The Definition of "Common Stock Valuation"

Common stock evalution

Common stocks are equities (or ownership) issued as shares in a publicly held corporation. Shareholders have voting rights and in most cases will receive dividends based on their proportionate ownership. Evaluating common stock is an important step in the determination of its price.

Calculation

Common stocks provide an expected future stream of cash inflows. A common stock's value is found by calculating the present value of the expected future cash inflows, accomplished by utilizing the constant growth formula, which is Constant Growth Formula: Price = Next expected dividend / (Rate of return - Growth rate). The next expected dividend is calculated by multiplying the last dividend by one plus the growth rate.

Expected Cash Flows

Expected cash inflows consist of two elements: the dividends expected in each year and the price the shareholder expects to receive when the common stock is sold in the future. The expected final stock price includes the return of the original investment plus an expected capital gain.

Assumptions

Common stock valuation assumes that the shareholder knows how much the common stock will sell for at a future date. It also assumes the future dividend payments are known. Both of these factors are almost impossible to determine. So, in order for the constant growth formula to be utilized, it is assumed that the stock will never be sold and the growth rate will remain steady for an indefinite period of time.

Example

The constant growth formula will be used to determine the price of one share of common stock. The last dividend paid was $10, the growth rate is 5 percent and the rate of return is 10 percent. First, determine the next expected dividend.

Remember the next expected dividend is the last dividend paid multiplied by one plus the growth rate. Therefore, $10 (1+.05) = $10.50.

So, to determine current price, divide the next expected dividend by the rate of return minus the growth rate. Therefore, $10.50 / (.10-.05) = $210. The price as determined by the Constant Growth formula is $210.

Considerations

Most corporations pay common stock dividends on a quarterly basis. So, theoretically, common stock should be evaluated four times a year rather than annually. However, most stock analysts work on an annual basis.

References

• Timothy R. Mayes; Ph.D.; Metropolitan State College of Denver: Common stock valuation PowerPoint
• Stock Valuation: Constant growth model