Common Stock Valuation & Types of Growth

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  • 0:04 Common Stock Valuation
  • 0:29 Discounted Cash Flow
  • 1:13 Growth
  • 4:19 Lesson Summary
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Lesson Transcript
Instructor: Ian Lord

Ian is a real estate investor, MBA, former health professions educator, and Air Force veteran.

Common stock valuation determines the price that a stock will sell for. Valuations are highly dependent on the expected growth of the stock. Let's look at how stock valuation works and the different ways of calculating growth.

Common Stock Valuation

Bill wants to understand how stock prices are determined. He learns that the process of valuation of a stock attempts to determine a stock's true or correct price by evaluating information about the company. Looking at cash flows is one way of figuring out that price. Bill can also judge a stock's value based on a variety of business growth expectations. Let's help Bill understand the basic workings behind these concepts.

Discounted Cash Flow

If Bill wants to determine the value of a stock, he should consider what kind of performance he can expect from the stock in the future. The discounted cash flow method of stock valuation gives a value based on a discount of the profits. The discount refers to the present value based on future investor returns from dividends and capital gains and also accounts for what the stock is expected to sell for at a future point. A positive cash flow allows a company to distribute some of this extra cash as dividends to the shareholders.

The goal for Bill is to figure out if the current price of a stock share justifies the expected dividends after the stock is held and possibly sold after some time. A dividend is the money paid to shareholders from profits.

Growth

Stock valuation depends on estimating the growth of a company. Growth refers to the company's total assets increasing over time, whether in the form of more facilities, equipment, land, employees, or profits. Growth depends on an increasingly positive cash flow so the company can fund its expansion. Increased growth also leaves available cash to issue dividends. There are several methods of calculating growth.

Zero-Growth

One is the zero-growth method. If Bill wants to base his purchase decision on dividend performance, he'll plan to hold on to the stock for the profits arising from positive cash flows. The zero-growth valuation method assumes that the dividend rate will stay at its current point. It considers the amount of the dividend by the investor's required rate of return.

For example, Bill is looking at a share of stock that typically pays out a dividend of 25 cents. Bill expects the stock to pay a 2% rate of return going forward.

$0.25 / 0.02 = $12.50

This values the stock at $12.50 per share, so Bill should buy at or below that price. As long as the dividend rate remains stable, Bill could buy a share at or below that value and meet his investment goal.

Constant-Growth

Another valuation method is constant-growth. This valuation method is useful for Bill if stock's dividends are believed to continue to grow at a steady and consistent pace over the long haul. If the current dividend is $1.00 and the next dividend from the share is expected to grow at a 5% rate, the next dividend will be $1.05. This valuation method gives Bill an upper limit purchase price for a stock assuming that a 5% growth rate continues for the foreseeable future.

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