Common Stock Valuation through Capitalization Technique.
A capitalization technique is merely a method of converting future cash returns into a single present or intrinsic value for security. Common stock offers the potential for growth of future cash flows, and this must be reflected in the intrinsic value analysis. Common Stock Valuation through Capitalization Technique.
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The value of the common stock for one period and more than one period can be estimated as follows.
The rate of return on investment can be expressed solely in terms of the effects for one period, normally a year. It is assumed that the security is purchased at point 0 i.e., the beginning period and sold at point 1 to be termed as the ending period. Any cash received during the year plus any increase in the value represents the return from the investment.
Such value can be calculated by using the following formula:
E(r)1 = [(P1-P0) + D]/P0
where,
E(r)1 = rate of return earned in period 1.
P1= price of the security at the end of period 1.
P0 = starting value of the security at point 0 and
D = any cash received in the form of dividends between point 0 and the end of period 1.
A second approach to the valuation of the common stock looks at more than one period. It is useful for firms that will perpetually pay dividends but will not grow in terms of earning or dividends.
The following formula can be used to find out the value of the stock:
PV = PMT/i
where,
PV = price of the security
PMT =
the annual receipt or payment
i = the appropriate time value of money (a considerable discount factor).
The above-mentioned formula can be rewritten as:
P0 = DPS1/ ke
whee,
P0 = price of the security.
DPS1= dividends per share in period 1 and every future period if the firm’s dividends are not growing.
ke = required a rate of return.
Common Stock Valuation through Capitalization Technique