Finance – Stock Valuation
Stock valuation is one of the important studies in Finance. It is the study of the various methods in which the stocks of the companies are calculated. The reason behind the calculation or valuation of stock is to predict the value of the stock in the future.
There are many ways in which the stocks of a company are calculated. The motive behind the calculation of the value of the stock is to identify which stocks are overvalued and which stocks are undervalued. For taking buying and selling decisions such as when to buy stock or when to sell the stock, etc. The most common method of valuing stock is to discount the expected dividends from the stock.
For example, if a company a constant dividends, the price given by
P0 = Di /Ke
This is a simple perpetuity formula that discounts the expected dividend (Di) by the required rate of return (Ke). Similarly, for a company that pays a constant dividend, the price of the stock would be given by:
P0 = D1/ (Ke – g)
Where, D1 is the expected dividend,
Ke is the expected return and g is the constant growth rate. Here D1 is obtained by multiplying the current dividend by the expected growth rate D0 x (1+g)
Preference Stock Valuation
Preference stock generally pays regular, fixed dividends. Preference dividends are not increased when the profits of the firm rise, nor are they lowered or suspended unless the firm faces financial difficulties. If preference dividends are cut or suspended for some time, the firm is normally required to pay the arrears before paying equity dividends. Preference stock may be perpetual or redeemable. While the former has no maturity period, the latter is expected to be redeemed after its limited life.
If we assume that the preference stock pays fixed annual dividends during its life and the principal amount on maturity, it value is given by
P0 = nΣt =1 D/(1+rp)t + M/(1+rp)n
Where P0 is the current price of the preference stock. D is the annual dividend, n is the residual life of the preference stock, rp is the required rate of return on the preference stock, and M is the maturity value.
According to the dividend discount model, the value of an equity share is equal to the present value of dividends expected from its ownership plus the present value of the sale price expected when the equity share is sold. For applying the dividend discount model, the required assumptions are, dividends are paid annually and the first dividend is received one year after the equity share is bought.
Single-period Valuation Model: When the investor expects to hold the equity share for one year, the price of equity share shall be
P0 = [D1/(1+r)] + [P1/(1+r)]
Where P0 is the current price of the equity share, D1 is the dividend expected a year hence, P1 is the price of the share expected a year hence and r is the rate of return required on the equity share.
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