Equity Markets and 7 Stock Valuation

An equity market is a hub in which shares of companies are issued and traded. Equity
markets play an important role in a market-based economy. They provide capital-
raising, liquidity, and investment options. To get the present value of stock, let P0 be the
current price of the stock, and assign P1 to be the price in 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.

Stock valuation is a method of determining the intrinsic value of a stock. There are two
types of valuation methods: absolute (DDM and DCF) and relative (P/E and PEG).
Absolute, or intrinsic, stock valuation relies on the company’s fundamental information,
while relative stock valuation compares the potential investment to similar companies.
The dividend discount model is one of the most basic techniques of absolute stock
valuation. It is a quantitative method used for predicting the price of a company's stock
based on the theory that its present-day price is worth the sum of all of its future
dividend payments when discounted back to their present value. The discounted cash
flow model is another popular method of absolute stock valuation. It is an analysis
method used to value investments by discounting the estimated future cash flows. A
project or investment is profitable if its DCF is higher than the initial cost.

Comparable companies’ analysis is an example of relative stock valuation. It is a

relative valuation method in which a company’s value is derived from comparisons to
the current stock prices of similar companies in the market. The Dividend Discount
Model (DDM) is a quantitative technique that assumes that the value of the stock
(intrinsic value) is the discounted value or the net present value of the sum of all the
future dividends that a firm would pay or expects to pay. These have three types,
namely: constant growth or garden growth models; variable growth (two-stage and
three-stage); and zero growth models.

A growth stock is any share in a company that is anticipated to grow at a rate

significantly above the average growth rate for the market. Zero-growth stock assumes
that the firm will pay the same number of dividends forever. The formula to get the value
of the stock using the zero-growth dividend discount model is: value of stock (P) =
(dividend per share / discount rate) or (div/r). The constant growth model is used to
evaluate the price of a stock that's paying a dividend at a steadily growing rate.

The dividend growth rate (DGR) is the percentage growth rate of a company’s dividend
achieved during a certain period of time. The following are the various formulas used in
the calculation of the growth of dividends in dividend growth stocks. Dividend Growth
Formula = Dividend(D2) - Dividend(D1) * 100 / Dividend(D1), where Dividend(D1) =
dividend paid by the company for Period P (any period). Dividend (D2) = dividend paid
by the company for Period P-1 (the period before Period P). If the difference between
the periods is greater than 1, then the following formula is used to calculate the dividend
in the dividend growth stocks: Dividend Growth = (Dividend (Dn) / Dividend (Do))1/n – 1.
Where Dividend (Dn) = Dividend for the period n, Dividend (D0) = Dividend for the
starting period or initial period, and N = The difference between the periods Dn and Do.

There are two components of the required return: dividend yield, which is a stock’s
expected cash dividend divided by its current price, and capital gains yield, which is the
dividend growth rate, or the rate at which the value of an investment grows. Common
stock represents the share in the ownership position of the company that gives the right
to receive the profit share, which is termed a dividend, and the right to vote and
participate in the general meetings of the company, while preferred stocks are company
stock with dividends that are paid to shareholders before common stock dividends are
paid out. Common stock offers certain rights to its shareholders, such as dividend
rights, asset rights, voting rights, and pre-emptive rights. Preferred stock is a very
flexible type of security. They can be convertible preferred stock, cumulative preferred
stock, exchangeable preferred stock, or perpetual preferred stock.

The stock market consists of a primary market and a secondary market. In the primary,
shares of stock are first brought to the market and sold to investors. In the secondary
market, the existing shares are traded among investors. Brokers are called agents as
they play the role of an intermediary between a buyer and a seller in carrying out the
transactions. Dealers are called the market makers for the securities he conducts
business on behalf of his clients.

Jerrie May B. Jambangan

BA309