Underlying Principle
Wheninvestorsbuystockinpubliclytradedcompanies,they
generallyexpect togettwo typesof cash flows:dividends
duringtheholdingperiodandanexpectedpriceattheendof
the holding period. Since this expected price is itself
determinedbyfuturedividends,thevalueofastockcanbe
written as the present value of dividends in perpetuity.
where
DPSt= Expected dividends per share in periodt
ke= Cost of equity
Therationaleforthemodelliesinthepresentvaluerule:The
valueofanyassetisthepresentvalue(PV)ofexpectedfuture
cashflowsdiscountedatarateappropriatetotheriskinessof
the cash flows.
Therearetwobasicinputstothemodel:expecteddividends
andthecostofequity.Toobtaintheexpecteddividends,we
make assumptions about expected future growth rates in
earningsandpayoutratios.Therequiredrateofreturnona
stockisdeterminedbyitsriskiness,measureddifferentlyin
differentmodels—themarketbetainthecapitalassetpricing
model (CAPM), and the factor betas in the arbitrage and
multifactormodels.Themodelisflexibleenoughtoallowfor
time-varying discount rates, where the time variation is