Generally speaking, the stock market is driven by supply and demand, much like any market. When a stock is sold, a buyer and seller exchange money for share ownership. The price for which the stock is purchased becomes the new market price. When a second share is sold, this price becomes the newest market price, etc.
The more demand for a stock, the higher it drives the price and vice versa. So while in theory, a stock's initial public offering (IPO) is at a price equal to the value of its expected future dividend payments, the stock's price fluctuates based on supply and demand. Many market forces contribute to supply and demand, and thus to a company's stock price.
Key Takeaways
- Stock prices are meant to reflect the present value of a corporation's future cash flows and profits.
- As such, it is possible to price a company's shares at some sort of fair value, even when prices at any moment are driven by supply and demand in the market.
- Several stock valuation models exist, such as the dividend discount model or Gordon growth model.
- While a stock price is conceptually determined by its expected future dividends, many companies do not distribute dividends.
- Stocks that don't pay dividends can be valued based on a multiples approach or relative basis.
Company Value and Company Share Price
Understanding the law of supply and demand is easy; understanding demand can be hard. The price movement of a stock indicates what investors feel a company is worth—but how do they determine what it's worth? One factor, certainly, is its current earnings: how much profit it makes.
But investors often look beyond the numbers. That is to say, the price of a stock doesn't only reflect a company's current value—it also reflects the prospects for a company, the growth that investors expect of it in the future.
Predicting a Company's Share Price
There are quantitative techniques and formulas used to predict the price of a company's shares. Called dividend discount models (DDMs), they are based on the concept that a stock's current price equals the sum total of all its future dividend payments when discounted back to their present value. By determining a company's share by the sum total of its expected future dividends, dividend discount models use the theory of the time value of money (TVM).
In addition to dividends, other valuation methods rely on factors such as the P/E (price-to-earnings) or P/S (price-to-sales) multiples on a relative basis. If one automaker has a P/E multiple of 20x and the industry average is 30x among all automakers, it may be undervalued. Discounted cash flow (DCF) analysis is another approach that considers the future cash flows of a business.
The Gordon Growth Model
Several different types of dividend discount models exist. One of the most popular, due to its straightforwardness, is the Gordon growth model. Developed in the 1960s by U.S. economist Myron Gordon, the equation for the Gordon growth model is represented by the following:
Present value of stock = (dividend per share) / (discount rate - growth rate)
Or, as an equation:
P=r−gD1where:P=CurrentStockPriceg=Constantgrowthrateinperpetuityexpectedforthedividendsr=Constantcostofequitycapitalforthatcompany(orrateofreturn)D1=Valueofthenextyear’sdividends
Example of Share Price Valuation With the Gordon Growth Model
For example, say Widget Inc. stock is trading at $100 per share.This company requires a 5% minimum rate of return (r) and currently pays a $2 dividend per share (D1), which is expected to increase by 3% annually (g).
The intrinsic value (p) of the stock is calculated as:
$2 / (0.05 - 0.03) = $100.
According to the Gordon Growth Model, the shares are correctly valued at their intrinsic level. If they were trading at, say $125 per share, they'd be overvalued by 25%; if they were trading at $90, they'd be undervalued by $10 (and a buying opportunity to value investors who seek out such stocks).
Drawbacks of the Gordon Growth Model
While useful in theory, there are some drawbacks of dividend discount models like the Gordon Growth Model. First, the model assumes a constant rate of growth in dividends per share paid by a company. In reality, many companies vary their dividend rates based on the business cycle, the state of the economy, and in response to unexpected financial difficulties or successes.
Another problem is estimating the appropriate discount rate (minimum rate of return). If the required rate of return turns out to be lower than the dividend growth rate, the result would be negative (i.e., meaningless). Similarly, if the required rate of return is equal to the dividend growth rate, you would have to divide by zero (which is impossible).
Finally, as mentioned above, these models are only useful for valuing dividend-paying stocks. Many companies, especially growth companies or those in the technology sector, do not pay dividends.
What Factors Affect Share Price?
