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
Restrictions on Investments: A mutual fund scheme shall not invest more than 15% of its NAV in debt instruments issued by a single issuer, which are rated not below investment

What are the negative consequences of a company holding too much cash? A company holding so much cash would be giving up the opportunity to invest much more in income producing a

Principal repayment before the scheduled date is called a prepayment. Every individual borrower normally has the option to pay off all or part of their loan

Question 1 State the key functions of the financial market. Question 2 Define "Bill of exchange". What are its features? Give different types of cheques. Question 3

What are the benefits of investing via international mutual funds? Answer:  The benefits of investing via international mutual funds consist of: (a) Save transaction or info

Q. What do you mean by Collateralized Mortgage Obligation? Collateralized Mortgage Obligation (CMO) - SECURITY whose cash flows equal the difference between cash flows of colla

Plugging back of the future of profit means the reinvestment by the concerns of its surplus in the business. it is an internal financial of the business and it is more suitable for

Market development A strategy which seeks to sell existing products in new geographical markets or new market segments. A strategy to find new uses for existing products or ser

Q. Explain Rate of the stock turnover? Rate of the stock turnover: this is high degree of the inverse co relation between the quantum of the working capital requirement and the

Q. Define the Cash Budget? Cash Budget: - A cash budget is an estimation of cash receipts and cash payments for a future period of time. It is prepared to predict the cash requ