The value of a stock or bond is the present value of the future cash flows that the stock or bond is expected to pay to its owners.
Stocks and bonds are the primary sources of capital of a firm. Stockholders and bondholders invest in the firm because they expect to earn a return that compensates them for the risk they take. It is important to be able to determine the values of stocks and bonds.
By issuing bonds, companies are borrowing money, promising to return it in the form of interest and principal. The interest and principal payments are known so finding their value is just a matter of finding their present value. The discount rate is often called the bondís yield-to-maturity or just yield, and represents the return the bondholders expect and require in order to justify lending the money. Of course, companies can default on their bonds, and bondholders expect higher returns to compensate them for this risk. At this point in the study of finance, the possibility of default is not being considered.
Stocks are more complex because their payments are not assured. To find the value of a stock, we must estimate the cash flows that are expected to be paid by the company to the stockholders in the future. These cash flows occur in the form of dividends. So we find the value of a stock by discounting the expected future dividends. Because a stock has an infinite life, we must discount the expected future dividends all the way to infinity.
Of course, as a practical matter it is impossible to forecast the dividends to infinity. We typically avoid this problem by making assumptions about projected growth rates of dividends. Stocks usually grow in stages, with early rapid growth eventually tailing off to a declining rate of growth, whereupon dividends might be expected to grow at a small but constant rate forever or might even remain level forever. When dividend growth can be projected at a constant rate, even if that rate is zero, formulas for present value calculations are simple.
As with bonds, the discount rate is the return investors expect and require. Thus, it is called the required rate of return or expected rate of return, or just the required rate or expected rate. It is also occasionally called the equity capitalization rate. But in general, it is just the discount rate, the rate at which dividends are discounted to determine the price of the stock.
What we do not know at this point is what rate to use. All we can say for sure is that it is more than the rate of return on a risk-free investment, such as a short-term government security.
The value of a stock or a bond is the price at which it would be expected to trade in the financial markets. For stocks, the value or price is what management should focus on. Maximizing the stock price should be the goal of management.
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Last updated: January 9, 2011