Applied Equity Analysis and Portfolio Management + Online Video Course: Tools to Analyze and Manage Your Stock Portfolio

CHAPTER 3

Valuation, Expected Returns, and the Dividend Discount Model

This chapter covers the basics of valuation and expected returns. We will begin by reviewing the general idea of discounted cash flow (DCF) valuation as applied to contracts, loans, bonds, corporate projects and common stock. Once the general ideas underlying DCF analysis are familiar, we will progress to a more detailed understanding of the concept of expected return. The remainder of the chapter will introduce the first of several equity valuation models we will consider, known as the dividend discount model (DDM). Each numbered example corresponds to the same numbered example in the chapter spreadsheet, which performs all of the illustrated calculations and shows the applicable Excel code for each. Note that this chapter assumes a thorough understanding of the time value of money (TVM). If any of the material in this chapter seems overly complex, please complete the time value of money tutorial in the appendix and then return to this chapter. The learning objectives for this chapter are:

1. Understand, explain, and apply the three fundamental principles of finance:

• Finance Principle 1: Value = The Present Value of Expected Future Cash Flows
• Finance Principle 2: The Inverse Relation between Value and Expected Return
• Finance Principle 3: We Expect to Observe a Positive Relation between Risk and Expected Return

2. Apply Principle 1 by estimating the value of cash flow streams, loans, bonds, the free cash ...