How To Calculate The Value of A Stock?

All securities are valued on the basis of the cash inflows that they are expected to provide to their owners or investors.

Value or current price should equal the present value (PV) of expected future cash flows, which, represents the intrinsic value of the asset.

The formula is also applied to the case of bond pricing. The cash flows from a typical bond are straightforward: the bond has a known and definite life, has fixed coupon payments paid on a regular basis, pays a known par value or principal when the bond matures and should have a discount rate (yield to maturity) close to that of bonds with similar credit ratings.

Although the principle for determining an appropriate stock price is the same as that for determining a bond price, equity does not offer the certainty of bond cash flows. Common and preferred stocks are generally assumed to have infinite lives. 

For common stock, relevant cash flows (dividend payments) will likely vary over time. Finally, determining an appropriate rate at which to discount future dividends is difficult. Despite these difficulties, in this section, we will see that the present value of all future dividends should equal a stock’s intrinsic value and that some simplifying assumptions can make the task of determining stock value easier. 

It may seem rather strange to treat the stock price as nothing more than the present value of all future dividends. Who buys a stock with no intention of ever selling it, even after retirement? Investors generally buy stock with the intention of selling it at some future time ranging from a few hours to 30 years later or longer. 

Despite the length of any one investor’s time horizon, the value of any dividend-paying common stock should equal the present value of all future dividends.

What if a corporation currently pays no dividends and has no plans to pay dividends in the foreseeable future? The value of this company’s stock will not be zero. Here’s why. First, because the firm has no plans to pay dividends does not mean that it never will. 

To finance rapid growth, young firms often retain all their earnings; when they mature, they often pay a portion of earnings as dividends. Second, although the firm may not pay dividends to shareholders, it may be generating cash (or have the potential to do so). 

Someone buying the entire firm can claim the cash or profits, so its current price should reflect this value. Third, the firm’s stock should be worth, at the least, the per-share liquidation value of its assets. But for a going concern, which is our focus in this chapter, the firm is worth the discounted cash flow value that can be captured by an acquirer.

Estimating all future dividend payments is impractical. Matters can be simplified considerably if we assume that the firm’s dividends will remain constant or will grow at a constant rate over time.

Valuing Stocks with Constant Dividends

If the firm’s dividends are expected to remain constant, so that D0 = D1 = D2 …, we can treat its stock as perpetuity.

A perpetuity is an annuity that never ends! It keeps going and going, paying cash flows on a regular basis throughout time.

That is, if you purchase perpetuity, you are buying a cash flow stream that you will receive for the rest of your life…. which can be passed on to your children, your grandchildren, and so forth as long as the payer is in business and financially able to make the payments.

Is such a concept practical? 

Do perpetuities exist? In the past, some governments (e.g., those in the UK) have issued perpetuity bonds that will pay interest as long as the government stands. Preferred stock pays a fixed annual dividend forever (that is, as long as the firm exists and can pay the dividend), another example of a perpetuity.

The present value of a perpetuity is the cash flow divided by the discount rate. For stocks with constant dividends, this means the equation becomes the following:

P0 = D0 rs

Many preferred stocks are valued using the equation since preferred stocks typically pay a constant dollar dividend and do not usually have finite lives or maturities. For example, if the FY Corporation’s preferred stock currently pays a $2.00 dividend and investors require a 10 percent rate of return on preferred stocks of similar risk, the preferred stock’s present value is the following:

$2.00 $0.10 = $20.00

For a preferred stock with no stated maturity and a constant dividend, changes in price will occur only if the rate of return expected by investors changes.

Valuing Stocks with Constant Dividend Growth Rates

Many firms have sales and earnings that increase over time; their dividends may rise, as well. If we assume that a firm’s dividends grow at an annual rate of g percent, next year’s dividend, D1, will be D0(1 + g); the dividend in two years’ time will be D0(1 + g)2.

