Stock Valuation
LECTURE
STOCK VALUATION 1. Common stock valuation A share of common stock is more difficult to value in practice than a bond, for at least three reasons. First, with common stock, not even the promised cash flows are known in a advance. Second, the life of the investment is essentially forever, since common stock has no maturity. Third, there is no way to easily observe the rate of return that the market requires. Nonetheless, as we will see, there are cases in which we can come up with the present value of the future cash flows for a share of stock and thus determine its value. Cash Flows Imagine that you are considering buying a share of stock today. You plan to sell the stock in one year. You somehow know that the stock will be worth $70 at that time. You predict that the stock will also pay a $10 per share dividend at the end of the year. If you require a 25 percent return on your investment, what is the most you would pay for the stock? In other words, what is the present value of the $10 dividend along with the $70 ending value at 25 percent? If you buy the stock today and sell it at the end of the year, you will have a total of $80 in cash. At 25 percent: Present value = ($10 + 70)/1.25 = $64 Therefore, $64 is the value you would assign to the stock today. More generally, let P0, be the current price of the stock, and assign P1 to be the price one period. If D1 is the cash dividend paid at the end of the period, then: P0 = (D1 + P1)/( 1 + R) where R is the required return in the market on this investment. Notice that we really haven 't said much so far. If we wanted to determine the value of a share of stock today (P0), we would first have to come up with the value in one year (P1). This is even harder to do, so we 've only made the problem more complicated. What is the price in one period, P1? We don 't know in general. Instead, suppose we somehow knew the price in two periods, P2. Given a
STOCK VALUATION 1. Common stock valuation A share of common stock is more difficult to value in practice than a bond, for at least three reasons. First, with common stock, not even the promised cash flows are known in a advance. Second, the life of the investment is essentially forever, since common stock has no maturity. Third, there is no way to easily observe the rate of return that the market requires. Nonetheless, as we will see, there are cases in which we can come up with the present value of the future cash flows for a share of stock and thus determine its value. Cash Flows Imagine that you are considering buying a share of stock today. You plan to sell the stock in one year. You somehow know that the stock will be worth $70 at that time. You predict that the stock will also pay a $10 per share dividend at the end of the year. If you require a 25 percent return on your investment, what is the most you would pay for the stock? In other words, what is the present value of the $10 dividend along with the $70 ending value at 25 percent? If you buy the stock today and sell it at the end of the year, you will have a total of $80 in cash. At 25 percent: Present value = ($10 + 70)/1.25 = $64 Therefore, $64 is the value you would assign to the stock today. More generally, let P0, be the current price of the stock, and assign P1 to be the price one period. If D1 is the cash dividend paid at the end of the period, then: P0 = (D1 + P1)/( 1 + R) where R is the required return in the market on this investment. Notice that we really haven 't said much so far. If we wanted to determine the value of a share of stock today (P0), we would first have to come up with the value in one year (P1). This is even harder to do, so we 've only made the problem more complicated. What is the price in one period, P1? We don 't know in general. Instead, suppose we somehow knew the price in two periods, P2. Given a