THE PRICE OF COMMON STOCK

Just as a bond is the debt security which promises to make periodical coupon payments and/or repayment of the face value at maturity date, a common stock is an equity claim representing ownership of the net income and assets of a company. It means that stockholder are paid dividends by company; moreover the stockholder has right to sell the stock at anytime at the secondary market.

The basic principle of finance is that the value of any investment is the value today (or present value) of all cash flows the investment will generate over its life.

For a bond it is

Similarly, we value common stock as the present value of all future cash flows, which include dividends and its sales price:

(4.1)

where

– the current price of the stock (the zero subscript refers to time period zero, or the present);

– the expected sales price of the stock at time period N[1];

– the required (or expected) return on investments in equity.

Suppose that you have surplus funds to invest only for three year. And you are going to buy the common stock of ABC Corporation, which provides 100 € per year in dividends, and to sell it at the end of third year at expected price of 1200 €. If you want to earn a 10% return on the investment, what price should be paid for this share?

So if the current price is the same (or little bit less) – you should make transaction. If the market price is higher than calculated one you get less return than you are planning:

But if the market price is substantially lower than estimated value, you should be aware. It means that other investors expect that cash flows will be less or estimate their probability in a different way. For example, the board of directors of the firm can make the decision not to pay dividends or to pay them in the smaller amount.

In this case there are no dividends in first year of holding of the stock:

And the current market price is therefore lower than estimated early.

In general, there is a posi­tive correlation between the growth of real national income and stock prices. Because a growing econ­omy means that sales, production, and incomes are expanding, dividends, as expected, also will increase that will lead to the stock price rising. While a declining economy means the opposite.

Date: 2014-12-22; view: 1543