As long as the dividend growth rate g is less than the discount rate rs, each future term will be smaller than the preceding term. Although technically, there are an infinite number of terms, the present value of dividends received farther into the future will move closer to zero.

By accepting that the sum of all these terms is finite, the equation becomes the following:

P0= D1 (rs − g)

With D1 equal to next year’s dividend, namely, D0(1 + g), the current dividend increased by the g percent constant growth rate.

This result is known as the Gordon model, or the constant dividend growth model. The model assumes that a dividend is currently being paid, and this dividend will grow or increase at a constant rate over time. 

Of course, the assumption of constant growth in dividends may be unrealistic for a firm that is experiencing a period of high growth (or negative growth; that is, declining revenues). Neither will constant dividend growth be a workable assumption for a firm whose dividends rise and fall over the business cycle.

Let’s assume the cash dividend per share for XYZ Company for last year was $1.89 and is expected to be $2.05 at the end of this year. This represents a percentage increase of 8.5 per cent [($2.05 – $1.89)/$1.89]. If investors expect a 12 percent rate of return, then the estimated current stock value (P0) would be the following:

P0 = $1.89(1.085)/(0.12 – 0.085) = ($2.05/0.035) = $58.59

Thus, if investors believed that the cash dividends would grow at an 8.5 percent rate indefinitely into the future and expected a 12 percent rate of return, they would pay $58.59 for the stock.

Risk in Stock Valuation

Investors in common stocks face a number of risks that bondholders do not. This additional risk leads them to require a higher rate of return on a firm’s stock than on its debt securities. 

For example, in the event of corporate failure, the claims of stockholders have lower priority than those of bondholders. So, stockholders face a greater risk of loss than bondholders. Dividends can be variable and omitted, whereas bond cash flows have a legal obligation to be met.

Poor ethical decisions and poor management are another source of risk for stock investors in that such decisions can lower future cash flows and raise the required rate of return demanded by future investors. 

Accounting gimmickry and decisions by self-serving managers can hurt stock prices, as happened with Enron, WorldCom, and Tyco. Poor customer or supplier relations, allegations of poor-quality products, and poor communications, as occurred between Ford Motor Company and one of its tire suppliers, Firestone, which hurt both companies and their shareholders. Volkswagen’s admission of “fixing” emissions tests on its diesel car engines led to declines of over 35 percent in its stock price in a matter of a few days.

If the general level of interest rates rises, investors will demand a higher rate of return on stocks to maintain their risk premium differential over debt securities. This will force stock prices downward. Therefore, stockholders risk losses from any general upward movement of market interest rates.

Also, future dividends, or dividend growth rates, are not known with certainty at the time stock is purchased. If poor corporate performance or adverse general economic conditions lead investors to lower their expectations about future dividend payments, this will lower the present value of shares of the stock, leaving the stockholder with the risk of capital loss.

Stock analysts systematically review economic, industry, and firm conditions in great detail to gain insight into corporate growth prospects and the appropriate level of return that an investor should require of a stock.

Valuation and the Financial Environment

The price of an asset is the present value of future cash flows; the discount rate used in the present value calculation is the required rate of return on the investment. 

Future cash flows of firms and the required returns of investors are affected by the global and domestic economic environments and the competition faced by firms. 

Slower sales or higher expenses can harm a firm’s ability to pay its bond interest or dividends or to reinvest in its future growth. 

Besides affecting cash flows, these can affect investors’ required rates of return by increasing risk premiums or credit spreads. Inflation pressures and capital market changes influence the level of interest rates and required returns.

Global Economic Influences on Stock Valuation

Two main overseas influences will affect firms. The first is the condition of overseas economies. Growth in foreign economies will increase the demand for U.S. exports. Similarly, sluggish foreign demand will harm overseas sales and hurt the financial position of firms doing business overseas. 

The rate of economic growth overseas can affect the conditions faced by domestic firms, too, as growing demand globally may make it easier to raise prices and sluggish demand overseas may lead to intense competition in the U.S. market.

