Stock valuation and stock price calculations
Beginner Stock Market Investing, Stock Market Investing Advice, Stock Valuation
In general terms, investors buy stocks for either two reasons or a combination of both. Stocks can provide investors with cash returns by way of dividend payouts and also provide investors with capital appreciation and capital gains. Most investors actually look to both and the expected return on their investment can be expressed by dividing the sum of the dividend paid and the capital appreciation divided by the current price of the stock . This expected return is often called market capitalization rate or discount rate and all three terms tend to be used interchangeably.
Let us assume that stock A has a current market price of $100 and pays a dividend of $3. The price is expected to be $105 in one year’s time so that the expected capital gain is $5. Using the above formula, the expected return is therefore $3 plus $5 divided by $100 which works out to 8%. We can now proceed to use this rate of expected return to calculate the prices of the stock which carries exactly the same risk as stock A. The formula that we use is the sum of the dividend and the expected stock price divided by 1 plus the expected rate of return. You may notice that this is the first stage of a discounted cash flow calculation. If you apply this calculation to stock A, the price would work out to $100 which is proof of the accuracy of the calculation.
So far, in the calculation, we have only looked at a short-term timeframe of one year. But let us now look at the calculations over a much longer time frame. Assuming that the investor would like to hold the stock for 100 years, so that the value that he receives is the yearly dividend for each of these years plus the capital gain at the end of the period. Let us assume that the expected return continues at 8% and the stock grows by 5% every year. The expected stock price at the end of the period will be just over $13,080 and the stock price on this basis will work out to just under $6. This calculation shows that the current stock price has no relationship to the future price of the stock.
What is relevant is the stream of cash dividends over this timeframe as well as the stock dividends and the stock pricing formula can therefore be simplified to read as follows:
Stock Price = Sum of Dividends (Div) in each Time (T) / (1 + R)^T.
This formula can further be simplified by using a model for constant growth for the dividends. The formula now simplifies itself to Stock Price = Div / (R – G) where R is the expected return and G is the expected growth rate in dividends.
With this simple formula in place, all we have to do is to calculate the projected growth rate in dividends and the market capitalization rate or the expected rate of return. We thus have the means to calculate stock prices based on some simple fundamental information. However, you should bear in mind that by and large, the stock market functions efficiently and if your calculated stock prices differ considerably from the current market prices, you should check your assumptions. There is never any easy money to be made in valuing and picking your stocks.
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