Time Value of Money in Equity Instruments

Mastering Time Value of Money for Equity Instruments | CFA Level I

We’re diving into the fascinating world of equity instruments, focusing on the time value of money for preferred and common stock. We’ll also decode how to calculate the implied growth rate and justified PE ratios. So, let’s jump right in!

Understanding Time Value of Money in Equity Instruments

In our previous discussions, we explored the time value of money in the context of fixed-income instruments, emphasizing the predictability of their cash flows. However, when we shift our focus to equity instruments, the scenario changes. Here, dividends represent the cash flows to shareholders, but unlike fixed-income securities, these are not set in stone. Dividends are discretionary and can fluctuate based on the company’s financial health and decisions.

Preferred Stock vs. Common Stock

  • Preferred Stock: This type of stock usually offers a fixed dividend, akin to receiving a perpetual income stream. It’s crucial to note that these dividends are not obligatory for the company; they have the flexibility to suspend payments if financial constraints arise.

    Valuation Formula for Preferred Stock
    PV = Dividend / Discount Rate

    For instance, purchasing preferred stock with an annual dividend of $5 for $97 implies a dividend yield (or return) of 5.15%.
  • Common Stock: The valuation of common stock introduces more complexity due to the discretionary nature of dividend payments. The present value (PV) of a common stock is the sum of all future dividends, discounted by the stock’s required return.

Modeling Dividend Growth

One practical approach to estimating common stock value is the Gordon Growth Model, which assumes a constant dividend growth rate. This model simplifies the valuation process significantly.

Formula for the Gordon Growth Model
PV = D1 / (r - g)

EXAMPLE
An analyst estimates a stock’s future dividends to grow at 4% annually with a required return of 6.5%. If the current dividend is $3, the stock’s value, according to the Gordon Growth Model, would be $124.80.

Gordon Growth Model for Equity Valuation

Implied Growth Rate and Justified PE Ratios

Solving for Implied Growth Rate

When the market price of a stock is known, rearranging the Gordon Growth Model allows us to deduce the implied growth rate, offering a glimpse into the market’s growth expectations for the company.

Implied return, Implied growth rate

Justified PE Ratios: Trailing vs. Forward

  • Trailing PE Ratio measures the stock’s current price against the past year’s earnings.
  • Forward PE Ratio evaluates the stock’s price against projected future earnings, providing a forward-looking perspective on valuation.

Justified PE Ratio Formula
Justified PE = Payout Ratio / (r - g)

EXAMPLE
A company with a consistent payout ratio of 0.6, expected growth of 4.5%, and a required return of 8% would have a justified trailing PE ratio of 17.9 times.

Justified PE Ratio

This lesson has equipped you with the tools to navigate the complexities of equity valuation through the lens of the time value of money. Stay tuned for our next adventure, where we’ll explore the cash flow additivity principle.

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