Since there are many investors in the market, there can
be many values for Pˆ 0. However, we can think of a group of
“average,” or “marginal,” investors whose actions actually
determine the market price. For these marginal investors,
P 0 must equal Pˆ 0 ; otherwise, a disequilibrium would exist,
and buying and selling in the market would change P 0 until
P 0 Pˆ 0 for the marginal investor.
g expected growth ratein dividends as predicted by a mar-
ginal investor. If dividends are expected to grow at a con-
stant rate, g is also equal to the expected rate of growth in
earnings and in the stock’s price. Different investors may
use different g’s to evaluate a firm’s stock, but the market
price, P 0 , is set on the basis of the g estimated by marginal
investors.
rsminimum acceptable, or required, rate of returnon the
stock, considering both its riskiness and the returns avail-
able on other investments. Again, this term generally re-
lates to marginal investors. The determinants of rsinclude
the real rate of return, expected inflation, and risk, as dis-
cussed in Chapter 3.
ˆrsexpected rate of returnthat an investor who buys the
stock expects to receive in the future. rˆs(pronounced “r
hat s”) could be above or below rs, but one would buy the
stock only ifˆrswere equal to or greater than rs.
̄rsactual,or realized, after-the-factrate of return,pro-
nounced “r bar s.” You may expectto obtain a return of
ˆrs15 percent if you buy Exxon Mobil today, but if the
market goes down, you may end up next year with an
actual realized return that is much lower, perhaps even
negative.
D 1 /P 0 expected dividend yieldduring the coming year. If the
stock is expected to pay a dividend of D 1 $1 during the
next 12 months, and if its current price is P 0 $10, then
the expected dividend yield is $1/$10 0.10 10%.
expected capital gains yieldduring the coming year. If
the stock sells for $10 today, and if it is expected to rise to
$10.50 at the end of one year, then the expected capital
gain isPˆ 1 P 0 $10.50 $10.00 $0.50, and the
expected capital gains yield is $0.50/$10 0.05 5%.
Expected total return ˆrsexpected dividend yield (D 1 /P 0 ) plus expected capital
gains yield [(Pˆ 1 P 0 )/P 0 ]. In our example, the expected
total return ˆrs10% 5% 15%.
Expected Dividends as the Basis for Stock Values
In our discussion of bonds, we found the value of a bond as the present value of inter-
est payments over the life of the bond plus the present value of the bond’s maturity (or
par) value:
VB
INT
(1rd)^1
INT
(1rd)^2
INT
(1rd)N
M
(1rd)N
.
Pˆ 1 P 0
P 0
Common Stock Valuation 195
Stocks and Their Valuation 191