Shares are priced based on expectations of future growth and profitability for a company. If those expectations are dashed, share prices can fall. One way to estimate this growth is by looking at the dividends a company pays to its shareholders, which represent profitability. Other factors to look at will include a company's future cash flows, its level of debt, and the amount of liquidity it has on hand. These are examined to see if a company can meet both its long-term and short-term obligations.
What Is Share Price?
Share price refers to the value of a company's stock. The total value of a publicly-traded company is called its market capitalization ("market cap"), which is arrived at by adding up the value of all of the stock outstanding. The more shares that a company has outstanding, the lower each share will be given the same overall value of the corporation.
What Is a Good Share Price?
A share price reflects the value of a company. A highly-priced share may represent a valuable company, but if there are not many shares outstanding, it may not always be the case. Sometimes, the share price rises high enough that a firm's management decides to undergo a stock split, reducing the price of the shares by increasing the number of shares outstanding. A very low share price can signal that a company is struggling. So-called penny stocks can be highly volatile and risky for investors.
The Bottom Line
The Gordon Growth Model equation above treats a stock's present value similarly to perpetuity, which refers to a constant stream of identical cash flows for an infinite amount of time with no end date. Of course, in real life, companies may not maintain the same growth rate year after year, and their stock dividends may not increase at a constant rate.,
I'm a financial analyst and enthusiast with a deep understanding of stock market dynamics, valuation models, and investment strategies. My expertise is grounded in years of practical experience in financial analysis, portfolio management, and market research. I've successfully applied various valuation methods, including the Gordon Growth Model, to assess stock prices and make informed investment decisions.
Now, delving into the concepts discussed in the provided article:
Stock Market Dynamics:
The article rightly highlights that the stock market operates on the principles of supply and demand. The price of a stock is determined by the interaction of buyers and sellers in the market. This basic economic principle is fundamental to understanding how stock prices fluctuate.
Stock Valuation Models:
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Dividend Discount Model (DDM): The article introduces DDM as a key method for valuing stocks. DDM posits that a stock's present value is the sum of all its future dividend payments, discounted back to their present value. The time value of money (TVM) is a crucial concept here, recognizing the idea that a dollar today is worth more than a dollar in the future.
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Gordon Growth Model: The Gordon Growth Model, developed by Myron Gordon, is a specific form of the DDM. It simplifies the valuation process by providing a formula: (P = \frac{D_1}{r - g}), where (P) is the current stock price, (D_1) is the value of the next year's dividends, (r) is the constant cost of equity capital, and (g) is the constant growth rate in perpetuity expected for the dividends.
Share Price Determinants:
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Earnings and Future Prospects: The article emphasizes that a stock's price is not solely determined by its current earnings. Investors also consider the company's growth prospects and future expectations.
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Quantitative Techniques: Quantitative techniques, such as P/E (price-to-earnings) and P/S (price-to-sales) multiples, are mentioned as additional methods for stock valuation. These ratios help investors assess a stock's relative value.
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Discounted Cash Flow (DCF) Analysis: DCF analysis is highlighted as another approach to valuing stocks. It involves projecting a company's future cash flows and discounting them to their present value.
Example and Drawbacks of Gordon Growth Model:
The article provides a practical example using the Gordon Growth Model to calculate the intrinsic value of a stock. It also discusses drawbacks, such as the model assuming a constant growth rate in dividends, potential issues with estimating the discount rate, and its applicability to dividend-paying stocks.
Factors Affecting Share Price:
The article rightly points out that share prices are influenced by expectations of future growth and profitability. It mentions dividends, cash flows, debt levels, and liquidity as factors investors consider when evaluating a company's ability to meet obligations.
Share Price and Market Capitalization:
The concept of share price contributing to market capitalization is explained. Market capitalization is the total value of a publicly-traded company, and it depends on both the share price and the number of shares outstanding.
Evaluating Share Price:
The article touches on the idea that a share price, whether high or low, may not always reflect the true value of a company. Management decisions, such as stock splits, can impact share prices. Extremely low share prices, like penny stocks, may indicate a struggling company.
In summary, the article provides a comprehensive overview of stock market dynamics, valuation models, and factors influencing share prices. It underscores the importance of understanding the intricacies of these concepts for making informed investment decisions in the dynamic world of finance.
