Got our test grades back today. Not bad. I got 112 points, out of I don’t know how many. My previous test was 120, though, and it was good, so assuming the point values are comparable, I should still be in a good range. Class average was in the 60s. Update: That translates to 80 percent. 28 correct out of 35 questions.
Common Stock today.
Common stock represents ownership and implies a degree of control in the running of the company. Generally this takes the form of stockholders electing a board of directors who appoint the management. This management is given the task of maximizing the company’s stock.
Outside investors, corporate insiders, and analysts use a variety of approaches to estimate a stock’s intrinsic value. In equilibrium, a stock’s price should be equal to its intrinsic value. When the price is not equal to its intrinsic value, it is either overvalued or undervalued. This can trigger decisions to buy or sell the company’s stock.
Dividend Growth Model of stock value.
In this model, the value of a stock is the present value of the future dividends the stock is expected to generate. For this to work, assumptions must be made about future dividend payments.
- The first possible assumption is the “constant growth stock” assumption. That assumes the stock’s dividends are expected to grow forever at a steady rate. If the constant growth assumption is true, the value of the stock pˆ, would be equal to the dividend received at the end of the next year divided by the minimum return on the stock minus the expected growth in its value. pˆ = D1 / ( r – g )
- The constant growth formula only works if g < r, which will be true in the long run
- Likewise, growth must be constant for the equation to be correct.
- If the stock’s growth will not be constant, the constant growth assumption cannot be used. In this case, it’s useful to set up a time-line to visualize the value growth. This situation is essentially finding the present value of uneven cash flows. Frequently, the growth rate can be expected to stabilize at some point; after that point the constant growth method can be used.
- The next possible assumption is the Corporate Value Assumption. This assumes the value of the stock is equal to the present value of the company’s free cash flows. This model is hence also called the free cash flow method. Free cash flow is the firm’s after-tax operating income less the net capital investment.
- To apply the model, you first find the market value of the firm by finding the present value of the firm’s future free cash flows. Subtract the firm’s debt and preferred stock value to get the monetary value of the common stock. Divide this by the number of shares of common stock outstanding to find the value of an individual share of common stock.
- This model is often preferred because a firm doesn’t pay dividends, or pays unpredictable dividends.
- Similar to the dividend growth model, at some point it must be assumed that free cash flows will grow at a constant rate.
- Firm Multiples Method is a quick-and-dirty approach to valuing stocks. Compare the firm’s ratio of some relevant measures to the same ratio for other firms in the same industry, and set the stock price accordingly. Common ratios used include the Price/Earnings ratio and the Price/Cash Flows ratio. Not a very reliable measure; use with caution.
In a stock market at equilibrium, stocks would be priced at their market value, and there would be no particular tendency to buy or sell any particular stock. Equilibrium value is a theoretical point that the value of a stock will move around as information becomes available and is acted on.
Preferred stock is a hybrid security, combining some of the strengths of bonds and common stock. Preferred stock must pay out a fixed dividend to its holders before any dividends are paid to common stockholders. However, companies can choose not to pay dividends to preferred stockholders with being insolvent. In such a situation, however, the company will still have to make up those payments before dividends can be paid to common stockholders.