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Subject 3. Equity Instruments and the Time Value of Money PDF Download

While the equity asset class has a different risk and return profile than fixed-income securities, the principle of discounting expected future cash flows applies to both types of instruments. The periodic cash flows paid to equity owners are called dividends, with D0 being the amount of the most recently paid dividend and D1 representing the expected amount of the next dividend to be paid.

There are three basic ways that a stock's expected dividend payments can be structured.

Constant Dividend

It is like a perpetual bond. PV = D/r

Constant Dividend Growth Rate

The dividends grow at a constant rate: PV = D1/(r - g)

Note the constant dividend formula is a special case of the constant growth rate formula with g = 0.

Changing Dividend Growth Rate

The dividends grow at a changing rate.

This is known as a two-stage dividend discount model.

Implied Return and Implied Growth

A stock's required return can be estimated given the stock's current price and assumptions about its expected future dividends and growth rates.

From PV = D1/(r - g), we can get r = D1/PV + g. The first component is dividend yield (D1/PV), and the second is the dividend growth rate (capital appreciation component).

We can also re-arrange the equation by dividing each side by the next period's expected earnings per share:

PV/E1 = (D1 / E1) /(r - g)

In this version, PV/E1 is the forward price-to-earnings ratio, and D1/E1 is the dividend payout ratio.

Gross returns are useful in comparing managerial performance before the impact of fees, but net returns are more accurate measures of what investors have actually earned.

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