Common stocks with a stream of future dividends are valued the same way as the present value of the expected future dividend cash flows, given that investors hold their stocks perpetually. If investors sell their stocks, the sale price is also part of the future cash flows. However, since the stock price at the future sale date would depend on the dividends that the future buyer expects, common stock valuation is always the present value of a stock's infinite stream of dividends.
Stock valuation is a function of each individual investor's own estimate of a stock's expected future dividend stream. Although the estimated dividend amount is specific to the investor doing the analysis, the pattern of dividend payouts by companies could be quite general. Corporate boards usually do not declare dividend payments high in one year and low in the next. To maximize shareholder value, which is almost a public company's mandate, companies try to pay dividends at a constant growth rate aiming to achieve a consistent growth in their stock value. Since current year dividend is a known number, by assigning a dividend growth rate, investors can then prescribe their estimation about a stock's expected future dividend stream.
Stock valuation is also a function of individual investors' risk assessment on future dividends. Investors may not view the possibility of receiving the amount of dividends they have expected to exactly the same degree. The more risky a stock's dividends are, the less value the stock has, given that the amount of dividends as estimated is the same for different investors. The different risk levels are expressed in rates of return that investors would expect to earn if purchasing the stock at its expected value. Such a rate is both the compounding rate on the stock investment and the discount rate for its future dividends.
Expected Stock Value
Stock valuation is the searching of intrinsic value of a stock today based on a particular investor's estimate of the stock's expected dividend stream and the riskiness of receiving the dividends as expected. The concept is the basis of the dividend discount model used to arrive at the expected, intrinsic value of a stock that pays steady future dividends. A stock's expected value could differ among investors depending on how they regard the company in terms of its dividends.
Actual Stock Price
While there may be many different valuations among investors at the same time, there is only one actual stock price as traded in the market and it is fixed for all investors. A stock's market price is closely related to stock valuations. In fact, the market price is settled on the marginal valuation that investors have come to agree on through continued buying and selling. Different valuations intersect to create a market price equilibrium until there is another imbalance of supply and demand.
Benefit of Stock Valuation
The main purpose of stock valuation is to identify whether a stock is undervalued, overvalued or fairly priced. By comparing their stock valuation with the stock's market price, individual investors can make their stock trading decisions accordingly. When a stock's valuation is above the stock's market price, the investor buys the stock. When the investor's valuation is below the market value, the investor sells the stock. If valuation is equal to the market, the investor holds the stock.
- Bureau of Economic Analysis. "How Are Dividends Defined in the U.S. National Accounts?" Accessed Nov. 10, 2019.
- U.S. Securities & Exchange Commission. "Ex-Dividend Dates: When Are You Entitled to Stock and Cash Dividends." Accessed Nov. 10, 2019.
- NASDAQ. "The Truth About Dividend Payout Ratio." Accessed Nov. 11, 2019.
An investment and research professional, Jay Way started writing financial articles for Web content providers in 2007. He has written for goldprice.org, shareguides.co.uk and upskilled.com.au. Way holds a Master of Business Administration in finance from Central Michigan University and a Master of Accountancy from Golden Gate University in San Francisco.