STOCK VALUATION

  • The value of a security is equal to the present value of its future cash flows.
  • A stock provides two types of cash flows. One of them is dividend paid to the investors. Another one is the proceeds from the sale of the stock. When an investor sales the stock that she/he owns she/he receives money from the buyer.
  • Stock has no maturity. Another words the maturity of a stock is infinite. That is why it is assumed that the investor will never sell the stock. So there won’t be any cash flow from the sale of the stock. By taking this fact into account, there is only one cash flow that a stock provides, which is dividend. So the price of a stock is the present value of its future dividends. This stock valuation model is called Gordon Dividend Discount Model.
  • In stock valuation required rate of return of the investors (ks) is used.  Required rate of return is determined by two factors, which are as follows:
    • Return of the alternative investments.
    • Risk of the stock.
  • One of the basic principles of finance is risk-return trade off. An investor takes on additional risk if she/he expects to be compensated by higher return. In other words if the risk of the stock is high, required rate of return of the investors that buy this stock is also high.
  • Stock price (value) calculated by the formula is called intrinsic value (price). Intrinsic value may be different from actual value. Actual value is the market price, or the price in the exchange.
  • If the intrinsic value is greater than the actual value the stock must be bought. Because the stock is cheap. It is logical to buy a stock when it is cheap.
  • If the intrinsic value is less than the actual value the stock must be sold. Because the stock is expensive. It is logical to sell a stock when it is expensive.
  • If the actual value is persistently greater than the intrinsic value it is called a bubble. Bubbles will eventually burst. When the bubble bursts the price of the stock decreases very fast. When a bubble bursts, investors who own the stock suffer great losses as a result of this price decrease.