Financial Markets and Institutions (2-downloads)

Growth (%)

Price

1

$ 14.43

3

17.17

5

21.00

10

44.00

11

55.50

12

74.67

13

113.00

14

228.00

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Problems with Estimating Risk

The dividend valuation model requires the analyst to estimate the required return for

the firm’s equity. Table 13.2 shows how the price of a share of stock offering a 

$2 dividend and a 5% growth rate changes with different estimates of the required

return. Clearly, stock price is highly dependent on the required return, despite our

uncertainty regarding how it is found.

Problems with Forecasting Dividends

Even if we are able to accurately estimate a firm’s growth rate and its required return,

we are still faced with the problem of determining how much of the firm’s earnings

will be paid as dividends. Clearly, many factors can influence the dividend payout

ratio. These will include the firm’s future growth opportunities and management’s

concern over future cash flows.

Putting all of these concerns together, we see that stock analysts are seldom very

certain that their stock price projections are accurate. This is why stock prices fluc-

tuate so widely on news reports. For example, information that the economy is slow-

ing can cause analysts to revise their growth expectations. When this happens across

a broad spectrum of stocks, major market indexes can change.

Does all this mean that you should not invest in the market? No, it only means that

short-term fluctuations in stock prices are expected and natural. Over the long term,

the stock price will adjust to reflect the true earnings of the firm. If high-quality firms

are chosen for your portfolio, they should provide fair returns over time.

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Part 5 Financial Markets

TA B L E   1 3 . 2

Stock Prices for a Security with 

D

0

= $2.00, 

g = 5%, 

and Required Returns as Listed