Stock Valuation

Preferred Stock Preferred stock is somewhat like a bond. They pay the same equal dividends forever.
Common Stock Common stock represents ownership in the company. Sometimes there are dividends, sometimes not.


What is the value of Preferred Stock?

This is easy. Preferred stock is basically a perpetuity.

What is the value of Common Stock?

This is not easy. This is a mess. Think about it. What is the value of a share of stock in a specific company? In one sense it is the price the stock trades at. Both the buyer and seller agree to exchange the stock at that price.

We assume that they are both rational people and both know something about the company and its future plans and profit potential. So, yes, that is one method: check the price of the stock in the paper or on the internet. But that's pretty darn easy. It's not really finance. It's more like reading. And I don't know if you realize this or not, but they don't give Nobel Prizes for reading. So there are other ways of doing stock valuation too.


The Gordon Growth Formula, also known as The Constant Growth Formula assumes that a company grows at a constant rate forever. This, by the way, is impossible. I mean, it can't grow forever. You know, if a company doubles in size every 5 years, pretty soon every single person in the world is their customer and then they can't grow at that rate anymore. (because the world population isn't doubling ever 5 years).

BUT, if we go ahead and assume that a company has a constant growth rate, we can use the following formula to get its value.

Constant Growth Formula Po = D 1 / ( Ks - G )

Po = Price
D1 = The next dividend. D1 = D0 (1 + G)
Ks = Rate of Return
G = Growth Rate
What is all this D1 and D0 stuff ?

D1 is the next dividend
D0 is the last dividend
Well we are assuming that the company has constant growth, right. So we take the last divided, multiply it by the growth rate and we can get the next dividend.

Example

Last years dividend = $ 1.00
Growth Rate = 5%
Rate of Return = 10%
First figure out D1.

D1 = D0 (1 + G)
D1 = $1.00 ( 1 + .05)
D1 = $1.00 (1.05)
D1 = $1.05
Next us the formula.

Po = D 1 / ( Ks - G )
Po = $1.05 / (10% - 5%)
Po = $1.05 / 5%
Po = $21.00
So, if we want to get a 10% rate of return on our money, and we assume that the company will grow forever at 5% per year, then we would be willing to pay $21.00 for this stock.