Valuation of Common Stocks

Fundamental Valuation Principle

• Valuation is based on the present value of all future cash flows generated by the stock.
• Unlike bonds, stocks do not have predetermined cash flows (e.g., coupons), and value is driven by expectations of future earnings and dividends.
• Stockholders expect dividends and capital gains, as stocks do not have a maturity date like bonds.
• Selling price in the future is uncertain, leading to potential capital gains or losses.

Stock Valuation Model

• Consider a one-period stock holding scenario:
  • Buy stock in period 0, sell in period 1.
  • Price depends on expected dividend (D1) and selling price (P1).
  • Discount these cash flows by the required rate of return (R) to determine the maximum price (P0):
    • [ P_0 = \frac{D_1}{1+R} + \frac{P_1}{1+R} ]
• Recursive substitution principle:
  • Even if not holding beyond period 1, future dividends impact selling price expectations.
  • Example substitutions show dependence on future dividends influencing price.

Dividends and Stock Pricing

• Stock value today is the present value of all future dividends.
• Stocks may not initially pay dividends, but future expectations affect current pricing.
• Example: Companies like Apple reinvest earnings during high growth stages before eventually paying dividends.

Stock Valuation Models

Zero Growth Model

• Assumes all dividends are equal (perpetuity):
  • [ P = \frac{\text{Dividend}}{R} ]
• Applicable to stable companies (cash cows) with little growth.

Constant Growth Model

• Dividends grow at a constant rate (G):
  • [ P_0 = \frac{D_1}{R - G} ]
• Example: Calculate based on known past dividend, growth rate, and required return.
• Highlights effects of changes in R (risk) and G (growth rate).

Differential Growth Model

• More sophisticated; used by analysts for stock price targets.
• Forecast dividends for a certain period (N), then assume constant growth:
  • Calculate present value of initial dividends and constant growth model for future.

Challenges in Stock Valuation

• Uncertainty in dividends and earnings makes stock valuation difficult.
• Analysts predict dividends based on earnings forecasts and industry trends.
• Estimating growth (G) and required return (R) involves industry rates and models like CAPM.

Stock Market Reporting

• Stocks are traded daily; some are over-the-counter with low volumes.
• Stock quotes include highest, lowest prices, dividends, PE ratio, etc.
• Indicators like dividend yield and changes in price are key for investors.

Conclusion

• Understanding valuation models helps in assessing fundamental stock value.
• Models are used extensively in industry for determining stock price targets, not short-term fluctuations.