Summaries of Chapter 7 and 8
For understanding stock valuation, first, it is to be noted that there are stock markets like primary market and secondary market in which stocks are traded. New stocks are issued in primary markets and for the trading of the existing shares, secondary markets are used. Dealers are the ones who maintain a steady inventory and trade at the quoted ask and bid prices for the gains acquired through their differences called as the bid-ask spread. Brokers are the ones who match sellers with buyers and charge a fee for this service. The NYSE is one of such stock exchanges. Stock valuation is difficult because cash flows are uncertain, have no maturity life, and necessary rate of return is unpredictable. The stock prices are computed as the present value of all future dividends. The returns on shares are in the form of either dividend or capital gains. Capital gain is the gain on investment when the share is sold at a higher price than its buying price. Dividends are needed to be distributed as a company cannot increase its share price forever. It will eventually be unproductive thus needing to pay dividends to its holders. The eternity of the stock value growth implies three models for the estimation of the growth rate of dividends; the constant dividend with no growth rate, the constant dividend growth model with a constant growth rate, and the supernormal growth model for the company expecting its currently abnormal growth rate to stabilize in the future. The stock value can also be computed through the price per earnings or price to sales ratio.
Looking at the investment criteria, it is important to evaluate each regarding the time value of money, the risk of cash flows, an indication of the value increase, permits ranking of projects. The Net Present Value and IRR consider all these factors by showing the difference in the market value and the cost of a project. IRR is the rate at which NPV of a project is zero. Payback Period does not consider the discounting of cash flows, risk factors, and not indicate the value of the firm. ARR with all the above factors does not even consider cash flows. Profitability Index considers the benefit per unit cost and considers all the factors except that it can be misleading in mutually exclusive projects.
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