Mastering Stock Valuation: A Comprehensive Guide to Understanding Stock Values

The Market for Common Stock 

Some companies are so small that their common stocks are not actively traded and are owned by only a few people, usually the company managers. Such firms are said to be privately owned or closely held corporations, and their stock is called closely held stock. On the contrary, the stocks of larger companies are owned by numerous investors and are generally termed publicly owned corporations, and their stock is known as publicly held stock.

Common stock basically signifies an ownership interest in a corporation, but to the typical core investor, a share of common stock is simply a piece of paper characterized as follows:

1. It entitles its owner to dividends, but only if the company has earnings out of which dividends can be paid and if management chooses to pay dividends rather than retaining and reinvesting all the earnings.

2. Stocks can be sold at some future date, hopefully at a price greater than the purchase price. Investors receive capital gains when the stock is sold at a price above its purchase price. Generally, when people buy common stocks, they expect to receive capital gains.

Types of Stock Market Transactions

There can be three distinct types of stock market transactions:

1. Trading in the outstanding shares of established, publicly owned companies, which are basically traded in a secondary market. Trading normally takes place on the used shares that are in the outstanding shares of the company.

2.  Additional shares are sold by established, publicly owned companies, and these transactions occur in the primary market. When a company basically plans to raise further capital through issuing additional shares,

3. Initial publicly offered offerings by privately held firms: whenever stock in a closely held corporation is offered to the public for the first time, the company is said to be going public. The market for stock that is just being offered to the public is called the initial public offering market, or, in short, the ‘IPO’.

Constant Growth Stock

Let’s take an example that a company just paid a dividend of $1.15 (D0 =$1.15), and its stock required rate of return (r s  = 13.4%), and investor expects dividend to grow at a constant rate of return of 8% in the future.
Then, D t = D0*(1+ G) ^t = $1.15*(1+1.08) ^1=$1.24
Expected dividend after one year would be $1.24.
Then current value of the stock can be determined through the use of expected future dividend.
Present value P0   =   $1.15*(1+1.08) 
                                 0.134 - 0.08
                                  $1.242
                                   0.054
                                  =$23
The expected rate return is comparatively higher than the constant dividend growth rate of 8%, which will eventually reduce the present value of dividend each year henceforth.

Expected Rate of Return on a Constant Growth Stock 

Expected rate of return = expected dividend yield + expected growth rate 
Expected dividend from the previous example was =$1.242
And current price was = $23
Constant growth rate was = 8%
The yield = $1.242     + 8%
                    $23
                = 5.4% + 8%
                = 13.4%

Dividend and Earnings Growth 

The expected growth in the dividend occurs on account of growth in earnings per share (EPS). Earnings growth then impacts numerous factors, such as inflation, the amount of earnings the company retains and reinvests, and the rate of return on equity. If the output is stable but both sales prices and costs rise at the inflation rate, then EPS will also grow equally at the inflation rate. The company may also grow without inflation due to their reinvestment of earnings in the business. In case the company doesn’t declare any dividends. Then the cash position will support the company in terms of growth in their earnings and a better commitment to shareholder returns.

However, a stock value is estimated from the expected future dividends, which doesn’t essentially mean that the company will increase the share price simply by raising the dividend. The common shareholder analyses the company's corporate actions, including the current dividend and future dividend management policy.

Frequently Asked Questions F.A.Q

What is the difference between closely held stock and publicly held stock?

Some companies are so small that their common stocks are not actively traded and are owned by only a few people, usually the company managers. Such firms are said to be privately owned or closely held corporations, and their stock is called closely held stock. On the contrary, the stocks of larger companies are owned by numerous investors and are generally termed publicly owned corporations, and their stock is known as publicly held stock.

What does owning a share of common stock in a corporation mean?

When investors participate in the stock exchange for buying shares, they partially hold ownership status when they purchase shares of a particular company and hold them in their portfolio.

What are the rights associated with owning common stock?

Publicly held shares by a common shareholder have voting rights during a critical decision-making process by the company.

How are dividends paid to common stockholders?

Companies pay dividends to shareholders directly into their bank accounts when the company makes surplus returns after all expenses are evaluated.

What factors should I consider when buying common stocks for potential capital gains?

Evaluate the company in a 360-degree manner that includes the fundamentals of the company, future potential, a sound track record, product efficiencies, and all the relevant investment aspects of the company.

What are the risks associated with investing in common stocks.

The risk of uncertainty commonly arises due to various other factors, such as economic factors, currency fluctuation, inflation, business risk, and operational risk, which create gyrations in the stock price movement in different possible directions.