Deprecated: mysql_connect(): The mysql extension is deprecated and will be removed in the future: use mysqli or PDO instead in /home/a26f9f83/public_html/articles/includes/config.php on line 159
The Value of Stocks of a Company > NetSparsh - Viral Content you Love & Share

The Value of Stocks of a Company

The debate rages all over Eastern and Central Europe, in countries in transition as well as in Western Europe. It raged in Britain during the 80s: Is privatization really the robbery in disguise of state assets by a select few, cronies of the political regime? Margaret Thatcher was accuse of it - and so was the Agency of Transformation in the Republic of Macedonia. At what price should the companies owned by the State have been sold? This question is not as simple and straight forward as it sounds.

There is a gigantic stock pricing mechanism known as the Stock Exchange. Willing buyers and willing sellers meet there to freely negotiate deals of stock purchases and sale. Every day new information, macro-economic and micro-economic, determines the value of companies.

Greenspan testifies, the economic figures are too good to be true and the rumour mill starts working: interest rates might go up. The stock market reacts with a frenzy - it crashes. Why?

A top executive is asked how profitable will his firm be this quarter. He winks, he grins - this is interpreted by Wall Street to mean that they WILL go up. The share goes up frantically: no one wants to sell it, everyone want to buy it. The result: a sharp rise in the price. Why?

Moreover: the price of the stock prices of companies A with an identical size, similar financial ratios (and in the same industry) barely budges. Why didn't it display the same behaviour?

We say that the stocks of the two companies have different elasticity (their prices move up and down differently), probably the result of different sensitivities to changes in interest rates and in earnings estimates. But this is just to rename the problem. The question remains: why? Why do the shares of similar companies react differently?

Economy is a branch of psychology and wherever and whenever humans are involved, answers don't come easy. A few models have been developed and are in wide use but it is difficult to say that any of them has real predictive or even explanatory value. Some of these models are "technical" in nature: they ignore the fundamentals of the company. Such models assume that all the relevant information is already incorporated in the price of the stock and that changes in expectations, hopes, fears and attitudes will be reflected in the prices immediately. Others are fundamental: these models rely on the company's performance and assets. The former models are applicable mostly to companies whose shares are traded publicly, in stock exchanges. They are not very useful in trying to attach a value to the stock of a private firm. The latter type (fundamental) models can be applied more broadly.

The value of a stock (a bond, a firm, real estate, or any asset) is the sum of the income (cash flow) that a reasonable investor would expect to get in the future, discounted at the appropriate discount (usually, interest) rates. The discounting reflects the fact that money received in the future has lower (discounted) purchasing power than money received now. Moreover, we can invest money received now and get interest on it (which should normally equal the discount). Put differently: the discount reflects the loss in purchasing power of money not received at present or the interest that we lose by not being able to invest the money currently (because we will receive it only in the future). This is the time value of money. Another problem is the uncertainty of future payments, or the risk that we will not receive them. The longer the period, the higher the risk, of course. A model exists which links the time, the value of the stock, the cash flows expected in the future and the discount (interest) rates.

We said that the rate that we use to discount future cash flows is the prevailing interest rate and this is partly true in stable, predictable and certain economies. But the discount rate depends on the inflation rate in the country where the firm is (or in all the countries where it operates in case it is a multinational), on the projected supply of the shares and demand for it and on the aforementioned risk of non-payment. In certain places, additional factors must be taken into consideration (for example: country risk or foreign exchange risks).

The supply of a stock and, to a lesser extent, the demand for it determine its distribution (how many shareowners are there) and, as a result, its liquidity. Liquidity means how freely can one buy and sell it and at which quantities sought or sold do prices become rigid. Example: if a lot of shares is sold that gives the buyer the control of a company - the buyer will normally pay a "control premium". Another example: in thin markets it is easier to manipulate the price of a stock by artificially increasing the demand or decreasing the supply ("cornering" the market).

In a liquid market (no problems to buy and to sell), the discount rate is made up of two elements: one is the risk-free rate (normally, the interest payable on government bonds), the other being the risk related rate (the rate which reflects the risk related to the specific stock).

But: what is this risk rate?

The most widely used model to evaluate specific risks is the Capital Asset Pricing Model (CAPM).

According to it, the discount rate is the risk-free rate plus a coefficient (called beta) multiplied by a risk premium general to all stocks (in the USA it was calculated to be 5.5%). Beta is a measure of the volatility of the return of the stock relative to that of the return of the market. A stock's Beta can be obtained by calculating the coefficient of the regression line between the weekly returns of the stock and those of the stock market during a selected period of time.

Unfortunately, different betas can be calculated by selecting different parameters (for instance, the length of the period on which the calculation is performed). Another problem is that betas change with every new datum. Professionals resort to sensitivity tests which neutralize the changes that betas undergo with time.

Still, with all its shortcomings and disputed assumptions, the CAPM should be used to determine the discount rate. But to use the discount rate we must have what to discount, future cash flows.

The only relatively certain cash flows are the dividends paid to the shareholders. So, Dividend Discount Models (DDM) were developed.

