with Estimating Growth

The constant growth model requires the analyst to estimate the constant rate of

growth the firm will experience. You may estimate future growth by computing the

historical growth rate in dividends, sales, or net profits. This approach fails to con-

sider any changes in the firm or economy that may affect the growth rate. Robert

Haugen, a professor of finance at the University of California, writes in his book, The

New Finance, that competition will prevent high-growth firms from being able to

maintain their historical growth rate. He demonstrates that, despite this, the stock

prices of historically high-growth firms tend to reflect a continuation of the high

growth rate. The result is that investors in these firms receive lower returns than

they would by investing in mature firms. This just points out that even the experts

have trouble estimating future growth rates. Table 13.1 shows the stock price for

a firm with a 15% required return, a $2 dividend, and a range of different growth

rates. The stock price varies from $14.43 at 1% growth to $228 at 14% growth rate.

Estimating growth at 13% instead of 12% results in a $38.33 price difference.

TA B L E   1 3 . 1

Stock Prices for a Security with 

D

0

= $2.00, 

k

e

= 15%, and 

Constant Growth Rates as Listed