Effect on stock valuation, Financial Management

Effect on Stock Valuation

Until the 1960s, common stocks were viewed as a good instrument against loss caused by inflation. Also, before 1960, stocks were not providing full hedge against the inflation. The only benefit attached with the investment in the common stocks was that their value was not very adversely affected during the period of inflation and their performance was comparatively better. To understand the effect of inflation on stocks' value, we will now try to evaluate the Gordon-Shapiro dividend discount model.

V0 = D0/K - G

Where,

V0 = value at time zero.

D0 = dividends received during time period zero.

K = constant discount rate.

G = constant growth rate of dividends.

According to the supporters claiming that common stocks are good inflation hedging instruments, there will be no change in V0 due to unexpected inflation. This is expected because the discount rate K also increases along with increase in the inflation expectations and the rate of change is almost similar to the dividend growth rate, ‘G'. Hence, the net effect on V0 will be almost zero. However, for this idea to hold good, companies should be able to forward the increase in costs of raw materials, borrowings and taxes in the form of higher selling price of their product.

Stocks are expected to show good gains during periods of unexpected inflation only when companies can increase their selling price at a higher rate than the increase in the cost of materials, labor and other inputs. But, past observed evidence recommends that common stocks have not established themselves as a perfect hedging instrument against unexpected inflation. It is important to mention here that this conclusion is based on a study conducted using pre-tax returns. In fact, the results based on after-tax returns are more remarkable. Now the question arises as to why stocks cannot provide hedging benefit against the unexpected inflation. The real output growth is not resistant to the negative effects of inflation and this ensures that unexpected inflation will damage the value of all the capital assets. Since the income of the common stocks comes mainly from the residual income of the economy, the decline in the value of common stocks is uneven.

 

Posted Date: 9/11/2012 4:53:56 AM | Location : United States







Related Discussions:- Effect on stock valuation, Assignment Help, Ask Question on Effect on stock valuation, Get Answer, Expert's Help, Effect on stock valuation Discussions

Write discussion on Effect on stock valuation
Your posts are moderated
Related Questions
Advantages to the Investors: The warrant acts as a sweetener and ensures a better subscription to the NCDs, especially for companies with good track record. NCDs with warran

Question 1: (a) Discuss the main limitations of using changes in national income as an index of economic welfare. (b) What are the alternatives measures and issues that sho

What are the benefits of Traditional approach Traditional approach had a very narrow perception and was devoid of an integrated conceptual and analytical framework. It had pre

Classification of finance and abrief description of each source of fund

Question 1: i) Activity Based Costing is better than the Traditional Product Costing. Discuss, by making use of empirical evidence ii) The replacement of cash-based accounti

Explain the organization and function of commodities exchange

LIMITATIONS OF BUDGETARY CONTROL 1. It involves predicting the future which is not certain. 2. Market is continuously and dynamically evolving.  Hence budgets based on past

Question 1 International trade is the economic interaction among different nations involving the exchange of goods and services. Discuss the role of Banks in International Trade T

Yield to put is the rate at which the present value of cash flow to the first put date is equal to the price plus interest rate. It is used for

conflicts between shareholders and government in agency relationship