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:


Investor's Business Daily

IBD's Best Mutual Funds 2017 Awards | Stock News & Stock Market ...
Investor's Business Daily
Except for the Harlem Globetrotters, repeat winning is hard. Even our Best Mutual Funds 2017 Awards winners have few repeats from last year.
Should you invest directly in equity or via mutual funds?Economic Times
Are you risk averse? Give hybrid mutual funds a chanceFinancial Express

all 10 news articles »

Motley Fool

The Worst Funds for Your 401(k)
Motley Fool
And all three of these options are far cheaper than the average U.S. stock mutual fund's expense ratio of about 1.25%. However, notice that there is a 65-basis-point difference in gross expense ratio between the highest- and lowest-cost funds on the ...
Mutual fund group aims for fee transparency with 'clean shares'San Francisco Chronicle

all 4 news articles »

Bloomberg

ETFs Are Giving Mutual Funds a Run for Their Money
Bloomberg
Mutual fund ownership of equities is at its lowest level in nearly 13 years, according to a research note from Goldman Sachs Group Inc. Meanwhile, exchange-traded funds are becoming an even bigger force in the stock market, the team led by Chief U.S. ...

and more »

US-based stock mutual funds take in most cash in a year -ICI
Reuters
By Trevor Hunnicutt NEW YORK, March 1 Fund investors' aversion to riding the market's highs showed signs of waning as stock mutual funds attracted the most cash in a year in the latest week, Investment Company Institute data showed on Wednesday.

and more »

Moneycontrol.com

Time to be careful: Fund managers are shying away from stocks
Moneycontrol.com
A look at the portfolio of ICICI Prudential Balanced Advantage Fund, the largest mutual fund scheme In India investing in stocks reveals that the exposure to stocks have been cut over last one year. The net equity investments of this scheme are down to ...

and more »

Barron's

ETFs Chasing Mutual Funds as Stock Buyer
Barron's
Mutual funds' outflows since last year have driven their equity ownership to a nearly 13-year low, according to Goldman Sachs. ETFs, meanwhile, are growing by leaps and bounds as a stock market force. “Corporations and ETFs will continue to drive ...


Mutual funds invest over Rs 2000 crore in stocks in February
Economic Times
Mutual fund managers purchased stocks worth a little over Rs 2,000 crore in February --- making it the seventh straight month of positive inflow in equities --- on sustained participation by retail investors. Fund managers have been investing ...

and more »

The Indian Express

Mutual Funds' exposure to bank stocks hits record Rs 1.2 lakh crore in February 2017 end
The Indian Express
Mutual Fund managers seem to be bullish on bank shares as they raised their allocation in the sector to an all time-high of over Rs 1.2 lakh crore at the end of February, primarily on account of cheaper valuations. In comparison, fund managers had ...

and more »

Utility Stocks for Retirement Investors: 1 Stock, 1 ETF and 1 Mutual Fund
Investorplace.com
While utility stocks have taken it on the chin lately with the Federal Reserve starting to raise rates, the reality is, they still make sense for retirement investors. Utilities For Retirement Investors: 1 Stock, 1 ETF and 1 Mutual Fund. Source: 401(k ...


CNBC

Why mutual funds could be on their way to another lousy year
CNBC
The improvement comes amid multiyear lows in the tendency of stocks to correlate up and down together, as well as an elevated level of dispersion, or the difference between returns for various sectors. Stock pickers in actively managed mutual funds ...
Stock pickers lift performance in battle of the benchmarksFinancial Times

all 4 news articles »
Google News

Play another Day

Money management starts with protecting your capital, realizing profits and... 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

Invest, Be Wrong, and Make Money in the Stock Market

I have been trading for several decades and was an... Read More

The Information Age

It is wonderful to be alive in the information age.... Read More

Inertia

One of the basic laws of physics is that a... Read More

Stock Trading - Daddy, Why Arent We Rich?

One Saturday morning, while he was sitting at his computer... Read More

Stock Loans

Hedge current portfolio positions and gain access to capital resources... Read More

Bottoms Ups

If you have talked to a stock broker or financial... Read More

The Great Stock Market Secret

When the stock market is going up and all your... Read More

Online Trading Strategy: Collecting Cash when Stocks Go UP - It PAYS to Know More than Others

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

Discipline

One of the great "secrets" of successful people is discipline... Read More

Downdraft

For the year 2000 we have seen hundreds of mutual... Read More

Municipal Bonds

Because there are so many stocks that are NOT paying... Read More

Trading Baskets II: The Crapolio, A Roll of the Dice in the Stock Market

In a previously written article, we expanded the use of... Read More

Trading Systems

To become a successful trader you must have some kind... Read More

Seecrets on Investment: Tired of Making Huge Losses in the Stock Market ? Part 2

Fundamental analysis.Fundamentals analysis says the best way to predict the... Read More

How We Eluded The Bear Of 2000

The date October 13, 2000 will forever be embedded in... Read More

Buying New Issues

Has your broker been calling you recently with the "great... Read More

Stock Market Volatility

In my opinion, due to the volatility of stock market... Read More

Small-Cap Stocks: The Beginning of the Journey

When an individual investor wants to roll up his sleeves... Read More

DIY Portfolio Management

Exchange Traded Funds (ETFs) are growing. Investors are choosing low... Read More

Complacency Indicator

If you haven't heard of the technical indicator with the... Read More

Stock Investment Advice

Stock investment advice is easy to find. Do you get... Read More

Will the Stock Market be Lower in October?

The stock market often closes a week in the middle... Read More

Fools Gold

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