ABSTRACT
EQUITY PRICES AND RETURNS This section illustrates the relationship between prices and returns and addresses the issue of when an investor should buy, sell, or hold a stock based on prices and returns. Let us begin with a basic question: Why do investors buy a stock? The answer is because they
expect future cash dividends and capital appreciation (if and when they sell the stock). Therefore, the now familiar expected holding period return (HPR) from the stock is reproduced here for convenience:
Expected HPR = D +
( )−P P (1)
where D1 is the next period’s dividend, P1 is the next period’s stock price, and P0 is the current stock price. Recall that D1/P0 is the dividend yield and (P1-P0)/P0 is the capital gain/loss yield. As an example, assume D1 = $1.20, P0 = $25, and P1 = $28. The stock’s expected HPR or E(rs) is: ($1.20 + $28-$25)/$25 = 0.168 or 16.8%. This number means that the stock is expected to yield (earn) 16.8%. However, this information is insuffi cient for the investor to decide whether he should buy, sell or hold the stock. He also needs to know the stock’s (or her) required rate of return, k.
