Stock Valuation and Market Basics

Overview

This lecture covers the determinants of stock prices, focusing on dividends and the dividend growth model, and explains how to value stocks, their types, and the functioning of stock markets.

Stock Valuation Basics

• Stock value equals the present value of all expected future cash flows (dividends and capital gains).
• Cash flows for equity holders are dividends and the price difference between buying and selling the stock.
• The value of a stock can be estimated as the present value of all expected dividends.

Dividend Growth Model

• Three dividend scenarios: no growth (perpetuity), constant growth, and supernormal (variable then constant growth).
• For constant dividends: Price = Dividend / Required Return.
• For constant growth: Price = Next Year Dividend / (Required Return - Growth Rate).
• For non-constant growth: Calculate present value of varying dividends, then apply the constant growth model once growth stabilizes.

Practical Application & Formulas

• To find current price, use: P₀ = D₁ / (R - g).
• D₁ represents expected dividend next year, R is required return, g is growth rate.
• Stock is overpriced if market price > calculated price; underpriced if market price < calculated price.
• Required return can be calculated: R = (D₁ / P₀) + g.
• If no dividend is paid, use P/E ratio: Price = Benchmark P/E × Expected EPS.

Features of Common and Preferred Stock

• Common stockholders have voting rights, receive dividends, and share assets if liquidated.
• Different classes of shares (e.g., A, B) may have different voting power.
• Dividends are not a company liability until declared and are not tax-deductible for firms.
• Preferred stock pays fixed dividends first; most are cumulative and usually have no voting rights.

Stock Markets and Trading

• Two main markets: Primary (new issues) and Secondary (trading existing shares).
• Secondary markets provide liquidity (e.g., NYSE, NASDAQ).
• Stock quotes (P/E, EPS) are available from finance websites.

Key Terms & Definitions

• Dividend Growth Model (DGM) — Method to value a stock based on expected future dividends.
• Perpetuity — Infinite series of equal cash flows.
• Required Return (R) — Minimum return investors demand for holding a stock.
• Growth Rate (g) — Expected rate of increase in dividends.
• P/E Ratio — Price-to-earnings ratio, used to value stocks relative to earnings per share.
• Proxy Voting — Voting on behalf of a shareholder.

Action Items / Next Steps

• Review all formulas and example calculations from the lecture.
• Take the online quiz posted by the instructor to test understanding.
• Practice valuing stocks using the DGM and P/E methods for different scenarios.