Module 8: Stock Valuation

Key Topics Covered:

• Common Stock
• Features of Stock
• Preferred Stock
• Stock Market

Stock Valuation Methods

1. Using Dividends
2. Using Multiples
3. Stock Market Discussion

Common Stock

• Basic Principle: The price of a stock is the present value of the expected cash flows. Cash flows include:
  • Dividends: Payments made to shareholders.
  • Capital Gains: Profit from selling the stock for more than its purchase price.

Calculating Stock Value

• Example 1:

  • Expected Dividend: $2 in one year.
  • Sell Stock for: $14.
  • Required Return: 20%.
  • Calculation: Present value (PV) of cash flows.
  • Result: Fair value of stock = $13.33.

• Extending to Multiple Periods:

  • Two-Period Example:
    • Dividend Year 1: $2, Year 2: $2.10.
    • Sell Stock for: $14.70 in Year 2.
    • Result: Fair value = $13.33 (same as one period).
  • Three-Period Example:
    • Dividend Year 1: $2, Year 2: $2.10, Year 3: $2.20.
    • Sell Stock for: $15 in Year 3.
    • Result: Fair value remains constant at $13.33.

Generalization of Stock Value

• Infinite Periods: The value remains the same regardless of the holding period.
• Gordon Growth Model:
  • Formula: ( P_0 = \frac{D_0(1 + G)}{R - G} )
  • ( D_0 ) = Initial dividend
  • ( G ) = Growth rate of dividend
  • ( R ) = Required rate of return
  • Applications: For positive, negative, or zero dividend growth.

Illustration Using Gordon Model

• Example:
  • Last Dividend Paid (( D_0 )): $0.50
  • Growth Rate (( G )): 2%
  • Required Rate of Return (( R )): 15%
  • Result: Stock price = $3.92

Using Multiples for Stock Valuation

• P/E Ratio:
  • Formula: Price = P/E Ratio x EPS
  • Example:
    • EPS: $3
    • Industry Average P/E: 12
    • Result: Estimated stock price = $36

Conclusion

• This recording covered the computation of stock prices using dividends, the Gordon Growth Model, and P/E ratios.
• Understanding these principles helps in making informed investment decisions.