Valuing Stocks

Valuing Stocks

• Key Concepts:

  • Corporations issue stocks and bonds to raise capital from investors.
  • Stockholders hold partial ownership with voting rights; bondholders do not have ownership.

• Differences between Stocks and Bonds:

  • Stockholders are residual claimants - they are paid after all other obligations are met.
  • Cash flow for stockholders is uncertain; bondholders have defined cash flows.
  • Cost of equity is generally higher than cost of debt due to increased risk.

• Equity Valuation Methods:

  • Dividend-Discount Model (DDM): Values stock based on expected dividends and growth rate.
  • Discounted Free Cash Flow Model (DCF): Values the firm based on future cash flows discounted to present value.
  • Valuation Multiples: Compares ratio metrics of similar firms, such as P/E, EV/EBITDA.

• Key Formulas:

  • DDM: $P<em>0 = \frac{Div</em>1 + P<em>1}{(1 + r</em>E)}$
  • Rate of return on equity: $r<em>E = \frac{Div</em>1 + P<em>1}{P</em>0} - 1$
  • DCF: $EV = MV_{Equity} + Debt - Cash$

• Examples:

  • Calculate share price based on expected dividends and growth rates.
  • Define enterprise value using future cash flows and WACC.
  • Use comparables to establish the value based on similar firms' metrics.