INVESTMENT ANALYSIS – AREAS OF CONCENTRATION (TOPIC: (COMMON STOCK VALUATION-SINGLE STAGE MODEL)

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DETERMINATION OF EXPECTED RETURNS FROM EQUITY (COMMON STOCK VALUATION)

The discount cash flow approach to common stock valuation suggests that the value of an asset is the present value of all cash flows an investor can expect from that asset.  With Common Stock, the expected cash flows are the cash dividends and the selling price.

“Common Stock Valuation - The Single Stage Model”

If we assume that dividend will grow at a constant rate forever and that the stock required rate of return will be greater than the dividend growth rate, then the stock rate of return or value will be : Po = Do (1 + g)

                                                      k-g

Where:

Po = Stock Expected Price or value

Do=Current Dividend per share

g = Expected annual growth in dividend

K = required rate of return

ILLUSTRATION:

M & M Corporation, recently pay a dividend of N40 per share.  Dividend have been growing at an annual rate of 8% and this growth is expected to continue in the foreseeable future.  If the required rate of return of M & M Stock is 14%, determine the value of her stock.

SOLUTION:

Po = Do (1 + g)

              k-g

Guys, this is easy ok.  Let’s do it.

From the formula above, fix the figures thus;

Po = 40  (1+8%)

             14%-8%

Po= 40  (1 + 0.08)

           0.14 – 0.08

Po= 40 (1.08)

            0.06

Po = 43.2

       0.06

Po = N720

I solved this step by step so that you can understand it yourself.  But in exam situation, you might want to seep up things by skipping some stages.

 ILLUSTRATION 2

The sweet mother corporation has a required rate of return of 16% and her current dividend is N3 per share.  If the current price of the sweet mother’s stock is N55 per share, what is the growth rate of her dividend?

Note: Want thing I will advise us is to pay attention to the question and read it carefully.  This question is asking us for the growth rate of dividend. That is to say it is asking of (g) in the question and not (Po) this time around.

Ok, let’s swing into action.

SOLUTION:

Po = Do (1 + g)

              k-g

Po is know is:

55 = 3   (1+g)

           0.16-g

g is not known, so we are going to cross multiply

55 = 3   (1+g)

1          0.16-g

55 (0.16 – g) = 3(1+g)

8.8 – 55g = 3 +3g

Little explanation:

When you cross multiply, it will be like this; 55 x 0.16 will give you 8.8, 55 x g will give you 55g, 3 x 1 will give you 3 then finally, 3 x g will give you 3g. that is how we got 8.8 – 55g = 3 +3g.

Now let’s collect like terms.

8.8 – 55g = 3 +3g

8.8-3 55g+3g

5.8   58g

58     58

g=0.1 or 10%

 Explanation:

When 55g cross to meet 3g it will carry plus sign and when 3 cross to meet 8.8, it will carry minus sign.  That is how we got 8.8-3 55g+3g.  8.8 – 3 gives you 5.8. and 55g added to 3g gives you 58g. Now divide both side with 58g.

You will get 0.1. Since we have to leave our answer in percentage, 0.1 x 100 is 100%.  But you should know that 0.1 is 10% ok.

That is it.

He also asked us that what is the difference between stock and share?  This question might come out so, here is the different:

For example, "stock" is a general term used to describe the ownership certificates of any company, in general, and "shares" refers to a the ownership certificates of a particular company. So, if investors say they own stocks, they are generally referring to their overall ownership in one or more companies.