STOCK VALUATION
April 27, 2010
Stocks are an investment to the stockholders and a source of finance to the company; thus their valuation is of paramount importance to the two parties due to the following reasons:
1) To the actual shareholder the value of his shares indicates to him the magnitude of his capital gain on the shares.
2) The value of the shares will indirectly reveal the performance of the company because high share values reflect a high demand of the company’s shares which will be possible if the company’s performance is viewed favorably by the potential investors.
3) The value of the shares is important to a potential shareholder because it will reflect the cost of investment in shares and it is on the basis of this value that he can compute the return on his investment using the dividend yield:
Dividend Yield = Dividend per share X 100
Market Price per share
The above return can be compared with the bank rate to determine whether the
investment in shares is viable or not.
4) To the company, the value of the shares reflects the opinion of potential investors in the company’s shares. If the value is too low, it usually reflects a negative opinion which may make it very difficult for the company to raise further finance by way of trade credit and debt finance.
FACTORS THAT INFLUENCE THE VALUE OF THE SHARE
1. Profitability of the company – It is usually assumed that profitable companies pay
good and stable dividends and this increases the market price of their shares due to the high demand of such shares.
2. Dividend policy of the company – This is the frequency and the amount of
dividends a company pays to its common shareholders.
3. Retention policy of the company – Normally those companies which retain a lot
of their earnings and declare small dividends, will experience lower share market
prices in the short-run but in the long-run the market values will increase if the
retained earnings are invested to yield returns which will be given to the shareholders.
4. Price-earnings ratio of the company – This will indicate the pay-back period of a
share and the lower the P/E ratio the shorter the pay-back period and the more favorable the company’s shares will be to potential shareholders as they will be assured of recovering their initial investment earlier. However, this depends on the dividend policy of the firm.
5. The size of the company – Usually companies in their growing stages do not
attract potential investors due to their size. They may not have accumulated sufficient assets and may also not qualify to be quoted on the stock exchange and this would tend to lower the value of their shares as their demand would be low.
6. Growth prospects of the company – Companies with ambitious expansion or
growth programmes will retain most of their earnings to facilitate growth. In the short-run they may pay no dividends which would tend to lower the share values. Investors who are far-sighted tend to buy such shares of potential growing companies for speculative reasons in the hope that they will get higher returns in the future. In this case the investments must be spread over several types of securities to spread risks should such a speculation work against the hopes of investors.
7. Political circumstances / Prevailing atmosphere – Stability in political
atmosphere is conducive to stable economic performance of a given country especially to long-term investments. Shares are long-term investments and investors have a higher demand for shares of companies operating in politically stable countries.
8. Attitudes of both actual and potential investors – Investors may speculate on a
number of things regarding the company’s performance. For instance, they may speculate about the areas in which the company is operating or the composition of its management, both of which they may view negatively. This would in turn tend to lower the share prices of the company affected.
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