Question

(a) why would an investor, concerned primarily with capital gains, estimate a stock's current market price on the basis of expected future dividends?

(b) Explain how the earnings and dividens approaches to stock valuation are equivalent

Answer 1

(a): An investor, who is concerned mainly with capital gains, will make use of expected future dividends so as to be able to determine the intrinsic value or fair value of a stock. It should be noted that value of a stock is equal to present value of dividends expected from the ownership of the stock plus the present value of sale price expected when the share is sold. This gives us the intrinsic value of a stock and using this intrinsic value an investor will be able to determine whether the stock is underpriced or overpriced. If the stock is underpriced then there is a possibility to book capital gains due to available upside.

Suppose, on a hypothetical basis, that you have determined that the intrinsic value of P&G’s stock to be $100 based on its expected future dividends. P&G’s stock, again hypothetically, is trading at $80 in the market. This means that the stock is undervalued and there is a potential for the price of P&G’s stock to increase in future thus leading to capital gains for the investor.

(b): Earnings and dividends approaches to stock valuation are equivalent as both approaches makes use of similar underlying principles of finance. In case of dividend approach we discount expected future dividends with cost of equity (or rate of return required on equity share). On the other hand the earnings model factors in payout ratio or the proportion of earnings devoted to dividend payments. In the earnings approach we take the payout ratio and then divide that amount by the difference between the investor's discount rate and the dividend growth rate. This will give us the earnings model’s P/E and this can then be compared to the market’s P/E to determine the fair value of the stock.