# Definition of Stock Value

To decide if a stock is overvalued or undervalued in the market, investors determine the stock's value. The difference between the calculated value and what the stock sells for in the market tells the investor whether he should invest in the stock or wait for a better time.

1. ## Dividend Discount Model

• The value of a stock is determined by the amount of dividends an investor expects to receive for the period she holds the stock (assuming dividends increase at a constant rate) and the risk associated with investing in the stock. According to the dividend discount model, the price of a stock can be calculated as follows:

Price of stock = expected dividend / (required rate of return on the stock -- dividend growth rate).

## Interpreting Dividend Discount Model

• Suppose an investor determines a stock is worth \$20. If the stock is trading at \$25 in the market, the investor will sell it because it is overvalued. However, if the stock is trading at \$15, the investor will buy the stock because it is undervalued and the investor expects that once others realize this, they will buy the stock. This increases the price of the stock, and the investor can sell it for a profit when the stock reaches the price it is worth.

## Risk

• The dividend discount model considers the required rate of return on the stock the investor must obtain. The required rate of return on a stock deals with the risk to the investor. When an investor considers holding a stock, he considers two forms of risk: market risk and firm risk. Market risk refers to the risk an investor takes by investing in the stock market. Firm risk refers to the risk an investor takes by investing in the stock of a specific company.

## P/E Ratio

• With the dividend discount model, an investor calculates a stock's P/E, or price-to-earnings ratio, which allows the investor to determine if a company can support the current amount of dividends it is paying. The ratio is calculated by the following formula:

P/E ratio = (earnings of each share / price of each share) / (required rate of return -- growth rate).

## Interpreting P/E Ratio

• If company does not have a high P/E ratio, investors know they shouldn't invest in the stock because the company's earnings are not stable and do not allow it to continue paying the current amount of dividends.

## Forecasting Stock Price

• An investor can forecast the stock's price based on the P/E ratio. If investors knows that during a period of economic growth stocks in a particular sector should have a certain P/E ratio and they know what the earnings per share of the stock is, an investor can multiply the P/E ratio by the earnings per share to calculate what the stock's price should be. When the investor knows the stock's worth, she can determine if it is overvalued or undervalued and make an appropriate purchase or sale decision.

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## References

• "Financial Markets and Institutions"; Maureen Burton, Reynold Nesiba, Ray Lombra; 2004
• "Canadian Securities Course Volume Two"; CSI Global Education; 2008
• Photo Credit formulas image by Anton Gvozdikov from Fotolia.com