Other models relate to the projected growth of the company (which is supposed to increase the payable dividends and to cause the stock to appreciate in value).

Still, DDM require, as input, the ultimate value of the stock and growth models are only suitable for mature firms with a stable and not too high dividend growth. Two-stage models are more powerful because they combine both emphases: on dividends and on growth. This is because of the life-cycle of firms: at first, they tend to have a high and unstable dividend growth rate (the DDM tackles this adequately). As the firm matures, it is expected to have a lower and stable growth rate, suitable for the treatment of Growth Models.

But how many years of future income (from dividends) should we use in a our calculations? If a firm is profitable now, is there any guarantee that it will continue to be so in the next year, the next decade? If it does continue to be profitable - who can guarantee that its dividend policy will not change and that the same rate of dividends will continue to be distributed?

The number of periods (normally, years) selected for the calculation is called the "price to earnings (P/E) multiple". The multiple denotes by how much we multiply the (after tax) earnings of the firm to obtain its value. It depends on the industry (growth or dying), the country (stable or geopolitically perilous), on the ownership structure (family or public), on the management in place (committed or mobile), on the product (new or old technology) and a myriad of other factors. It is almost impossible to objectively quantify or formulate this process of analysis and decision making. In telecommunications, the range of numbers used for valuing stocks oa private firm is between 7 and 10, for instance. If the company is in the public domain, the number can shoot up to 20 times the net earnings.

While some companies pay dividends (some even borrow to do so), others just do not pay. So in stock valuation, dividends are not the only future incomes you expect to get. Capital gains (profits which are the result of the appreciation in the value of the stock) also count. This is the result of expectations regarding the firm's free cash flow, in particular the free cash flow that goes to the shareholders.

There is no agreement as to what constitutes free cash flow. In general, it is the cash which a firm has after sufficiently investing in its development, research and (predetermined) growth. Cash Flow Statements have become a standard accounting requirement in the 80s (starting with the USA). Because "free" cash flow can be easily extracted from these reports, stock valuation based on free cash flow became increasingly popular and feasible. It is considered independent of the idiosyncratic parameters of different international environments and therefore applicable to multinationals or to national firms which export.

The free cash flow of a firm that is debt-financed solely by its shareholders belongs solely to them. Free cash flow to equity (FCFE) is:

FCFE = Operating Cash Flow MINUS Cash needed for meeting growth targets

Where

Operating Cash Flow = Net Income (NI) PLUS Depreciation and Amortization

Cash needed for meeting growth targets = Capital Expenditures + Change in Working Capital

Working Capital = Total Current Assets - Total Current Liabilities

Change in Working Capital = One Year's Working Capital MINUS Previous Year's Working Capital

The complete formula is:

FCFE = Net Income PLUS

Depreciation and Amortization MINUS

Capital Expenditures PLUS

Change in Working Capital.

A leveraged firm that borrowed money from other sources (could also be preferred stockholders) has a different free cash flow to equity. Its CFCE must be adjusted to reflect the preferred dividends and principal repayments of debt (MINUS sign) and the proceeds from new debt and preferred stocks (PLUS sign). If its borrowings are sufficient to pay the dividends to the holders of preference shares and to service its debt - its debt to capital ratio is sound.

The FCFE of a leveraged firm is:

FCFE = Net Income PLUS

Depreciation and Amortization MINUS

Principal Repayment of Debt MINUS

Preferred Dividends PLUS

Proceeds from New Debt and Preferred MINUS

Capital Expenditures MINUS

Changes in Working Capital.

A sound debt ratio means:

FCFE = Net Income MINUS

(1 - Debt Ratio)*(Capital Expenditures MINUS

Depreciation and Amortization PLUS

Change in Working Capital).

About The Author

Sam Vaknin is the author of "Malignant Self Love - Narcissism Revisited" and "After the Rain - How the West Lost the East". He is a columnist in "Central Europe Review", United Press International (UPI) and ebookweb.org and the editor of mental health and Central East Europe categories in The Open Directory, Suite101 and searcheurope.com. Until recently, he served as the Economic Advisor to the Government of Macedonia.

His web site: http://samvak.tripod.com

In The News:

This RSS feed URL is deprecated, please update. New URLs can be found in the footers at https://news.google.com/news

This week's Mutual Funds and ETF stories
MarketWatch
Correction? What correction? Stock price declines are so last week. As financier J.P. Morgan once dryly observed, “The market will go up and it will go down, but not necessarily in that order.” Here's the thing to remember about market declines. They ...


Madison.com

Best healthcare mutual funds
Motley Fool
The Delaware fund takes a global approach to its focused exposure to healthcare, putting its emphasis on leaders whose shares aren't overpriced and that have sustainable competitive advantages. About a third of the fund's assets are invested in ...
The 3 Best Healthcare Mutual Funds in the Past YearNasdaq

all 1 news articles »

Investor's Business Daily

Some Mutual Funds Look For Hot Stocks Abroad
Investor's Business Daily
"Many investors believe that Europe and Latin America and places like Japan have the potential for even stronger earnings growth than the U.S. in coming quarters," said Tom Galvin, lead manager of $4.3 billion Columbia Select Large Cap Growth (ELGAX ...


