Stocks are valued based on the amount they will return to the investor in the future, coupled with the investor's required rate of return. As the dividends paid by common stock may vary, investors must assess a price they are willing to pay. Common stocks are typically valued by the constant growth formula, as well as its extensions.
Preferred stock is valued based on perpetuity — the amount the investor will receive from holding such stock. This is because the dividends paid to the investor are always the same. The dividends for common stock, however, may vary. This makes the valuation process of common stock more complicated. The investor must take into account future expectations, as well as her required rate of return. A stock's value does not necessarily equal its price. The price, assuming that the investor is realistic and not too optimistic, is equal to or less than the stock's perceived value.
Growth and Required Rate of Return
The value of common stock is influenced by both the expected growth rate of a company and the Required Rate of Return (RRR). Company growth is gauged by the perceived future increases in profits. The RRR differs from person to person. It is essentially the return on an investment, measured as a percentage, that an investor needs in order to make the investment worthwhile. It is typically greater than the yield of government bonds, which are often perceived as safe investments.
The Constant Growth Formula
The constant growth formula, also known as the Gordon growth formula, assumes that the investor has a certain level of knowledge about the company he is investing in. That is, he will know the company's dividend payouts and expected future growth. This expected future growth is assumed to be constant in order to derive a more simplistic formula. First, the expected growth rate is subtracted from the investor's required rate of return. This produces "A". Second, the next dividend of a company is estimated by multiplying the value of the last dividend by the company's expected growth. For example, if the company is expected to grow by 5 percent, and assuming that the last dividend was $100, the next dividend would be $105. This produces "B". B divided by A gives the price the investor is willing to pay for the common stock.
The Non-Constant Growth Model
The constant growth model gives simplicity to the valuation of common stock. However in most situations, the rate of growth is expected to change with time, instead of remaining constant. Many investors thus prefer a multiple-stage growth model when valuing stocks. Such models are similar to the constant growth formula, but instead calculate stock value in multiple stages. The cash flows are calculated at each stage before adding them up.