7.2 Valuing Corporate Equities

 7.2 Valuing Corporate Equities

A corporate equity, stock, sometimes called a share. It is a share in the ownership of a joint-stock corporation. 

Ownership entitles investors to a say in how the corporation is run, usually means one vote per share in corporate elections for the board of directors, and monitor the corporation’s professional managers. 

Ownership also means that investors are residual claimants, entitling them to a proportionate share of the corporation’s net earnings (profits).

In exchange for their investment, stockholders may receive a flow of cash payments, usually made quarterly, called dividends. Unlike bond coupons, they are not fixed, it is not considered in default. 

The stock valuation method, the one-period valuation model, simply calculates the discounted present value of earnings and selling price over a one-year holding period:

P = E / ( 1 + k ) + P1 / ( 1 + k )

P = price now

E = yearly earnings or profit

k = required rate of return

P1 = expected price at year’s end

So if a company is expected to earn no profit, its share price is expected to be $75 at the end of the year, and the required rate of return on investments in its risk class is 10%, an investor would buy the stock if its market price was at or below P = 0/1.10 + 75/1.10 = $68.18. 

Another investor might also require a 10% return but think the stock will be worth $104 at the end of the year. He’d pay P = 0/1.10 + 104/1.1 = $94.55 for the stock today! 

What should be the price of a common stock paying $3.50 annually in dividends if the growth rate is zero and the discount rate is 8%?

P = 3.5 / (1+ 8%) + P / (1+8%) 

P = 43.75

If the next year’s dividend is forecast to be $5.00, the constant growth rate is 4%, and the discount rate is 16%, then the current stock price should be 42.67 (You can do it yourself)

What constant growth rate in dividends is expected for a stock valued at $37.82 if a $4.00 dividend has just been paid and the discount rate is 15%?

Suppose g = the constant growth rate

37.82 = 4 (1+ g) / (1+ 15% ) + 37.82 (1+ g) / (1+ 15%)

g = 4%