Kiplinger's Personal Finance

5 Dirt-Cheap Index Funds That Invest in Dividend Stocks
Kiplinger's Personal Finance
Generally speaking, buying an exchange-traded fund (ETF) or other diversified fund offers something of a safety net. While investors can go the stock-picking route and hold onto a handful of picks, a fund provides wide diversification across dozens or ...

and more »

Bloomberg

China Is Said to Call on Companies, Mutual Funds to Boost Stocks
Bloomberg
The Shanghai Stock Exchange said on Friday that it has issued warnings and limited intraday trading to prevent large equity sales that affected the market's stability. Meanwhile, the China Securities Investment Services Center -- a body serving smaller ...

and more »

NJ.com

The risk of stocks vs. mutual funds
NJ.com
GE is a household name and yet this decrease in value greatly hurts your total return in a small stock portfolio, Feit said. When an individual buys a diversified equity mutual fund or exchange-traded fund, he will get broad market exposure among ...


Seeking Alpha

Best And Worst Q1 2018: Technology ETFs And Mutual Funds
Seeking Alpha
State Street Technology Select Sector SPDR (XLK) is the top-rated Technology ETF and Fidelity Select Communication Equipment Portfolio (FSDCX) is the top-rated Technology mutual fund. Both earn a Very Attractive rating. ARK Innovation ETF (ARKK) is the ...


Investor's Business Daily

This Top Mutual Fund's Surprising Appetite For Leading Stocks
Investor's Business Daily
Currently, Barrow Hanley runs about 40% of fund assets, with the balance run by the USAA team. Parent firm USAA maintains that ratio by allocating new inflows. Although the Barrow Hanley team's mandate is to focus on value stocks, their portfolio ...


Zacks.com

Is Goldman Sachs Large Cap Growth Insights A (GLCGX) a Strong Mutual Fund Pick Right Now?
Zacks.com
This dedication to giving investors a trading advantage led to the creation of our proven Zacks Rank stock-rating system. Since 1988 it has more than doubled the S&P 500 with an average gain of +25% per year. These returns cover a period from 1988-2017 ...


Bloomberg

Hybrid Stock-Bond Mutual Funds Suffer Worst Week in 17 Months
Bloomberg
Coordinated selling in stocks and bonds is making life miserable for investors in one of the most popular asset allocation strategies: those lumped together under the rubric of 60/40 mutual funds. Counter to their owners' hope, that pain in one will be ...

and more »
Google News

Analyst Reports

When you become interested in a stock or mutual fund... Read More

My Stock - Right or Wrong

We all know the expression, "My country, right or wrong",... Read More

What Our Investment Advisor Wont Say Off The Bat

Most advisors will tell you they can beat the market.... Read More

Market Psychology

Today we are inundated with tons of information about the... Read More

Stock Market Course .... Day Trader Online Seminar ... Can You Generate Profits Trading from Home?

When it comes to stock market trading it PAYS to... Read More

Starbucks Stock is Up

Starbucks earnings are up again and so is their stock... Read More

Mutual Fund Expense Lies

When purchasing mutual funds we are cautioned to read the... Read More

Size Counts!

What the heck am I talking about?It is often said... Read More

Shorting Stocks ? The Basics, Part I of II

What does it mean to short a stock?This means that... Read More

Selling

The stock market has been going up for more than... Read More

One Way Street

Ever turn down a street, get half way and suddenly... Read More

Protectionism

First let's see what protectionism is. According to Mr. Webster... Read More

How to Short Stocks? How to Make Money when Your Stocks Go Down by Shorting

The stock market can present you with a lot of... Read More

How To Be A Winner

Everyone who invests in the stock market wants to be... Read More

Using Sector Funds to Construct Diversified Mutual Fund Portfolios

'Sector funds are too risky.' 'I doubled my money with... Read More

Discover the Retirement Breakthrough the Federal Government Created for You - The Roth IRA!

If you don't know what a Roth IRA is then... Read More

Fools Gold

The stock market has been in an up trend for... Read More

Buy and Hold Investment Philosophy

Wall Street has been preaching the doctrine of Buy and... Read More

Emotional Maturity

If you are going to be a winner in the... Read More

Stocks & Oil, Sat Jun 18th, 2005

Both the stock market and oil prices rallied recently, which... Read More

Stock Market Education; Day Trading for Beginnners; How to Pick Stocks

The trading method you employ to approach the stock market... Read More

Are You A Stockaholic?

Today's society gives special recognition to alcoholics, sexaholics, binge-aholics, shopaholics,... Read More

Mr. Market

I constantly hear the talking heads on CNBC-TV, the radio... Read More

Is Your Garage Full Of Junk?

I have a 2-car garage. There are nice shelves on... Read More

Emotional Trading

The single most expensive stock market trades are those made... Read More