## Monday, August 29, 2011

### How to value current stock market prices

In order to learn to evaluate the current stock market prices of common stocks, it is important to know what is common stock? Common stock is a type of equity which when owned by an investor represents a part ownership of that company.

Suppose a company has 100,000 shares representing 100% of the total company’s worth. Out of these 100 shares 50,000 shares are given to public for trading. If a common man buys 100 nos of this share at current stock market prices it means he can claim 0.1% (100/100,000) ownership of the company. Owning a common stock is similar to capital contributed by each partners in a partnership firm.

This concept of evaluating the value of current stock market prices has been made popular by the great investor Warren Buffett. He calls this concept of investing in stocks after evaluating the value of current stock market prices as ‘Value Investing’.

The evaluated value of stock he call as ‘Intrinsic Value”. In financial term, intrinsic value of stock is nothing but “present value of all future cash inflows expected to be received by the investor. This includes inflow of dividends and current stock market prices at the time the stocks are sold”.

### Let us try to find intrinsic value of current stock market prices of a stock for a holding period of one year.

For an investor who is interested to buy a common stock at current stock market prices and intends to hold the stock of one year can use this method of calculating intrinsic value. The intrinsic value (future cash inflows) of the stock is the represented by both the expected dividends to be received in one year (D1) and expected current stock market prices after one year when it is, sold (P1). If the investor required rate of return is say ‘r” then the intrinsic value (Po) will be equal to:

Po = [ D1 / (1+ r)^1] + [ P1 / (1+ r)^1]

Let us see an example
An investor decides to buy a stock at the beginning of the financial year a stock at current stock market prices of a company A. In the past the company has paid on an average a dividend at the rate of \$1.5 (D1) per share. Also the trend shows that the current stock market prices will rise to \$40 (P1) after end of the year. If the expected rate of return of the investor is 15% (r ) then the present value (Po) of stock will be:

Po = [ D1 / (1+ r)^1] + [ P1 / (1+ r)^1]
Po = [ \$1.5 / (1+ 15%)^1] + [ \$40 / (1+ 15%)^1]
Po = \$1.31 + \$34.8 = \$36.11

Now, how to use the value of Po to buy stocks? If the current stock market prices are higher than \$36.11 then it means that the stock is over priced and if the current stock market prices are lower than \$36.11 it means the stocks are under priced. Champion investor Warren Buffett always buys undervalued stock of world class companies.

### Let us try to find intrinsic value of current stock market prices of a stock for a long term basis.

Expected Rate of Return Ro = Dividend Yield + Capital Yield
Suppose the dividend yield of a stock is 3.5% and current stock market prices increases with an yield rate of 9% per annum.
It means Ro = 3.5% + 9% = 12.5% per annum

### Conclusion

In this article we have discussed the valuation of common stocks. Intrinsic value of stock is nothing but present value of all future cash inflows expected to be received by the investor. This article discussed how to calculate the intrinsic value of stocks on basis of expected dividends inflows and current stock market prices appreciation.
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