Question

1. How might one value common stock? Discuss some of the commonly used methods. Do you think interest rates have any impact on the value of common stock? If so, how and if not, why not?
2. Based on the current level for the S&P500 market average, would you recommend stocks as an attractive asset class? Explain in detail your rationale for being interested in buying stocks or not in the current environment.

Answer 1

Common stock is a security that represents ownership in a corporation. Holders of common stock elect the board of directors and vote on corporate policies. This form of equity ownership typically yields higher rates of return long term. However, in the event of liquidation, common shareholders have rights to a company's assets only after bondholders, preferred shareholders, and other debt holders are paid in full. Common stock is reported in the stockholder's equity section of a company's balance sheet.

                                                 If a company goes bankrupt, the common stockholders do not receive their money until the creditors, bondholders, and preferred shareholders have received their respective share. This makes common stock riskier than debt or preferred shares.       

1. Common stock is a security that represents ownership in a corporation.

2. In liquidation, common stockholders receive whatever assets remain after creditors, bondholders, and preferred stockholders are paid.

3. There are different varieties of stocks traded in the market. For example, value stocks are stocks that are lower in price in relation to their fundamentals. Growth stocks are companies that tend to increase in value due to growing earnings.

4. Investors should diversify their portfolio by putting money into different securities based on their appetite for risk.

a. A value stock is a stock that trades at a lower price relative to its fundamentals, such as dividends, earnings, or sales, making it appealing to value investors.

1. Common characteristics of value stocks include high dividend yield, low P/B ratio and/or a low P/E ratio.

2. A value stock typically has a bargain-price as investors see the company as unfavorable in the marketplace.

3. A value stock typically has an equity price lower than stock prices of companies in the same industry.

                                                 A value stock is a security trading at a lower price than what the company’s performance may otherwise indicate. Investors in value stocks attempt to capitalize on inefficiencies in the market, since the price of the underlying equity may not match the company’s performance.

                                                    it is important to understand that the stock's intrinsic value is not necessarily directly tied to its current market price, though some would have you believe it is. In fact, there are many who buy into the efficient market hypothesis, a theory that states that all known information is currently priced into a stock. The implication of this theory is that beating the market is almost purely a matter of chance and not one of expert stock selection.

b. Methods of stock valuation

Valuing stocks is an extremely complicated process that can be generally viewed as a combination of both art and science. Investors may be overwhelmed by the amount of available information that can be potentially used in valuing stocks (company’s financials, newspapers, economic reports, stock reports, etc.).

Two Categories of Valuation Models

1. Absolute

Absolute stock valuation relies on the company’s fundamental information. The method generally involves the analysis of various financial information that can be found in or derived from a company’s financial statements. Many techniques of absolute stock valuation primarily investigate the company’s cash flows, dividends, and growth rates. Notable absolute stock valuation methods include the dividend discount model (DDM) and the discounted cash flow model (DCF).

2. Relative

Relative stock valuation concerns the comparison of the investment with similar companies. The relative stock valuation method deals with the calculation of the key financial ratios of similar companies and derivation of the same ratio for the target company. The best example of relative stock valuation is comparable companies’ analysis.

Stock Valuation Methods

1. Dividend Discount Model (DDM)

The dividend discount model is one of the basic techniques of absolute stock valuation. The DDM is based on the assumption that the company’s dividends represent the company’s cash flow to its shareholders. the model states that the intrinsic value of the company’s stock price equals the present value of the company’s future dividends. Note that the dividend discount model is applicable only if a company distributes dividends regularly and the distribution is stable.

2. Discounted Cash Flow Model (DCF)

The discounted cash flow model is another popular method of absolute stock valuation. Under the DCF approach, the intrinsic value of a stock is calculated by discounting the company’s free cash flows to its present value.

3. Comparable Companies Analysis

The comparable analysis is an example of relative stock valuation. Instead of determining the intrinsic value of a stock using the company’s fundamentals, the comparable approach aims to derive a stock’s theoretical price using the price multiples of similar companies.

                                The most commonly used multiples include the price-to-earnings (P/E), price-to-book (P/B), and enterprise value-to-EBITDA (EV/EBITDA). The comparable companies analysis method is one of the simplest from a technical perspective.

