Principles of Corporate Finance_ 12th Edition

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338 Part Four Financing Decisions and Market Efficiency


bre44380_ch13_327-354.indd 338 09/11/15 07:55 AM


For example, imagine that in December 2014 you wanted to check whether the stocks
forming Standard & Poor’s Composite Index were fairly valued. As a first stab you might use
the constant-growth formula that we introduced in Chapter 4. In 2014, the annual dividends
paid by the companies in the index were roughly $350 billion. Suppose that these dividends
were expected to grow at a steady rate of 4.0% and that investors required a return of 6.0%.
Then the constant-growth formula gives a value for the common stocks of

PV common stocks = _____DIV
r − g
= __________^350
.060 − .040

= $17,500 billion

which was roughly their value in December 2014. But how confident could you be about
these figures? Perhaps the likely dividend growth was only 3.5% per year. In that case your
estimate of the value of the common stocks would decline to

PV common stocks = _____DIV
r − g
= __________^350
.060 − .035

= $14,000 billion

In other words, a reduction of just half a percentage point in the expected rate of dividend
growth would reduce the value of common stocks by 20%.
The extreme difficulty of valuing common stocks from scratch has two important conse-
quences. First, investors find it easier to price a common stock relative to yesterday’s price
or relative to today’s price of comparable securities. In other words, they generally take

◗ FIGURE 13.5 Log deviations from Royal Dutch Shell/Shell T&T parity.
Source: Mathijs van Dijk, http://www.mathijsavandijk.com/dual-listed-companies. Used with permission.

–40

–30

–20

–10

0

10

20

30

01/01/198001/01/198201/01/198401/01/198601/01/198801/01/199001/01/1992

Deviation, %

01/01/199401/01/199601/01/199801/01/200001/01/200201/01/2004
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