Firms obtain their long-term sources of equity financing by issuing common and preferred stock. The payments of the firm to the holders of these securities are in the form of dividends. Unlike interest payments on debt which are tax deductible, dividends must be paid out of after-tax income. The common stockholders are the owners of the firm. They have the right to vote on important matters to the firm such as the election of the Board of Directors. Preferred stock, on the other hand, is a hybrid form of financing, sharing some features with debt and some with common equity.

Stock Valuation For example, preferred dividends like interest payments on debt are generally fixed. In addition, the claims against the assets of the firm of the preferred stockholders, like those of the debtholders, are also fixed. The common stockholders have a residual claim against the assets and cash flows of the firm. That is, they have a claim against whatever assets remain after the debtholders and preferred stockholders have been paid. Moreover, the cash flow that remains after interest and preferred dividends have been paid belongs to the common stockholders.

Stock Valuation The priority of the claims against the assets of the firm belonging to debtholders, preferred stockholders, and common stockholders differ. The owners of the firm's debt securities have the first claim against the assets of the firm. This means that the debtholders must receive their scheduled interest and principal payments before any dividends can be paid to the equity holders. If these claims are not paid, the debtholders can force the firm into bankruptcy. The preferred stockholders have the next claim. They must be paid the full amount of their scheduled dividends before any dividends may be distributed to the common stockholders.

Stock Valuation The value of these securities is based upon the discounted value of their expected future cash flows. Two approaches are presented for the valuation of common stock.

Concepts Constant Growth Stock Valuation Non constant Growth Stock Valuation Preferred Stock Valuation

Constant Growth Stock Valuation Stock Valuation is more difficult than Bond Valuation because stocks do not have a finite maturity and the future cash flows, i.e., dividends, are not specified. Therefore, the techniques used for stock valuation must make some assumptions regarding the structure of the dividends. A constant growth stock dividends are expected to grow at a constant rate in the forseeable future. This condition fits many established firms, which tend to grow over the long run at the same rate as the economy, fairly well. The value of a constant growth stock can be determined using the following equation:

Constant Growth Stock Valuation The value of a constant growth stock can be determined using the following equation:

Constant Growth Stock Valuation

Nonconstant Growth Stock Valuation Many firms enjoy periods of rapid growth. These periods may result from the introduction of a new product, a new technology, or an innovative marketing strategy. However, the period of rapid growth cannot continue indefinitely. Eventually, competitors will enter the market and catch up with the firm. These firms cannot be valued properly using the Constant Growth Stock Valuation approach.

Calculating Today's Stock Prices Since investors buy stocks for both the dividends they pay today and the possibility of a gain in a stock's selling price, then the expected return can be expressed by the following calculation: Expected Return = (Dividends Paid + Capital Gain) / Price of Stock This expected return for a stock is also known as the market capitalization rate or discount rate. We're going to use all three terms interchangeably throughout our calculations / explanations

Let's look at a quick example of how this works. These are our assumptions: Price of Stock A is currently $ per share or (P0). Dividends are expected to be $3.00 per share (Div). The price of Stock A is expected to be $ per share in one year's time (P1). Therefore our capital gain is expected to be $ $ or $5.00 per share. In this example: Expected Return, or R = ($ $5.00) / $ = 8.0% Calculating Today's Stock Prices

We can now use this expected return to calculate the price of a stock in the same risk class as Stock A using the following formula: Stock Price = (Dividends Paid (Div) + Expected Price (P1)) / (1 + Expected Return (R)) Proving this calculation with our example information above, we have: Stock Price = ($ $105) / ( ) = $ / 1.08 = $100 Calculating Today's Stock Prices

Some of you may recognize this stock price calculation as the beginnings of a discounted cash flow formula. Essentially, the price of a stock is the cash flows gained by the stockholder divided by the discount rate or market capitalization rate.

Discounted Cash Flows and Stock Pricing The stock prices we just calculated are really just short term values - a one year horizon. But let's think about the value of a stock over a nearly infinite timeline. Let's say a stockholder plans to sell their stock in 100 years. In this example the value of the stock would be all of the dividends received each year plus the capital gain of the stock in 100 years.