Dear All
For example, based the CAPM the equity required rate of return is 10%, so from the issuer perspective , 10% is the cost that they have to pay the investor (stockholder) , while from the stockholder perspective , 10% is the returns from buying the stock. So here is the point if I am the stockholder I always want my stock price to increase or my return rate higher, but according to this GGM , Price= Dividend/Rate + g. if the return rate is high then the stock price is low and vice versa. what is the logic explaination behind this.
Thank you so much for your time.
First of all GGM = Dividend(1) / r - g Plus using this formula we calculate the price which we think is suitable for us to pay based on our required rate of return and if using this formula and a higher rate of return, we get a price which is more than the current market price then we think that the stock is undervalued and we purchase it so that we could generate that return from it. Or on the other way round if it is overvalued then we sell it. Obviously we believe that the stock price will converge to it. Moreover as a stock holder you want your stock price to increase once you’ve bought the stock and if its likely that the stock price will rise then you’d want to have maximum capital gain, for that you’ll wish to purchase the stock at minimum price. Your overall return for this transaction (expected) would be your holding period return which includes the required rate of return (of the market) plus the capital gains yield.
Dear Mahammad:
My point is that according to the GGM, I can’t have both high price and high return beucase the required rate in the denomintor , if the rate is high then the price is low and vice versa. so the formular of GGM does not make sense to me.
Thank you so much for your time.
The required rate of return needs to be distinguished from the expected rate of return. The required rate of return, as used in GGM, is basically the opportunity cost of your capital. It’s only logical that the price of the stock decreases as you require a higher rate of return on your investments.
Dear Sunnyisready:
what do mean by "It’s only logical that the price of the stock decreases as you require a higher rate of return on your investments.
if I want the higher return , then my stock price is low. how can it be?
thank you so much for your time
If a particular stock is deemed risky (thereby incrasing your required return), this stock should be priced cheaper than its less-risky counterparts, right? It’s not that you WANT higher returns. You REQUIRE higher returns because you have good reasons to do so (e.g., your high risk aversion, high risks involved in the particular investments, more attractive investment opportunities elsewhere, etc.)
got it . Thank you so much
Hello,
Lets start with two formulas which are rearrangements of the GGM.
P0 = D1 / r - g
r = (D1 / P0) + g
It might help to consider the perspective. Whenever making an investment decision, we do not yet hold the investment so we want the price to be low and the return to be high for it to be worth buying.
Once we have paid the price (P0), we only care about return which is the dividend yield + return on price appreciation. So we only care about D1 and g. Or to put it another way, we want a higher D1 and and higher P1, g = (P1 - P0) / P0.
When you say the investor wants both high price and return, but they have an inverse relationship, I think you might be confusing P0 and P1.
When holding a stock, we want a high P1 which is consistent with a high r, as they are positively related. When purchasing a stock, we want a low P0 and high r, as they are negatively related.
I hope this helps.
I would like to look at CAPM based rate of return as a proxy for cost of equity (Ke) , like the other member mentioned it is also used as cost of capital (which is used to discount the future cash flows ). Generally from investment perspective one looks to get rate of return higher than the required rate (CAPM rate) . As per your question from the shareholder perspective ,he has to get a return greater than capm rate . IMO CAPM rate moves in tandem with the risk structure of the particular company . required rate increases or decreases based on the potential of the company to generate cashflows for less than the required rate .
for example : If co X is able to raise debt at lower than the market rate (due to many factors) the WACC or COC will come down and the discounted cashflows becomes undervalued .
In case of GGM , it is assumed that the co has a dividend history and the company is growing at a constant rate , more often than not the variables of capm dont change , maybe Rf might change due to macro economic factors .