- CFA Exams
- 2024 Level I
- Topic 1. Quantitative Methods
- Learning Module 2. Time Value of Money in Finance
- Subject 3. Equity Instruments and the Time Value of Money

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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 D

_{0}being the amount of the most recently paid dividend and D

_{1}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 = D

_{1}/(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 = D

_{1}/(r - g), we can get r = D

_{1}/PV + g. The first component is dividend yield (D

_{1}/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:

_{1}= (D

_{1}/ E

_{1}) /(r - g)

In this version, PV/E

_{1}is the forward price-to-earnings ratio, and D

_{1}/E

_{1}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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