Question

Why is stock valuation more challenging than bond valuation? Are dividend paying stocks easier to value than non-dividend paying stocks? Why or why not?

Answer 1

Valuation of a stock is more difficult compared to bond valuation because stocks lack a maturity value. The prediction of the future amount of money...

You have to discount the cash flow in both instances - find the present value of the assets. The only difference between stocks and bonds is that, bonds have a fixed coupon payment, years to expiration, and face value, which makes determining their present value simpler.

For example, a bond with having a Face Value = $1000; Annual Coupon payment = $100; Years to expiration = 3 years; Interest rate = 5% can be valued as, 100/1.05+100/(1.05)2+1100/(1.05)3=$1136.16100/1.05+100/(1.05)2+1100/(1.05)3=$1136.16

The ease here is that we are aware of most of the variables - barring the interest rate (5%).

In theory you first have the risk free rate, which is the rate at which a risk free asset pays interest. However, in reality there is no such thing, but in the USA the US treasury rate is serves as a good proxy. For the relevant bond at hand, a ‘risk premium’ is added to that ‘risk free rate’ to get the rate at which you need the discount the cash flows. Furthermore, a liquidy preference and future expectations of interest rates also affect the value of the bonds.

Valuation of stocks is more complicated, because not only is the expiration date uncertain (a business can go on forever), the cash flows are also not fixed (yearly revenues are varied), and you need to come up with an appropriate discount rate again - making most of the valuation guess work, or extrmely probabilistic in it's conclusion.

There is also a theoretical model, for valuing a stocks based on dividends alone, P=D1/R−gP=D1/R−g. Here the value is the dividend of next period (D1), divided by the required rate (R, estimated using CAPM or DGM) minus the growth rate (g). However, not all companies pay dividends so the problem with this model is very obvious.

In reality, you can simply look at the book value (assets - liabilities) of a company and compare it with the market value (share price*number of shares) to determine how 'valued' (over or under) the stock is, or look at the Price/Equity ratio and compare it with the industry average etc.

Essentially to value stocks you can choose a number of different methods, based on each person's individual preference and the situation at hand.

There is no formula for non dividend stock

Non-dividend paying stocks have value for two reasons:

1. People expect that at some point in the future they will pay a dividend

2. People expect that at some point in the future, the company in question will be acquired by another company.

The stock price for a non-dividend paying stock is the value of the likelihood and monetary value of those two future events, discounted because they are future events.

Value of a Preferred Stock

Unlike common equity, preferred stocks pay a fixed dividend. As such, the value of a preferred stock can be calculated using the dividend discount model. The value of the preferred stock is essentially the present value of the dividend in perpetuity, where k is the required return.

Value of a preferred stock

There are many other methods

Thereby valuing non dividend stock is difficult