The second influence is the behavior of exchange rates, the price of a currency in terms of another currency. 

A change in exchange rates over time has two effects on the firm. Changing exchange rates lead to higher or lower U.S. dollar cash flows from overseas sales, more competitively priced import goods, or changing input costs. 

Thus, changing exchange rates affect profitability by influencing sales, price competition, and expenses. 

Changing exchange rates also affect the level of domestic interest rates. Expectations of a weaker U.S. dollar can lead to higher U.S. interest rates; to attract capital, U.S. rates will have to rise to compensate foreign investors for expected currency losses because of the weaker dollar.35 Conversely, a stronger dollar can result in lower U.S. interest rates.

Domestic Economic Influences on Stock Valuation

Individuals can spend only what they have (income and savings) or what their future earning capacity will allow them to borrow. Consumption spending (spending by individuals for items such as food, cars, clothes, computers, and so forth) comprises about two-thirds of gross domestic product (GDP) in the United States. 

Generally, higher disposable incomes (that is, income after taxes) lead to higher levels of consumer spending. Higher levels of spending mean inventories are reduced and companies need to produce more and hire additional workers to meet sales demand.

Corporations will spend to obtain supplies and workers based upon expectations of future demand. Similarly, they will invest in additional plants and equipment based on expected future sales and income. 

Economic growth results in higher levels of consumer spending and corporate investment, which in turn stimulates job growth and additional demand. Slow or negative growth can lead to layoffs, pessimistic expectations, and reduced consumer and corporate spending. These effects will directly influence company profits and cash flows.

Economic conditions affect required returns, too. Investors will be more optimistic in good economic times and more willing to accept lower-risk premiums on bond and stock investments. In poor economic times, credit spreads will rise as investors want to place their funds in safer investments.

Governments shape the domestic economy by fiscal policy (government spending and taxation decisions) and monetary policy. These decisions may affect consumer disposable income (fiscal policy) and the level of interest rates as well as inflation expectations, (monetary policy) and, therefore, affect the valuation of the bond and stock markets.

Some industry sectors are sensitive to changes in consumer spending. Sales by auto manufacturers, computer firms, and other manufacturers of high-priced items will rise and fall by greater amounts over the business cycle than will food or pharmaceutical firms. 

Changes in interest rates affect some industries more than others, too; banks and the housing industry (and sellers of large household appliances) are sensitive to changes in interest rates more than, say, book and music publishers or restaurants.

Influence of Industry Competition on Stock Valuation

A firm’s profits are determined by its sales revenues, expenses, and taxes. We have mentioned taxes and some influences on sales and expenses in our discussion of global and domestic economies, but industry competition and the firm’s position within the industry will have a large impact on its ability to generate profits over time. 

Tight competition means it will be difficult to raise prices to increase sales revenue or profitability. Nonprice forms of competition, such as customer service, product innovation, and the use of technology to the fullest extent in the manufacturing and sales processes may hurt profits by increasing expenses if the features do not generate sufficient sales. 

Competition may not come only from similar firms; for example, a variety of “entertainment” firms, from music to theater to movies to sports teams, vie for consumers’ dollars. Trucking firms and railroads compete for freight transportation. 

Cable and satellite firms compete in the home television markets (and for Internet service, along with telephone service providers). Changes in the cost and availability of raw materials, labor, and energy can adversely affect a firm’s competitive place in the market.

The influences of competition and supply ultimately affect a firm’s profitability and investors’ perceptions of the firm’s risk. This, in turn, will affect its bond and stock prices. The most attractive firms for investing in will be those with a competitive advantage over their rivals. 

They may offer a high-quality product, be the low-cost producer, be innovators in the use of technology, or offer the best customer support. Whatever the source of the firm’s advantage is, if it can build and maintain this advantage over time it will reap above-normal profits and be an attractive investment.

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