4. The Bottom Line

No single valuation model fits every situation, but by knowing the characteristics of the company, you can select a valuation model that best suits the situation. Additionally, investors are not limited to just using one model.

c. interest rates have any impact on the value of common stock? If so, how and if not, why not?

                                             The investment community and the financial media tend to obsess over interest rates—the cost someone pays for the use of someone else's money—and with good reason.

1. When the Fed changes interest rates, it affects markets in both direct and indirect ways as borrowing becomes more or less costly for individuals and businesses.

2. The stock market's reaction to interest rate changes is generally immediate, however the real economy takes about a year to see any widespread effect.

3. Higher rates tend to negatively affect earnings and stock prices, with the exception of the financial sector - and vice-versa

Interest Rate That Impacts Stocks

               The interest rate that moves markets is the federal funds rate. Also known as the discount rate, this is the rate depository institutions are charged for borrowing money from Federal Reserve banks. The federal funds rate is used by the Federal Reserve (the Fed) to attempt to control inflation. By increasing the federal funds rate, the Fed basically attempts to shrink the supply of money available for purchasing or doing things, thus making money more expensive to obtain.

                        When the Fed increases the discount rate, it does not directly affect the stock market. The only truly direct effect is that borrowing money from the Fed is more expensive for banks. But, as noted above, increases in the rate have a ripple effect. Because it costs them more to borrow money, financial institutions often increase the rates they charge their customers to borrow money. Individuals are affected through increases to credit card and mortgage interest rates, especially if these loans carry a variable interest rate. This has the effect of decreasing the amount of money consumers can spend.

                                                     A decrease in interest rates by the Fed has the opposite effect of a rate hike. Investors and economists alike view lower interest rates as catalysts for growth—a benefit to personal and corporate borrowing, which, in turn, leads to greater profits and a robust economy. Consumers will spend more, with the lower interest rates making them feel they can finally afford to buy that new house or send their kids to a private school. Businesses will enjoy the ability to finance operations, acquisitions, and expansions at a cheaper rate, thereby increasing their future earnings potential, which, in turn, leads to higher stock prices.

d. Based on the current level for the S&P500 market average, would you recommend stocks as an attractive asset class?

1. The S&P 500 index is a benchmark of American stock market performance, dating back to the 1920s.

2. The index has returned a historic annualized average return of around 10% since its inception through 2019.

3. While that average number may sound attractive, timing is everything - get in at a high or out at a relative low and you will not enjoy such returns

                                                       Another major factor in annual returns for an investor in the S&P 500 is when they choose to enter the market. Investors who buy during market lows and hold their investment, or sell at market highs, will experience larger returns than investors who buy during market highs, particularly if they then sell during dips. It's clear that the timing of a stock purchase plays a role in its returns. For those who want to avoid the missed opportunity of selling during market lows, but don't want the risk of active trading, dollar-cost averaging is an option.

An asset class is a grouping of investments that exhibit similar characteristics and are subject to the same laws and regulations. Asset classes are made up of instruments which often behave similarly to one another in the marketplace. Historically, the three main asset classes have been equities (stocks), fixed income (bonds), and cash equivalent or money market instruments.

An examination of several decades of historical asset class returns shows that stocks have outperformed almost all other asset classes. Using the 87-year period from 1928 to 2015, the S&P 500 returned an average of 9.5% per year. This compares favorably to the 3.5% return of three-month Treasury bills and the 5% return of 10-year Treasury notes.

                                        The Standard & Poor’s 500 Index is a collection of stocks intended to reflect the overall return characteristics of the stock market as a whole. The stocks that make up the S&P 500 are selected by market capitalization, liquidity, and industry. Companies to be included in the S&P are selected by the S&P 500 Index Committee, which consists of a group of analysts employed by Standard & Poor's.

1.    In a low interest-rate environment, investors may be tempted to dabble in stocks to boost short-term returns, but it makes more sense—and pays out higher overall returns—to hold on to stocks for the long-term.

2. The main reason to buy and hold stocks over the long-term is that long-term investments almost always outperform the market when investors try and time their investments.

3. Emotional trading tends to hamper investor returns.

4. Over a 20-year time period, the S&P 500 has always posted a positive return, no matter when you would have invested.

5. Riding out temporary market downswings is considered a sign of a "good investor."