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What are Stocks?

Everyone talks about stocks and everyone thinks that people in the stocks business are always getting rich, that they are stealing from other people and that stocks are just something really mean. But what are stocks really? I will try to answer this question in this article.

Stocks are pieces of paper. But not just regular ones. Every piece of paper is actually a part of the company. For example a company that has one hotel has 1 million euros worth of capital, because this is how much one hotel costs. Now there aren’t many people in this world that would be able to afford to give one million euros to be the owner of this kind of a company. That is why we invented stocks. Let’s say we split this 1 mil company into 1.000 parts. That would mean that this company can have 1.000 owners, each one owning 1.000 euros worth of the hotel. This is more or less the explanation of the stocks. Stocks are these parts of the company.

Each stock would be worth 1.000 euros in our case and there could potentially be 1.000 owners of this company. Of course usually people own more than on share and there are way less stockholders than there are stocks. But you understand the idea now.

If this is all there is about stocks, how come some people are making lots of money out of it?

There are two ways to earn money from stocks. First one are dividends and second one are capital gains. You can read more about these two in other articles on MakeMoneyInStocks.net because here we’ll just give a very short description of both.

Dividends

Dividends are nothing else but profits. If our hotel made 10.000 EUR of profit last year, this could be payed out to the owners. So if we split 10.000 EUR of profits between 1.000 stocks, then each stock would make 10 EUR. That’s not a lot since people are usually looking for 5-25 % return in stocks, but that’s not the only way to get money out of stocks.

Capital gains

Capitals gains are usually the ones that help people make these huge profits. What are capital gains? Well stocks aren’t always worth their nominal value. In our case, stocks have a nominal value of 1.000 euros, but they will usually be sold at a higher price. Why? Well because this hotel has a good brand, it makes profit and people are willing to pay for that profit. But stocks can also be worth less than a nominal value, if hotel has a “bad name” and investors don’t think it will make any profits. This speculations about profits are always changing and as they change, so does the price. Now if you can anticipate these changes you can make lots of money. Let’s give an example.

Today people think our hotel will not earn any money. That’s why the stock is worth only 500 EUR. But you believe that the company will make lots of profit next year and you buy 10 stocks. Next year, this actually happens. Hotel starts making profit and price of these stocks goes to 1.500 EUR. You now sell them at this price, because you think the hotel will stop making profit next year. You just sold 10 stocks with a total profit of 10.000 euros. This is how the capital gains work.

I hope you now understand better what are stocks and how you can make money out of them.

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25. Feb, 2011
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Gordon Model

Valuing a firm is very important when it comes to fundamental investing, that is, for investors who plan to invest for a medium to longer time period. According to ‘Value Investors’, investing in a business is worth while only if its‘Present Value’ (also referred to as ‘Intrinsic Value’ or ‘Fundamental Value’) is more than its current market value. In simple words, it is worth investing in a stock only if present value of all the expected gains from this stock (in the form of dividends and capital appreciation) is higher than the current market value. When Present Value (PV) is higher than the current market price, the stock said to be being ‘Undervalued’ , and when it is lower than the market value, the stock is referred to as being ‘Overvalued’.

For example, consider stock of a Company A with current market price of $20. A value investor will consider investing in this stock only if he feels that the intrinsic value is greater than $20. That is, he assumes that Company A is ‘undervalued’. On the contrary, if the PV is less than $20, an investor may consider selling it short. It’s important to remember is that a cheap stock is not necessarily ‘under valued’. A low price may reflect poor market sentiments or a general economic slowdown and may not necessarily mean that it is under valued.

PV is calculated by discounting all the future gains expected from a stock using the rate of return expected by the investor. These gains may be in the form of dividends and capital appreciation.

Dividend Discounting Method (DDM)

This is the most familiar method applied for valuing companies that have consistently paid out dividends to their investors over the last few years, and are assumed to pay dividends over the next few years as well. Mature companies generally pay-out dividends regularly and are valued using this method. DDM can be modified for companies that are expected to grow consistently at the same rate, or at a higher rate for the first few years and later grow at a lower rate. Following are some of the commonly used DDM formulas.

Companies that are expected to pay consistent dividend per share perpetually can be valued as:

Present Value = Dividend per share / Discount Rate

This is the most basic DDM formula. However, its biggest shortcoming is that it assumes zero growth, which is taken care in the following formula:

Present Value = Dividend per share / (Discount Rate – Dividend Growth rate)

Companies that are expected to grow at a constant rate perpetually can be valued using this formula, which is also referred to as Gordon Model or Constant Growth DDM. However, it cannot be applied if dividend growth rate exceeds the investor’s rate of return, as the denominator will be negative and a stock value can never be negative.

DDM can be further modified as a Multi Stage DDM for valuing companies that are expected to grow at varying rates initially and then at a constant rate perpetually. For example, a company say, A, can be expected to grow at 10% annually for the initial 3 years, at 7% for the following 3 years and then at 4% perpetually.

While applying DDM for valuing stocks, investors should bear in mind that the value calculated will be as good as their assumptions applied in DDM. A lot of assumptions need to be applied while valuing a stock using DDM. An investor should have a strong fundamental understanding of the company to determine its earnings growth rate and its dividend pay-out ratio, besides knowing his/her own risk adjusted rate of return. Understanding your risk profile will enable you to set a realistic expected rate of return. Hence, PV of a stock will be different for every investor. Higher the expected return, lower will be the PV. Similarly, longer the time period for holding the stock, lower the PV.

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06. Jan, 2011