Stock Valuation

Stock Valuation Overview

• Valuing common stock is challenging due to:

  • Uncertainty in future cash flows.

  • Indefinite life of investment.

  • Inability to observe required market return.

Stock Valuation Methods

• Present Value of Future Dividends:

  • Price determined by calculating the present value of expected future dividends.

• Types of Dividend Growth:

  1. Zero Growth: Constant dividends, akin to perpetuity:

  • Formula: $P_0 = \frac{D}{r}$

  1. Constant Growth: Dividends grow at a steady rate (g):

  • Formula: $P<em>t = \frac{D</em>{t+1}}{r - g}$ (where r > g)

  1. Non-Constant Growth: Dividends may start low and grow at a steady rate after some time.

Required Return Analysis

• Required return $r$ calculated as:

  • $r = \frac{D<em>1}{P</em>0} + g$

  • Includes dividend yield and capital gain yield.

Preferred vs. Common Stock Features

• Common Stock:

  • No preferential treatment in dividends/bankruptcy.

  • Voting rights, control in corporate decisions.

  • Dividends declare by director's discretion.

• Preferred Stock:

  • Typically non-voting.

  • Cumulative or non-cumulative dividends.

  • Liquidating value and cash dividends defined per share.

Price Earnings Ratio (P/E)

• Analysts often use P/E ratios for stock valuation.

• Differences in P/E ratios can indicate potential issues with relying solely on this metric.