Instructor: Bai Charity Pandita Show bio
Charity has college degrees in Finance and Management Accounting. She also has an MBA and is currently a university professor, financial advisor and real estate broker.
Knowing the value of the stock is very important. Although there are several ways of valuing a stock, in this lesson we are going to focus on one of the most commonly used model. Learn the whys and hows of stock valuation using the constant growth model.
Getting into the Stock Market
Sunny gets jealous whenever her friend, Rain, updates his social media about how much money he makes by trading in stocks. After several months of doing a part-time job, Sunny finally has her own money. Just like her friend, Rain, she is also determined to invest in stocks. However, Rain seems to be very busy and a little bit selfish to walk Sunny through the basics of stock trading. Join Sunny as she learns about stock issuance and intrinsic value computation.
Why do companies issue stocks?
The first thing Sunny has to know is the concept of stocks. Stock issuance has long been done by companies primarily to raise money or capital. Basically, they raise money by selling shares or ownership in their own company. So, in contrast to raising funds by borrowing or loaning, selling your ownership in the company does not require paying off a debt.
Importance of Stock Valuation
This brings us to the question as to why people buy stocks or ownership in a corporation. Some people buy stocks because they have a very positive outlook of the company. They may think that the company is worthy enough for them to own. Basically, they hope that the price of owning the company today will increase in the future.
Market value is the current price of the stock in the market while intrinsic value is deemed to be the real price of the stock. They should ideally be equal, but most of the time, the market value and the intrinsic value are not equal. Logically, investors like Sunny should prefer a stock with a low market value but high intrinsic value. This is because they are buying it at a lower price yet they may potentially sell it in the future for a higher value.
Constant growth model: Understanding the formula
But how do we compute the intrinsic value of the stock so we can compare it to the market value? One of the most common methods is the constant growth model. The formula of the constant growth model is:
Value of Stock (P0) = D1 / (rs - g)
Before we go further, first you have to understand that D1 stands for the dividend expected to be paid at the end of the year. A dividend is an amount of money that the company gives its shareholders as owners because the company performed well.
Take note that the dividend that we are interested in for our constant growth model neither refers to the dividends which are already paid nor does it refer to dividends which will be paid in a couple of years or more. It has to be the dividend which will be paid right after the previous payment.
The required rate of return is represented by rs. This is the minimum percentage of gain or return that the investor wants to receive out of the stock.
Lastly, the g is the rate of growth. Since we are talking about constant growth model here, we assume that the growth of the stock is the same all throughout the years.