Equity is the major source and composite of capital structure. And its values are defined in per stock basis. In finance, the value of the financial securities is calculated by determining the present value of the future cash flows. Unlike the valuation of the bond, having the coupon payment and redemption of face value on maturity, the stock comprises dividend payments and horizon value, i.e. the price at which we sell the stock. These future cash flows are discounted at the cost of capital (discounting rate). It can be expressed in formulae as: -
·Present value of stock as today(P0) = (Div1+ P1)/(1+k) (assuming only one-year dividend payout)
Where Div1: the expected dividend on the end of the first year
P1: is the horizon value of the stock,
k: the expected rate of return which is equivalent to the sum of dividend yield and capital gain yield, in formulae we can write it as: -
·Expected return (k) = (Div1+P1-P2)/P0, Further,
Cost of Equity capital (r) can be calculated as: Dividend Yield + Growth Rate
= (Div1/ P0) + g
Often, the company plans to retain certain percent of their earnings, (k) is equivalent to the retention ratio * return in equity. This is called the intrinsic or theoretical value of the stock, on the basis of which we can determine whether the stock is over or underpriced.
Let's take an example where the following parameter is given
The dividend is paid Quarterly
Expected value based on historical growth rate(HV) 300
Opportunity Cost (k) 10%
Number of compounding in a Year (m) 4
Number of year (n) 20
Dividend Payment (PMT) 5
The present value of the stock = PMT*(1-1/(1+k/m) ^(m*n)/(k/m) +HV(1+k/m) ^(m*n)
=5*(1-1/ (1+0.1/4) ^ (20*4))/ (0.1/4) + 300/(1+0.1/4)^(20*4)
=213.8705
Hence as per the above-provided example, the intrinsic value of the stock having 5 years of period and dividend worth $5 being paid quarterly at the discounting rate of 10% is $ 213.87. Here as per this theoretical value, the stock could be determined if it is over or underpriced. For example, if the stock is currently being traded on the market for $250, it is overpriced and it is better to sell the stock (take short position) and if it is being traded at $200, then it is undervalued it is better to better to buy or hold the current stock(take long position).
And, I do not think the deduction of the liabilities from the assets is the best way of determining the value of the stock but could be one way to do so. Since the balance sheet of the companies is recorded in the Book Value of the assets. The book value measures the original(historical) cost and does not incorporate the inflation. They also exclude the worth of intangible assets like goodwill, trademark, and patents. The value of the stock can also be inferred from the Price to Earnings ratio (P/E Ratio) which is equivalent to Market value of the share(MPS) /Earning Per Share(EPS), these gives the relation of the investors' readiness to pay for each unit of EPS which considers the market price but if we undertake balance sheet determined value, i.e. book value per share which is equivalent to Market value of the share(MPS) /Book Value Per Share(BPS) it come with unadjusted value of the share.
The investment psychology of the investor while investing in the financial market is not driven alone by the theoretical concepts and principles. They are also guided by various external factors like existing marketing condition, future projects of economy, prospects of future interest rate, monetary policy, fiscal policy, technological innovation, interest rate risk, competition, default rate risk et cetera which could not be found in the balance sheet but has direct influence in the price of the stock. The data privacy plummeted the value of the Facebook stock which was governed by the emotion and sentiments and trust issue on investors rather than the empirical values and findings.
Hence above mentioned are some ways of calculating the present value of the stock on the basis of future cash flow and it is not well advised to calculate the value of stock alone by subtracting the liabilities from the asset in the balance sheet and investor has to incorporate holistic approach(i.e. assessing multi-dimensional variables)
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