Module 6: Stocks Takeaways 1

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Module 6: Stocks

Takeaways

1. A stock is a share of equity, that is transferable and comes in small denominations. It is provides part ownership of the company to an individual and has a limited liability of the amount invested. It is also a residual claimant which means that we get money after every expense and every other form of liability is taken out first.

2. When measuring we want to look at the stock indexes. These will show the fluctuations of the stock overtime. We can look at the Dow, S and P 500, Wilshire, NASDAQ or World markets to do so. These allow us to measure the wellbeing of the market. We value stocks by using the Dividend Discount Method. This implies that we will keep the Stock for a long time and treat it like a consol bond. 

3. Stocks are only risky in short term. This is because, due to the theory of efficiency markets, stocks are unpredictable and we can't know what the stock price will be in the future. However, when looking at stocks over the long-term, we see that the stocks often have yields that are above zero. This means that the risk of losing or not making money is gone and the risk of holding a stock is much smaller.

Problems

Next year, the price of a stock is expected to be $2,200 and the stock will pay a $55 dividend. The interest rate is 10%. Based on the dividend-discount model, what is the current price of this stock?

For this we use the Basic Current price equation to solve for the price of the stock. This is because we have the expected price of the stock.

PToday=D/(1+i)+PNext Year/(1+i)

(2200/(0.10+1))+(55/(0.10+1)

 

Since they have the same denominator we can add them across

2200+55/1.1= 2050

you are thinking about investing in a stock that payed a dividend of 10 this year. You expect the dividends to grow by 4%. The risk-free interest rate is 3% and the risk premium is 5%. If the current market price for the stock is $200, should you buy the stock?

For this we will use the Dividend Discount Model with risk

PToday=DToday(1+g)/rf+rp-g

10(1+0.04)/0.03+0.05-0.04

10.4/0.04=260

Ptoday=260

We should buy because the estimated price today is more than what the market is offering. 

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