Question

Forecasting Stock Value

When buying stock, you can expect to earn money through future current income (from ________________ increases in stock price OR dividends) and future capital appreciation (from ________________ increases in stock price OR dividends). Together, your total earnings from a given investment can be expressed in terms of the approximate yield. This value makes it easier for you to compare investment options.

The formula for the approximate yield of an investment can look intimidating, but it's really just a function of three things: (1) average current income, (2) average capital gains, and (3) the average value of the investment. Based on the information in the table, compute each of these values for the two stocks over a 3-year period and enter the values into the bottom half of the table.

	Stock 1	Stock 2
Expected average annual dividends (2012-2014)	$1.40	$3.10
Current stock price	$60	$104
Expected future stock price (2014)	$78	$131
Average current income (CI)	_____	_____
Average capital gains (CG)	_____	_____
Average value of the investment (VI)	_____	_____

Next, derive the correct formula for approximate yield by correctly arranging these three variables in the equation that follows.

Approximate Yield = _________________ / ___________________

Using this formula, you can see that the approximate yield for Stock 1 is ________ and the approximate yield for Stock 2 is ____________.

True or False: If both investments carry the same rate of risk, Stock 1 is a better investment than Stock 2. _________

Answer 1

Ans. When buying stock, you can expect to earn money through future current income from increases in dividends.

When buying stock, you can expect to earn money through future capital appreciation from increases in stock price.

The workings for 3 year period table for two stocks are as under:-

	Stock 1	Stock 2	Derivation
Expected average annual dividends (2012-2014)	1.4	3.1	Provided in the question
Current stock price	60.0	104.0	Provided in the question
Expected future stock price (2014)	78.0	131.0	Provided in the question
Average current income (CI)	1.4	3.1	It is nothing but Expected Average Annual Dividends for 3 years
Average capital gains (CG)	6.0	9.0	CG can be calculated by dividing the Capital Gains i.e. (Expected Future Stock Price - Current Stock Price) by 3 years
Average value of the investment (VI)	69.0	117.5	Average Value of Investment is nothing but Average of (Expected Future Stock Price + Current Stock Price)/2.

Approximate Yield = (Total of Average Current Income + Total of Average Capital Gains) / Total of Average Value of Investment.

Using the above formula, you can see that the approximate yield for Stock 1 = (1.4+6.0)/69.0 = 10.72% and the approximate yield for Stock 2 = (3.1+9.0)/117.50= 10.30%.

True or False: If both investments carry the same rate of risk, Stock 1 is a better investment than Stock 2. TRUE as the initial investment outlay is less for Stock A than Stock B.