Stock Valuation - The Present Value of Preferred Stock, Common Stock and the Gordon Growth Formula

Contents
Time Value of Money
Annuities
Perpetuities
Kinds of Interest Rates
Future Value of an Uneven Cash flow
Probability Distribution
Standard Deviation
CAPM
Security Market Line
Bond Valuation
Stock Valuation
Cost of Capital
The Balance Sheet
Capital Budgeting
Hall of Fame
Credit Report
Forex
401K
ETFs
Futures
Inflation
IPOs
Mergers
Online Scams
Calculators
Financial Terms
Scientific Terms
Military Terms
Financial Charts
Unemployment
Fuel Mileage
Sports Finance
Energy Efficiency

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Disclaimer

Stock Valuation - see our disclaimer

Preferred Stock	Preferred stock is somewhat like a bond. They pay the same equal dividends forever.
Common Stock	Common stock represents ownership in the company. Sometimes there are dividends, sometimes not.

What is the value of Preferred Stock?

This is easy. Preferred stock is basically a perpetuity.

What is the value of Common Stock?

This is not easy. This is a mess. Think about it. What is the value of a share of stock in a specific company? In one sense it is the price the stock trades at. Both the buyer and seller agree to exchange the stock at that price.

We assume that they are both rational people and both know something about the company and its future plans and profit potential. So, yes, that is one method: check the price of the stock in the paper or on the internet. But that's pretty darn easy. It's not really finance. It's more like reading. And I don't know if you realize this or not, but they don't give Nobel Prizes for reading. So there are other ways of doing stock valuation too.

The Gordon Growth Formula, also known as The Constant Growth Formula assumes that a company grows at a constant rate forever. This, by the way, is impossible. I mean, it can't grow forever. You know, if a company doubles in size every 5 years, pretty soon every single person in the world is their customer and then they can't grow at that rate anymore. (because the world population isn't doubling ever 5 years).

BUT, if we go ahead and assume that a company has a constant growth rate, we can use the following formula to get its value.

Constant Growth Formula

Po = D 1 / ( Ks - G )

Po = Price
D1 = The next dividend. D1 = D0 (1 + G)
Ks = Rate of Return
G = Growth Rate

What is all this D1 and D0 stuff ?

D1 is the next dividend
D0 is the last dividend

Well we are assuming that the company has constant growth, right. So we take the last divided, multiply it by the growth rate and we can get the next dividend.

Example

Last years dividend = $ 1.00
Growth Rate = 5%
Rate of Return = 10%

First figure out D1.

D1 = D0 (1 + G)
D1 = $1.00 ( 1 + .05)
D1 = $1.00 (1.05)
D1 = $1.05

Next us the formula.

Po = D 1 / ( Ks - G )
Po = $1.05 / (10% - 5%)
Po = $1.05 / 5%
Po = $21.00

So, if we want to get a 10% rate of return on our money, and we assume that the company will grow forever at 5% per year, then we would be willing to pay $21.00 for this stock. That is the theory anyways. And again, here is our disclaimer.

About the author

Mark McCracken

Author: Mark McCracken is a corporate trainer and author living in Higashi Osaka, Japan. He is the author of thousands of online articles as well as the Business English textbook, "25 Business Skills in English".