Finance
Pre-MBA
2010-2011
Dr Abdeldjelil Ferhat BOUDAH
Business School
Management
Department
King Faisal University [11
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CHAPTER 8
COMMON STOCK VALUATION
King Faisal University 2[
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Dr Abdeldjelil Ferhat BOUDAH
CHAPTER 8: COMMON STOCK VALUATION
Introduction
I- Market Efficiency
II- The Basic Stock Valuation Equation
Conclusion
King Faisal University [3
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Dr Abdeldjelil Ferhat BOUDAH
CHAPTER 8: COMMON STOCK VALUATION
Introduction
Common stockholders expect to be rewarded
through the receipt of periodic cash dividends and
an increasing – or at least nondeclining- share
value. Like current owners, prospective owners
and security analysts frequently estimate the
firm’s value.
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Dr Abdeldjelil Ferhat BOUDAH
CHAPTER 8: COMMON STOCK VALUATION
They choose to purchase the stock when they
believe that it is undervalued (i.e that its true
value is greater than its market price) and to sell it
when they feel that it is overvalued (i.e that its
market price is greater than its true value)
King Faisal University [5
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Dr Abdeldjelil Ferhat BOUDAH
CHAPTER 8: COMMON STOCK VALUATION
I- Market Efficiency
Economically speaking, rational buyers and
sellers use their assessment of an asset’s risk
and return to determine its value. To a buyer
the asset’s value represents the maximum price
that he or she would pay to acquire it, and a
seller views the asset’s value as a minimum
sale price.
King Faisal University [6
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Dr Abdeldjelil Ferhat BOUDAH
CHAPTER 8: COMMON STOCK VALUATION
In competitive markets with many active
participants , such as the New York Stock
Exchange, the interactions of many buyers
(demanders of shares) and sellers (suppliers of
shares) result in equilibrium price or market
value for each security. This price reflects the
collective actions of buyers and sellers based
on all available information.
King Faisal University [7
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Dr Abdeldjelil Ferhat BOUDAH
CHAPTER 8: COMMON STOCK VALUATION
As new information becomes available, buyers
and sellers are assumed to react through their
sale and purchase activities to quickly create a
new market equilibrium price.
The process of market adjustment to new
information can be viewed in terms of rates of
return.
King Faisal University [8
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Dr Abdeldjelil Ferhat BOUDAH
CHAPTER 8: COMMON STOCK VALUATION
From Chapter 6 , we know that for a given level
of risk, investors require a specified periodic
return- the required return k, which can
estimated. The estimation of k can calculated
as follows:
:The return that is expected to be earned each
period on a given asset over an infinite time
horizon
King Faisal University [9
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Dr Abdeldjelil Ferhat BOUDAH
CHAPTER 8: COMMON STOCK VALUATION
Whenever investors find that the expected
return is not equal to the required return
a market price adjustment will occur.
If the expected is less than the required,
investors will sell the asset, because it is not
expected to earn a return goes with its risk.
Such action would drive the price down.
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CHAPTER 8: COMMON STOCK VALUATION
However, if the expected return were above
the required return
Investors would buy the asset, driving its price
up and its expected return down to the point
that it equals the required return. This market
adjustment
process
can
be
better
demonstrated with an example…which will be
later on.
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Dr Abdeldjelil Ferhat BOUDAH
CHAPTER 8: COMMON STOCK VALUATION
II- The Basic Stock Valuation Equation
Like bonds, the value of shares of common stock is
equal to the present value of all future benefits it
is expected to provide. Simply stated, the value of a
share of common stock is equal to the present value
of all future dividends it is expected to provide over
an infinite time horizon.
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CHAPTER 8: COMMON STOCK VALUATION
Although by selling the stock at a price above
that originally paid, a stockholder can earn
capital gains in addition to dividends. The price
or value of a common stock can be calculated
as follows:
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CHAPTER 8: COMMON STOCK VALUATION
Where,
= value of common stock
= per share dividend expected at
the end of year t
= required return on common stock
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Dr Abdeldjelil Ferhat BOUDAH
CHAPTER 8: COMMON STOCK VALUATION
Conclusion
By now, it can be concluded that common stock
valuation is a matter of being in direct with the
market trading of common stocks. Being either
effective or efficient in investing within a specified
market is something related to how a greater
extent the market is developed and efficient.
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Dr Abdeldjelil Ferhat BOUDAH
‫بحمد هللا‬
King Faisal University 16
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