Stock Valuation by Dividends
There are two reasons why people by stocks. First one is investing to earn money from dividends and the second one is buyins stocks out of speculations to make profit on capital gains. Now how do we valuate stocks? I will show you how to valuate stocks and I will try to show you why should stocks be valuated by dividends.
So one decides to buy stocks in order to raise his value of capital, to make profit. He buys it by 100$ and he sells it after one year. Now how did he make money from it? One source of profit are dividends, which are the most important ones. Let’s first tell what dividends actually are and then I will tell you why are the dividends the only source of profit when investing in stocks that matters.
Companies make profit (at least they should) and this profit can go into many places. Let’s split those places into two groups. First one is “Stays in company” and second one is “Goes to stock owners”. Now the profit that goes out of a company and is splited onto all stocks and then payed to stock owners is named dividends. So dividends are nothing but profit of a company payed to stockholders.
Now the other source of income for out investor is the capital gain. Capital gain is the price that he sold the stock for minus the price that he bought the stock for. As you might have figured it out already, he can earn money if he buys cheaper then he sells and he can lose money if he sells cheaper than he bought. Becouse we cannot know how much stocks will be worth after one year (when we decide to sell) we valuate stocks only by its dividends. We can assume a certain ammount of growth in value, since the companies ussually grow with time, but this is higher valuation and I will speak about it in a different article coming out soon. Let’s tell a little bit more about how to valuate stocks by dividends.
First we need to know how much we want to make out of buying a stock for one year. This is ussually given in a percent, like 5% profit in one year. We then turn this into koeficient (5% – 0.05) and they move on to predicting the dividend that will come to us by owning the stock for one year. Let’s assume that the dividend will be the same as it was last year and we know that last year it was 7 $. We then calculate the price of the stock we are willing to pay for by this formula:
Price=Dividend/r
, where r is koeficient of our wanted profit (0.05 in our case). If we do the math for our example, we get that the valuation of this stock shows 140 $ worth. So if we can buy this stock for 140 $ or less, we are going to buy it.
Now the interpretation of this stock valuation by dividends. If we know we are going to get 7 $ in dividend and if we want this 7 $ to be 5% return on our investment then we are willing to invest 140 $ into this stock.
Hope this gave you a brief idea on how to valuate stock and I hope you now understand why stocks should be valuated only by its dividends and not its capital gains as well.
Written by: Matt
We also suggest this relevant article if you have time: When to Invest in Stocks?
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